PHOTON DYNAMICS INC - 10-Q Quarterly Report

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨

As of July 30, 2004, there were 16,807,936 shares outstanding of the Registrant’s Common Stock, no par value.

NOTE 1—Basis of Presentation and Summary of Significant Accounting Policies

Basis of Presentation. The accompanying unaudited condensed consolidated financial statements of Photon Dynamics, Inc. (“Photon Dynamics” or the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, the unaudited interim financial statements reflect all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation of the financial position, results of operations and cash flows for the periods indicated.

These financial statements and notes should be read in conjunction with “Item 8, Financial Statements and Supplementary Data” included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2003, filed with the Securities and Exchange Commission on December 24, 2003. Operating results for the three and nine months ended June 30, 2004, are not necessarily indicative of the results that may be expected for any other interim period or for the full fiscal year ending September 30, 2004.

The condensed consolidated balance sheet as of September 30, 2003 is derived from the Company’s audited consolidated financial statements as of September 30, 2003, included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission, but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

Description of Operations and Principles of Consolidation. Photon Dynamics is a supplier of integrated yield management solutions for the flat panel display industry. The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. Intercompany accounts and transactions have been eliminated.

Through January 14, 2003, the Company conducted business in three operating segments: flat panel display products, cathode ray tube display and high quality glass inspection products and printed circuit board assembly inspection products. In January 2003, the Company implemented a plan to exit the printed circuit board assembly inspection business. In June 2003, the Company implemented a plan to exit the cathode ray tube display and high quality glass inspection businesses. Accordingly, the operating results of these former business segments have been presented as discontinued operations in accordance with the provisions of Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets,” (“FAS 144”) and the Company’s condensed consolidated financial statements and related footnotes have been reclassified to conform with the current period’s basis of presentation. Accordingly, in the condensed consolidated statements of operations, the net operating results of these former businesses have been classified as “loss from discontinued operations,” for all periods presented. The cash flows from these businesses have been presented as “Net cash flows from discontinued operations” in the operating, investing and financing sections of the condensed consolidated statements of cash flows.

Management Estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

Fair Value of Financial Instruments. The Company evaluates the estimated fair value of financial instruments using available market information and valuation methodologies as provided by the custodian. The use of different market assumptions and/or estimation methodologies could have a negative effect on the estimated fair value amounts. The fair value of the Company’s cash, cash equivalents, accounts receivable, accounts payable and other current liabilities approximates the carrying amount due to the relatively short maturity of these items. The Company’s derivative instruments, consisting of forward exchange contracts, are recorded at fair value based on quoted market prices for comparable instruments.

Inventories. Inventories, consisting of raw materials, work in process and finished goods, are stated at the lower of cost (first-in, first-out) or market. Inventory which is obsolete (defined as inventory that will no longer be used in the manufacturing process) or in excess of the forecasted usage is written down to its estimated market value based on projected demand, historical usage and other known factors. Photon Dynamics reviews the valuation of its inventories on a quarterly basis. If actual demand were to decline below the Company’s forecasts, the Company may need to take additional inventory write-downs.

Concentration of Credit and Other Risk. Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of available for sale securities, trade accounts receivable and derivative financial instruments used to mitigate the effect of exchange rate changes.

The Company invests excess cash in securities that the Company believes bear minimal risk. These investments are of a short-term nature and include investments in auction rate preferred securities, commercial paper and government and corporate debt securities. The Company has not experienced any losses due to institutional failure or bankruptcy.

The Company’s principal customers are located in Korea, Taiwan and Japan. Therefore, the Company’s sales to these customers may be adversely affected by the overall health of these economies, including the effects of currency exchange rate fluctuations. The Company generally does not require collateral for most of its trade accounts receivable. The Company maintains a provision for potential credit losses based upon expected collectibility of all accounts receivable. For sales to some of its customers the Company requires letters of credit. The majority of the Company’s revenue is invoiced in U.S. dollars. The Company believes its credit evaluation and monitoring mitigates its credit risk.

The Company is exposed to credit loss in the event of non-performance by counterparties on the foreign exchange contracts used to mitigate the effect of exchange rate changes. These counterparties are large international financial institutions and to date, no such counterparty has failed to meet its financial obligations to the Company. Photon Dynamics does not anticipate nonperformance by these counterparties.

The Company’s products include certain components that are currently single-sourced. The Company believes that other vendors would be able to provide similar components; however, the qualification of such vendors may require start-up time. In order to mitigate any adverse impacts from a disruption of supply, the Company attempts to maintain an adequate supply of critical single-sourced components.

Revenue Recognition. Photon Dynamics derives revenue primarily from the sale and installation of equipment and spare part sales. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the selling price is fixed or determinable and collectibility is reasonably assured.

The Company accounts for certain of its product sales, including sales to a value-added reseller, as arrangements with multiple deliverables in accordance with Emerging Issues Task Force Issue 00-21 “Revenue Arrangements with Multiple Deliverables.” For arrangements with multiple deliverables, the Company recognizes revenue for the delivered items if the delivered items have value to the customer on a standalone basis, the amount of revenue for delivered elements is not subject to refund, the Company has met defined customer acceptance experience levels for the delivered items, and the fair value of undelivered items, such as installation and system upgrade rights, can be reliably determined. The Company allocates revenue to the delivered items based on the lesser of the amount due and billable upon shipment and the allocated fair value, with the remaining amount recognized after installation and acceptance when the final amount becomes due. The Company recognizes all other product sales upon customer acceptance. The Company recognizes revenue from the sale of spare parts generally upon shipment.

Terms and conditions of the Company’s sale of products to its value-added reseller are generally consistent with terms and conditions offered to other customers and title typically transfers to the value-added reseller upon shipment. The Company does not grant any rights of return, stock rotation or price protection for its product sales to its value-added reseller. Accordingly, sales transactions with the value-added reseller are recorded in accordance with the policy stated above.

The Company records a provision based on historical rates for estimated sales returns in the same period as the related revenue is recorded, which is netted against revenue.

The Company’s products are generally subject to warranty and such estimated costs are provided for in costs of sales when product revenue is recognized. Installation and other services are not essential to the functionality of the products as these services do not alter the product capabilities, do not require specialized skills or tools and can be performed by other vendors.

Shipping Costs. The Company’s shipping and handling costs are included under cost of sales for all periods presented. In those instances where the Company does bill for shipping and handling, the amounts billed are classified as revenue.

Research and Development Cost. Costs to develop the Company’s products, which include both hardware and software components are expensed as incurred. Software incorporated in the Company’s products is an integral part of the overall product design process and costs to develop software, which is deemed to be incidental, are not tracked separately. The Company does not sell or market any software product on a standalone basis.

Interest Income. Interest Income was approximately $325,000 and $563,000 for the three months ended June 30, 2004 and 2003, respectively and $1.2 million and $2.1 million for the nine months ended June 30, 2004 and 2003, respectively.

Stock-Based Compensation Plans. The Company accounts for its stock-based employee compensation plans in accordance with the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations. Statement of Financial Accounting Standards No. 148 “Accounting for Stock-Based Compensation Transition and Disclosure” (FAS 148) amends the disclosure provisions of Statement of Accounting Standards No. 123 “Accounting for Stock-Based Compensation” (FAS 123) to require prominent disclosure about the effects on reported net income of an entity’s accounting policy decisions with respect to stock-based employee compensation. Finally, this Statement amends APB Option No. 28, “Interim Financial Reporting,” to require disclosure about those effects in interim financial information. Because Photon Dynamics continues to account for stock-based compensation according to APB 25, its adoption of SFAS 148 required the Company to provide prominent pro forma disclosures about the effects SFAS 123 would have on reported income if it were the method of accounting utilized by the Company to account for its stock options and required the Company to disclose these effects in the financial statement footnotes.

Pro forma information regarding net income and earnings per share is required by FAS 123 and has been determined as if the Company had accounted for its employee stock purchase plan and employee stock options under the fair value method of FAS 123. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model for the multiple option approach with the following weighted-average assumptions:

SFAS 123 requires the use of option pricing models that were not developed for use in valuing employee stock options. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s employee stock option and employee stock purchase plans have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of such Company options.

For purposes of pro forma disclosures required by FAS 123, the estimated fair value of the options is amortized to expense over the options’ vesting periods. The Company’s pro forma information for the three and nine months ended June 30, 2004 and 2003 is as follows:

The Company’s printed circuit board assembly inspection products enabled printed circuit board assembly inspection manufacturers to detect and identify defects, thereby increasing yields and quality and reducing costs. The Company previously sold its products for the printed circuit board assembly industry primarily through sales representatives and distributors. The Company generally recognized revenue from the sale of its printed circuit board assembly inspection products upon shipment as such product sales were not subject to customer acceptance provisions. In January 2003, the Company implemented a plan to exit the printed circuit board assembly inspection business. Accordingly, the operating results of this former business segment have been reclassified as a discontinued operation for all periods presented. As of June 30, 2004, the Company has completed liquidation of the operation’s remaining inventory through a third-party auctioneer and is attempting to sublease the facilities associated with the discontinued operations, but there can be no assurances that the Company will be successful in recovering any additional costs associated with this discontinued operation.

The following table summarizes the results of the printed circuit board assembly inspection products reporting segment for the three and nine months ended June 30, 2004 and 2003:

The loss from discontinued operations for the three and nine months ended June 30, 2004 includes litigation costs of approximately $169,000 and $1.4 million, respectively, for settlement of prior inventory purchase commitments, the settlement of the Thomason v. Photon Dynamics lawsuit (See Note 10) and the legal expenses incurred as part of the settlement.

The loss from discontinued operations for the nine months ended June 30, 2003 includes a write-off of inventory of approximately $7.8 million, a write-off of accounts receivable of approximately $1.7 million and a write-off of licensed technology of approximately $1.9 million. In addition to these charges, the loss from discontinued operations for the nine months ended June 30, 2003 includes impairment charges of approximately $15.1 million of goodwill, $2.9 million of purchased intangibles and $2.5 million of long-lived assets. These charges were recorded as a result of management’s assessment of indicators of impairment that existed prior to the Company’s formal decision to discontinue the operations of this segment in January 2003. Such impairment charges were recorded in accordance with the provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” and FAS 144.

The following summarizes the assets and liabilities of the printed circuit board assembly inspection products discontinued operations:

Other current assets at June 30, 2004, include a receivable of approximately $663,000 against shares that are being held in escrow related to the IRSI acquisition and approximately $202,000 in security deposits on various leases.

Other current liabilities at June 30, 2004, include approximately $84,000 related to current operating lease obligations and approximately $537,000 related to potential vendor obligations. Other liabilities of approximately $137,000 relate entirely to non-current operating lease obligations. Lease obligations are to be paid out through December 2006.

In the second quarter of fiscal 2003, in accordance with Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“FAS 146”), the Company recorded a liability of approximately $2.0 million for costs associated with the discontinuation of the business, including termination benefits of approximately $700,000 and approximately $1.3 million of purchase obligations to suppliers. The following summarizes the liability since inception:

The Company’s cathode ray tube display and high quality glass inspection products allowed cathode ray tube display manufacturers to locate and characterize defects and glass manufacturers to detect and identify defects such as scratches, pits, bubbles, stones, inclusions and distortions, thereby increasing yields and quality and reducing costs. The Company previously sold its products for the cathode ray tube display and high quality glass inspection industry primarily through sales representatives and distributors. The Company generally recognized revenue from product sales upon customer acceptance. In June 2003, the Company implemented a plan to exit the cathode ray tube display and high quality glass inspection business. Accordingly, the operating results of this former business segment have been reclassified as a discontinued operation for all periods presented and the Company now conducts business in one segment.

The following table summarizes the results of the cathode ray tube display and high quality glass inspection products reporting segment for the three and nine months ended June 30, 2004 and 2003:

The following summarizes the assets and liabilities of the cathode ray tube display and high quality glass inspection discontinued operations:

Other current liabilities at June 30, 2004, include approximately $184,000 related to warranty obligations, approximately $287,000 related to operating lease obligations, approximately $309,000 related to a loan payable and approximately $41,000 in other accrued amounts. Lease obligations are to be paid out through March 2008. Future minimum lease payments, due by fiscal year are: $44,000 in fiscal 2004, $87,000 in fiscal 2005, $80,000 in fiscal 2006, $72,000 in fiscal 2007 and $4,000 in fiscal 2008.

The loan payable of approximately $309,000 relates to an advance from the National Research Council of Canada under a program for pre-commercialization assistance in the development of glass inspection technology. The Company is repaying this loan through June 2005.

In the third quarter of fiscal 2003, in accordance with FAS 146, the Company recorded a liability of approximately $1.9 million for costs associated with the discontinuation of the business. The following summarizes the liability since inception:

In May 2004, the Company sold all of its assets in Korea related to its TFT-LCD Backlight Inverter business to WOOYOUNG CO. LTD for approximately $481,000. The assets include inventory and production equipment for which the Company had previously recorded impairment charges, intellectual property and certain employees related to the inverter business. In the three months ended June 30, 2004, the Company recorded a gain on the transaction of approximately $419,000, which is included in “Interest income and other, net” in the Condensed Consolidated Statements of Operations.

In June 2004, the Company acquired from Quantum Composers, Inc., all of the assets of Quantum Composers related to the design and manufacture of laser assembly products for flat panel display LCD manufacturing and repair (the “Quantum Assets”). Quantum Composers designed and sold pulse generator and laser diagnostic systems and provided contract engineering and system design services to the laser industry. The purchase price was approximately $3.0 million, of which the Company paid $1.0 million up front and issued $2.0 million of non-interest bearing Notes Payable, due through June of 2007. In addition, the Company assumed approximately $156,000 of liabilities and incurred approximately $75,000 in acquisition-related expenses, consisting primarily of consulting, legal and accounting fees. The identifiable tangible assets acquired consisted primarily of inventory. The funds used to purchase the Quantum Assets came out of the Company’s working capital.

In May 2003, the Company acquired all of the assets of Summit Imaging, Inc. related to the design and manufacture of “cooled” cameras for the Company (the “Summit Assets”). Summit Imaging designed and manufactured cooled cameras for the capital equipment industry. The purchase price was $1.5 million of cash. In addition, the Company assumed approximately $15,000 of liabilities and incurred approximately $130,000 in acquisition-related expenses, consisting primarily of consulting, legal and accounting fees. The identifiable tangible assets acquired consisted primarily of inventory. The funds used to purchase the Summit Assets came out of the Company’s working capital.

In November 2002, the Company acquired certain assets relating to rapid thermal processing technology (the “RTP Assets”) from Intevac, Inc. (“Intevac”). The purchase price was $20.0 million of cash, of which $18.0 million was paid to Intevac at closing and an additional $2.0 million was placed into escrow to be released either to the Company or to Intevac depending on the occurrence of certain future events during the escrow period as follows: $1.2 million related to the attainment of a certain level of sales by the Company of equipment included in the RTP Assets acquired from Intevac; $500,000 related to the re-issuance of a former rapid thermal processing patent in Japan for certain acquired technology; and $300,000 for indemnification and reimbursement should Intevac breach any representations and warranties under the acquisition agreement.

In September 2003, the Company filed a claim against the escrow for the full $2.0 million. In October 2003, the Company received $1.7 million on its claim against the $2.0 million escrow related to the purchase of the RTP Assets from Intevac. The claim for the remaining $300,000 was resolved in favor of Intevac and, accordingly, the Company recorded an additional goodwill impairment charge in the three months ended December 31, 2003.

The acquisitions of Quantum Assets, Summit Assets and RTP Assets were accounted for under the purchase method of accounting. The purchase prices were allocated by management to the assets acquired and liabilities assumed taking into account an independent appraisal of their respective fair values. To determine the value of the developed and core technologies, the expected future cash flows attributed to all existing technology were discounted, taking into account risks related to the characteristics and application of the technology, existing and future markets and assessments of the life cycle stage of the technology. The value of the non-compete agreements was valued at the cash paid up front and the present value of the non-interest payments on the notes issued. The value attributed to the RTP backlog was related to purchase orders that had been received prior to the close of the acquisition, determined as the expected discounted cash flow resulting from the revenue related to the shipment of such orders, less normal profit margins.

The value of in-process research and development for all acquisitions was determined based on the expected cash flow attributed to the in-process projects, taking into account revenue that was attributable to previously developed technology, the level of effort to date in the in-process research and development, the percentage of completion of the project and the level of risk associated with the in-process technology. The projects identified as in-process were those that were underway as of the acquisition date and that will, after the applicable closing date, require additional effort in order to establish technological feasibility and have no alternative future uses. These projects have identifiable technological risk factors that indicate that even though successful completion is expected, it is not assured. The value of in-process research and development has been included in the Company’s results of operations.

The Company applied discount factors to the projected cash flows of the acquired technology in order to determine the present value, based on discount rates with inherent risk and expected growth of the developed, core and in-process technologies. The discount rates used for the Quantum Assets were 75% for both the core and in-process technologies. The discount rates used for the Summit Assets were 50% and 60% for the core and in-process technologies, respectively. The discount rates used for the RTP Assets were 15%, 20% and 25% for the developed, core and in-process technologies, respectively.

The acquired core technology and acquired developed technology associated with the Quantum Assets are being amortized over four years. The acquired core technology associated with the Summit Assets is being amortized over four years. The non-compete agreements from the Summit Assets and Quantum Assets are being amortized over two and three years, respectively. The RTP backlog was amortized to cost of sales at the time revenue was recognized for the related customer orders.

The purchase price for the Summit Assets and RTP Assets resulted in the recognition of goodwill. The primary factor contributing to the recognition of goodwill for Summit Assets was the ability to integrate a workforce with technical expertise. The primary factors contributing to the recognition of goodwill for the RTP Assets included 1) an increase in speed to market through acquisition of the business and associated products and technology, 2) the integration of a workforce with the technical expertise, and 3) a deeper penetration of the Company’s current customer base with a broader portfolio of products. The Company expects that the goodwill for both the Summit Assets and RTP Assets will be deductible for tax purposes in the United States.

The purchase price of the Quantum Assets resulted in the fair value of the identifiable assets acquired exceeding the cost of the acquired business by approximately $676,000. In accordance with Statement of Financial Accounting Standards No. 141 “Business Combinations,” the values of the non-current assets acquired were reduced by a proportionate part of the excess to determine the assigned values.

The acquired core technology and acquired developed technology associated with the RTP Assets were partially written off and the goodwill associated with the RTP Assets was entirely written off as part of the impairment of intangibles and goodwill impairment

charges taken in the fourth quarter of fiscal 2003. The remaining acquired core technology and acquired developed technology amounts were written off in the three months ended December 31, 2003 as additional impairment charges. These additional impairment charges were a result of the continuing deterioration in business conditions that included emergence of alternative and competing technologies, shrinkage of the potential total market opportunity due to one of the primary potential customer’s decision to pursue an alternative technology and further softness in this particular sector of the market since September 30, 2003. Accordingly, the Company performed an impairment analysis for the remaining acquired intangible assets as required by Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“FAS 144”).

The following pro-forma information presents the results of continuing operations of the Company for the nine months ended June 30, 2004 and 2003 as if the Quantum Assets, Summit Assets and RTP Assets had been acquired as of the beginning of the fiscal year of acquisition and the immediately preceding period. The pro-forma information does not purport to be indicative of what would have occurred had the acquisition been made as of these dates or of results that may occur in the future.

The pro forma results exclude nonrecurring charges, such as the write-off of purchased in-process research and development, which resulted directly from these transactions. The unaudited pro forma information is as follows:

Changes in the carrying amount of goodwill for the nine months ended June 30, 2004, are as follows:

In November 2002, as part of the acquisition of the RTP Assets, $2.0 million was placed into escrow to be released either to the Company or to Intevac depending on the occurrence of certain future events during the escrow period. In September 2003, the Company filed a claim against the escrow for the full $2.0 million. In October 2003, the Company received $1.7 million on its claim against the $2.0 million escrow related to the RTP Asset purchase from Intevac. The claim for the remaining $300,000 was resolved in favor of Intevac. Because the Company has written off all goodwill resulting from the acquisition of the RTP Assets, the $300,000 resolved in favor of Intevac resulted in an adjustment to record additional goodwill, which was deemed to be impaired due to continuing deterioration in business conditions during the three month period ended December 31, 2003 (See Note 4).

During the three months ended December 31, 2003, the Company recorded a goodwill impairment charge of approximately $365,000 under the provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“FAS 142”), representing the remaining goodwill associated with its Akcron reporting unit. This impairment charge was a result of the continuing softness in the inverter market since September 30, 2003. Accordingly the Company performed an impairment analysis for the remaining acquired intangible assets as required by FAS 144.

Goodwill as of June 30, 2004 relates entirely to the Company’s purchase of assets from Summit Imaging.

During the three months ended March 31, 2004, the Company signed a Termination and Assignment Agreement (the “Agreement”) with Ishikawajima-Harima Heavy Industries (“IHI”), the Company’s value-added reseller of its flat panel display products in Japan. Under the terms of the Agreement, all prior existing agreements between IHI and the Company were terminated, including IHI’s rights to sell and support the Company’s flat panel display products on an exclusive basis in Japan. As part of this agreement IHI assigned to the Company the right to use all intellectual property rights associated with the Company’s products held by IHI, including any patents and patent applications associated with the intellectual property rights. Additionally, as part of this agreement, IHI has retained rights to purchase systems from the Company for resale to one particular customer in Japan for purchase orders issued from the customer to IHI prior to April 1, 2005. The Company paid to IHI $1.5 million, consisting of $339,000 for IHI’s remaining field spares inventory and $1.1 million for the aforementioned intellectual property rights and other intangible assets. These intangible assets are being amortized over three years, beginning in April 2004.

During the three months ended December 31, 2003, the Company recorded impairment charges of approximately $2.1 million related to the remaining portion of the acquired developed technology and core technology related to the Akcron and RTP reporting units. These charges have been reflected in the results of operations in the quarter ended December 31, 2003 (See Note 4).

Photon Dynamics uses financial instruments, such as forward exchange and currency option contracts, to hedge a portion of, but not all, existing and anticipated foreign currency denominated transactions. The terms of currency instruments used for hedging purposes are generally consistent with the timing of the transactions being hedged. Under its foreign currency risk management strategy, the Company utilizes derivative instruments to protect its interests from unanticipated fluctuations in earnings and cash flows caused by volatility in currency exchange rates. This financial exposure is monitored and managed by the Company as an integral part of its overall risk management program which focuses on the unpredictability of financial markets and seeks to reduce the potentially adverse effects that the volatility of these markets may have on its operating results. As of June 30, 2004, the Company had entered into certain derivative instruments to protect its anticipated foreign currency exposures with these derivative instruments having original maturities of up to sixteen months.

The Company accounts for its derivatives instruments according to Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”), which requires that all derivatives be recorded on the balance sheet at fair value. Changes in the fair value of derivatives that do not qualify, or are not effective as hedges, must be recognized currently in earnings. The Company does not use derivative financial instruments for speculative or trading purposes, nor does it hold or issue leveraged derivative financial instruments.

The Company’s international sales are primarily denominated in U.S. dollars. For foreign currency denominated sales, however, the volatility of the foreign currency markets represents risk to the Company’s margins. The Company defines its exposure as the risk of changes in the functional-currency-equivalent cash flows (generally U.S. dollars) attributable to changes in the related foreign currency exchange rates. In fiscal 2003, the Company entered into certain transactions with forward sales contracts with critical terms designed to match those of the underlying exposure. The Company did not qualify these forward sales contracts as hedging instruments, as defined by FAS 133, and, as such, records the changes in the fair value of these derivatives immediately in “Interest

income and other, net” in the Company’s condensed consolidated statements of operations. At June 30, 2004 and 2003, the Company had foreign exchange forward contracts maturing throughout fiscal 2004 to sell approximately $2.9 million and $2.8 million, respectively, in foreign currencies, primarily Japanese Yen. The Company recorded a net gain of approximately $185,000 from changes in fair values of these foreign currency exchange contracts for the three month period ended June 30, 2004 and a net loss of approximately $23,000 from changes in fair values of these contracts for the nine month period ended June 30, 2004. Losses from changes in fair values for both the three and nine month periods ended June 30, 2003, were approximately $29,000. These gains and losses are included in “Interest income and other, net” in the condensed consolidated statements of operations. The fair value of these open contracts at June 30, 2004 and September 30, 2003 were approximately $231,000 and $208,000 respectively and are included in “Other current liabilities” in the condensed consolidated balance sheet.

Stock Option Plans. On January 26, 2004, at the Company’s Annual Meeting of Shareholders, the Company’s shareholders approved an increase of 400,000 shares reserved for grant under the Company’s 1995 Employee Stock Option Plan from a total of 2,990,943 shares to a total of 3,390,943 shares and an increase of 250,000 shares authorized for issuance under the Company’s 1995 Employee Stock Purchase Plan from a total of 1,250,000 shares to a total of 1,500,000 shares.

Stock Repurchase Program. In August 2002, the Company’s Board of Directors approved a stock repurchase program authorizing the Company to repurchase up to an aggregate of $25.0 million of the Company’s common stock. The repurchase program was terminated on January 15, 2003. The repurchases were made from time to time on the open market at prevailing prices, in negotiated transactions off the market or pursuant to a 10b5-1 plan adopted by the Company. The 10b5-1 plan allowed the Company to repurchase its shares during a period in which the Company was in possession of material non-public information, provided that the Company communicated share repurchase instructions to the broker at a time when it was not in possession of such material non-public information.

During the period October 1, 2002 through January 15, 2003, the Company repurchased 903,032 shares for an aggregate repurchase price of approximately $17.7 million. As of January 15, 2003, at the termination of the program, the Company had purchased a total of 1,253,932 shares for an aggregate repurchase price of approximately $24.6 million.

Basic net income (loss) per share is calculated using the weighted average number of shares of common stock outstanding. Diluted net income (loss) per share is computed in the same manner and also gives effect to all dilutive common equivalent shares outstanding during the period. Common equivalent shares consist of stock options issued to employees under employee stock option plans and warrants.

The following table sets forth the computation of basic and diluted net income (loss) per share:

During the three and nine month periods ended June 30, 2004, options to purchase 272,322 and 233,923 shares, respectively, were not included in the computation of diluted net income (loss) per share because the exercise price was greater than the average market price of common shares for the respective periods. During the three and nine month periods ended June 30, 2003, options to purchase 834,374 and 1,103,799 shares, respectively, were not included in the computation of diluted net income (loss) per share because the exercise price was greater than the average market price of common shares for the respective periods.

The Company’s open purchase commitments were approximately $40.0 million as of June 30, 2004. The majority of these purchase commitments relate to inventory purchases. The Company maintains certain open inventory purchase commitments with some of its suppliers to ensure a smooth and continuous supply chain for key components. The Company’s liability under these inventory purchase arrangements is generally restricted to purchase commitments over a forecasted time horizon as mutually agreed upon between the parties. The majority of these inventory purchase commitments are covered by confirmed customer orders.

The Company generally offers warranty coverage for a period of one year from the date of final customer acceptance. Upon product shipment, the Company records the estimated cost of warranty coverage, primarily material and labor to repair and service the equipment. Factors that affect the Company’s warranty liability include the number of installed units under warranty, product failure rates, material usage rates and the efficiency by which the product failure is corrected. The Company periodically assesses the adequacy of its recorded warranty liability and adjusts the amount as necessary.

Changes in the Company’s warranty liability during the nine month periods ended June 30, 2004 and 2003 were as follows:

The Company and certain of its directors and officers have been named as defendants in a lawsuit captioned Amtower v. Photon Dynamics, Inc., No. CV797876, filed on April 30, 2001 in the Superior Court of the State of California, County of Santa Clara. The plaintiff, who previously served as one of the Company’s officers, has asserted several causes of action arising out of alleged misrepresentations made to plaintiff regarding the existence and enforcement of the Company’s insider trading policy. The plaintiff is seeking damages of approximately $17.7 million for defendants’ alleged refusal to allow plaintiff to sell shares of the Company’s stock in May of 2000, plus unspecified emotional distress and punitive damages. On December 6, 2001, the court granted defendants’ motion to dismiss the complaint for failure to allege facts sufficient to state a cause of action, with leave to file an amended complaint. On January 17, 2002, plaintiff filed his amended complaint and defendants again moved to dismiss the action. On June 27, 2002, the court issued an order granting in part and denying in part the motion, and further granted plaintiff an opportunity to restate certain claims. On October 1, 2002, plaintiff filed his Second Amended Complaint, which was heard on April 8, 2003, and defendants again moved to dismiss the action. On April 21, 2003, the court granted in part and denied in part the Company’s motion. The pleadings have been finalized and certain claims against the Company and the individual defendants will proceed. The parties currently are engaged in discovery, and a court-mandated mediation session on July 30, 2004 did not resolve the case. No trial date has been set, although the Company expects the Court to set a trial date at the next Status Conference on August 19, 2004. The Company believes the plaintiff’s case is without merit and intends to defend this action vigorously. Although the Company cannot predict the outcome of this litigation, the Company believes that any adverse judgment in this litigation could have a material adverse effect on the Company’s financial condition or results of operations.

The Company has been named as a defendant in a lawsuit captioned Sanmina SCI Corporation v. Photon Dynamics, Inc., No. CV 013715, filed on February 3, 2004 in the Superior Court of the State of California, County of Santa Clara. The plaintiff in this action, who previously was a third-party manufacturer of the Company, has asserted several causes of action arising out of the alleged nonperformance by the Company of the manufacturing outsourcing agreement between the Company and the plaintiff, and is seeking approximately $3.1 million in compensatory damages and punitive damages in a unknown amount. The Company responded to the complaint on March 19, 2004, by filing an answer and cross complaint seeking damages of at least $135,000. The Company amended its cross complaint on June 26, 2004. The parties are currently seeking to mediate this dispute. Although the Company cannot predict the outcome of this litigation, the Company believes that any adverse judgment in this litigation would not have a material adverse effect on the Company’s financial condition or results of operations.

The Company was named as defendant in a lawsuit captioned Thomason v. Photon Dynamics, Inc. et al., No. 02CC03568, filed on February 28, 2002 in the Superior Court of the State of California, County of Orange. The plaintiff in this action purported to assert that he was wrongly not allowed to exercise certain stock options and sought damages of approximately $1.1 million and punitive damages in an unknown sum. On April 23, 2004, the parties to the litigation settled all litigation between them and the Company paid $750,000 to the plaintiff as part of the settlement agreement. The charge for this settlement is included in discontinued operations for the Printed Circuit Board Assembly Inspection Business in the Condensed Consolidated Statement of Operations.

The Company filed a lawsuit captioned Photon Dynamics, Inc. vs. PanelVision Technology and Guillermo Toro-Lira, No. CO202563PJH on May 28, 2002, in the U.S. District Court for the Northern District of California, County of Santa Clara. The Company was alleging infringement of a U.S. Patent owned by it and was seeking full compensatory damages and an injunction against the defendants. On July 17, 2002, the defendants answered the Company’s complaint and asserted a counterclaim alleging damages of at least $6.0 million in compensatory damages for loss of business. On January 23, 2003, the Company added Shimadzu Corporation as an additional defendant. On April 23, 2003, the defendants added additional counterclaims against the Company alleging violations of the antitrust laws and requesting the damages sought to be trebled. Subsequently, the court bifurcated the antitrust claims of Toro-Lira and Shimadzu Corporation against the Company, thus deferring any consideration of these claims until the conclusion of the patent infringement issues. On October 16, 2003, the parties to the litigation settled all litigation between them regarding US Patent 5,081,687, US Reissue Patent No.37,847 and Japanese Patent 3292990. Pursuant to the agreement between the parties, Shimadzu Corporation, companies affiliated with Shimadzu, and customers of Shimadzu are irrevocably licensed world-wide under US Patent 5,081,687, US Reissue Patent No.37,847 and Japanese Patent 3292990 and any corresponding patents to manufacture, use, and sell e-beam based panel test equipment designed by or for Shimadzu. All other terms of the settlement agreement are confidential. The proceeds of this settlement are included in “Interest income and other, net,” in the Condensed Consolidated Statements of Operations.

Photon Dynamics is named from time to time as a party to lawsuits in the normal course of its business. Litigation, in general, and intellectual property and securities litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict. We believe that we have defenses in each of the matters and are vigorously contesting each of these matters.

The Company sells its products directly to customers in Korea, Taiwan and Japan and through a value-added distributor, Ishikawajima-Harima Heavy Industries Co., Ltd., in Japan. For geographical reporting, revenue is attributed to the geographic location to which the product was shipped. Long-lived assets consist primarily of property, plant and equipment, goodwill and intangibles and are attributed to the geographic location in which they are located.

The following is a summary of revenue by geographic area based on location where the product was shipped:

Accounts receivable from individual unaffiliated customers in excess of 10% of total gross accounts receivable were as follows:

In July 2003, the Company extended its bank the line of credit until July 2004. In July 2004, the line of credit was extended through September 2004. The line of credit has a $4.0 million borrowing capacity and is secured by substantially all of the Company’s assets and contains certain financial and other covenants. The Company has not made any drawings under this line as of June 30, 2004.

On August 6, 2004, the Company acquired from Tucson Optical Research Corporation (“TORC”), all of the assets of TORC related to the design and manufacture of pellicle products which are used in the Company’s modulators (the “TORC Assets”). The purchase price was approximately $1.2 million. The funds used to purchase the TORC Assets came out of the Company’s working capital.

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual results could differ materially from those projected in the forward-looking statements as a result of a number of factors, risks and uncertainties, including the risk factors set forth in this discussion, especially under the caption “Factors Affecting Operating Results” in this Form 10-Q. Generally, the words “anticipate”, “expect”, “intend”, “believe” and similar expressions identify forward-looking statements. The forward-looking statements made in this Form 10-Q are made as of the filing date with the Securities and Exchange Commission and future events or circumstances could cause results that differ significantly from the forward-looking statements included here. Accordingly, we caution readers not to place undue reliance on these statements. We expressly disclaim any obligation to update or alter our forward-looking statements, whether, as a result of new information, future events or otherwise.

The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements and notes thereto in Item 1 above and with our financial statements and notes thereto for the year ended September 30, 2003, contained in our Annual Report on Form 10-K.

Photon Dynamics, Inc. is a leading provider of yield management solutions to the flat panel display industry. Our customers use our systems to increase manufacturing yields of high performance flat panel displays used in a number of products, including notebook and desktop computers, televisions and advanced mobile electronic devices such as cellular phones, personal digital assistants and portable video games. Our test and repair systems are used by manufacturers to collect data, analyze product quality and identify and repair product defects at critical steps in the manufacturing process.

We sell our products to manufacturers in the flat panel display industries. Our flat panel display customers are located primarily in Korea, Taiwan and Japan, where flat panel display production is concentrated. We derive most of our revenue from a small number of customers, and we expect this to continue for the foreseeable future.

Our products are primarily manufactured in San Jose, California. Our manufacturing activities consist primarily of final assembly and test of components and subassemblies, which are purchased from third party vendors. We schedule production based upon customer purchase orders and anticipated orders during the planning cycle. We generally expect to be able to accept a customer order, build the required machinery and ship to the customer within 26 to 39 weeks.

The success of our business depends upon numerous factors, including, but not limited to:

We do not consider our business to be seasonal in nature, but it is cyclical with respect to the capital equipment procurement practices of flat panel display manufacturers and is impacted by the investment patterns of these manufacturers in different global markets. A substantial percentage of our revenue is derived from the sale of a small number of yield management systems ranging in price from approximately $400,000 to $2.5 million. Therefore, the timing of the sale of a single system could have a significant impact on our quarterly results.

We have not always focused solely on the flat panel display industry. Previously we also produced printed circuit board assembly inspection products and cathode ray tube display and high quality glass inspection products. However, we determined to exit these markets as we believed that they did not have the potential to be profitable for us. Consequently, in January 2003 we implemented a plan to exit the printed circuit board assembly inspection business, and in June 2003 we implemented a plan to exit the cathode ray tube display and high quality glass inspection business. Accordingly, the operating results of these former businesses have been reclassified as discontinued operations for all periods presented.

In view of continued deterioration in market opportunities that began in the fourth quarter of fiscal 2003, we have suspended operations in the low temperature poly-silicon (“LTPS”) technology and inverter markets. In our third quarter of fiscal 2004, we sold all assets related to the inverter business. Although we continue to support LTPS systems in the field with parts and service, we currently are not actively pursuing new business for systems, upgrades or enhancements for the foreseeable future.

Our transition to the singular focus on our core business of developing yield management solutions for the flat panel display industry has given us a clear focus and direction in fiscal 2004 to strengthen our product and market position. Our fiscal 2004 strategic objectives are to build stronger customer partnerships and to enhance our operating performance. Our management team is focused on several imperatives to support these objectives:

We moved into our new facility in our second fiscal quarter. We have increased our manufacturing operations staff in order to meet increased demand for our products. In the short-term, the incremental capacity of our new facilities has caused our manufacturing operations to be less efficient due to staff training and redundancy. This has caused certain delays in executing our cost reduction programs and has impacted our ability to increase our gross margins.

We continue to make additional acquisitions of businesses with complementary products and technologies. In June 2004, we acquired from Quantum Composers, Inc., all of the assets of Quantum Composers related to the design and manufacture of laser assembly products for our repair product line. In May, 2003, we acquired all of the assets of Summit Imaging related to the design and manufacture of “cooled” cameras for us. Both of these acquisitions were to purchase technology that we use in our products, so that we are not dependent on these suppliers for providing this technology and related components used in our products. In November 2002, we completed our acquisition of certain assets from Intevac, Inc. related to Intevac’s rapid thermal processing technology. This LTPS technology expanded our flat panel display product offering.

We also continue to refine our strategic direction and, as a result, no longer have a need for certain acquired businesses and technologies. For example, in fiscal 2003 we exited the printed circuit board assembly inspection and cathode ray tube and high quality glass inspection businesses. As a result, some or all of the technologies acquired in connection with certain of our prior acquisitions, including Advanced Research Technologies Inc., Intelligent Reasoning Systems, Inc. and Image Processing Systems, Inc. have been sold or abandoned. In addition, in the first quarter of our fiscal 2004 we suspended operations in the LTPS technology and inverter markets.

Continuous innovations in microelectronics and materials science have enabled manufacturers, including our customers, to produce flat panel displays with sharper resolution, brighter pixels and faster imaging in varying sizes for differing applications. Growth in the mobile electronic devices market, the desktop computer market and the television market have driven the demand for flat panel displays, which offer reduced size, weight, power consumption and heat emission and better picture quality as compared to cathode ray tube displays, the current standard technology for stationary display devices.

Demand for active matrix liquid crystal display (“AMLCD”) products continues to grow. During 2003, demand for computer monitor displays and notebook demand resulted in Korean and Taiwanese flat panel display manufacturers investing heavily in

Generation 5 factories to keep pace with the demand for products (“Generations” refer to the size of the panels produced, with increasing generations being larger panels). In addition, 2003 signaled the start of AMLCD television mass production. During 2004, flat panel display manufacturers have increased their investments in Generation 6 factories and continue to move forward with plans for Generation 7 factories. Growth in the AMLCD television market is expected to continue to fuel the overall growth in the flat panel display market; however, lower panel prices are essential to stimulate demand. The next generation factories are being built to help reduce manufacturing cost to allow panel producers to achieve the proper panel pricing. However, there are many factors that will dictate how successful AMLCD manufacturers are in penetrating the television market, including display performance, price reduction and the ability to maintain profitability. The adoption rate of television products is uncertain and will affect demand and overall market growth.

We believe continued growth in demand for AMLCD products will fuel investments in Generation 6 and 7 factories to keep pace and that inspection, test and repair systems will continue to represent a significant percentage of our customers’ capital spending, driving increased demand for our products and services.

Our backlog for unshipped system orders as of June 30, 2004, was approximately $92.8 million. Our backlog consists of orders for which we have accepted purchase orders and assigned shipment dates within the next twelve months and which are reasonably expected to be filled within that time frame. We received orders valued at $46.2 million in the three months ended June 30, 2004, $47.2 million in the three months ended March 31, 2004, and $42.1 million in the three months ended December 31, 2003. All orders are subject to delay or cancellation with limited or no penalty to the customer. Because of possible changes in product delivery schedules and cancellation of product orders, among other factors, our backlog may vary significantly and, at any particular date, is not necessarily indicative of actual sales for any succeeding period.

Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information. The preparation of our financial statements and the related disclosures requires our management to make judgments, assumptions and estimates that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Note 1 of our “Notes to Condensed Consolidated Financial Statements,” describes significant accounting policies used in the preparation of our condensed consolidated financial statements. Certain of these significant accounting policies are considered to be critical accounting policies.

A critical accounting policy is defined as one that is both material to the presentation of our financial statements and requires management to make difficult, subjective or complex judgments that could have a material effect on our financial condition and results of operations.

Estimates and assumptions about future events and their effects cannot be determined with certainty. We base our estimates on historical experience and on various other assumptions that are believed to be applicable and reasonable under the circumstances. These estimates may change as new events occur, as additional information is obtained and as our operating environment changes. In addition, management is periodically faced with uncertainties, the outcomes of which are not within its control and will not be known for prolonged periods of time. These uncertainties are discussed in the section below entitled “Factors Affecting Operating Results.”

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition. Note 1 of our “Notes to Condensed Consolidated Financial Statements” provides an understanding of our revenue recognition policy. For each arrangement, we make judgments as to whether persuasive evidence of an arrangement exists, delivery has occurred, the services have been rendered, the selling price is fixed and determinable, collection of the receivable is reasonably assured, and no significant post-delivery obligations remain unfulfilled. If any of these criteria are not met, we defer revenue recognition until such time as all of the criteria are met.

In addition, for arrangements with multiple deliverables, we make additional judgments as to whether each item has value to the customer on a stand-alone basis, the amounts of revenue for each element that are not subject to refund, all defined customer acceptance experience levels have been met, and the fair values of any undelivered items have been reliably determined.

We record a provision for estimated sales returns in the same period as the related revenue is recorded, which is netted against revenue. These estimates are based on historical sales returns and other known factors which have not varied widely in the past and we do not reasonably expect these factors to significantly change in the foreseeable future. If the historical data we use to calculate these

estimates does not properly reflect future returns, additional provisions may be required. Historically, we have not experienced the return of any of our flat panel display systems and do not expect this to change in the foreseeable future. However, due to the relatively high prices of our systems, the actual return of one of these systems would have a material adverse effect on our results of operations.

Allowance for Doubtful Accounts. Our trade receivables are derived from sales to flat panel display manufacturers located primarily in Korea, Japan and Taiwan. In order to monitor potential credit losses, we perform periodic evaluations of our customer’s financial condition. We maintain an allowance for doubtful accounts for the potential inability of our customers to make required payments based upon our assessment of the expected collectibility of all accounts receivable. In estimating the provision, management considers (i) historical experience, (ii) the length of time the receivables are past due, (iii) any circumstances of which we are aware of a customer’s inability to meet its financial obligations, and (iv) other known factors. We review this provision periodically to assess the adequacy of the provision.

Our allowance for doubtful accounts was approximately $650,000 and $726,000 at June 30, 2004 and September 30, 2003. These balances each represent approximately 1% of fiscal 2003 revenues. Historically, losses due to bad customer debt in our flat panel display business have been immaterial and we expect that this will not change in the foreseeable future. However, if a single customer returned a product or was unable or unwilling to make payments, additional allowances may be required. Accordingly, inability of a single customer to make required payments could have a material adverse effect on our results of operations.

Inventories. The valuation of inventory requires us to estimate obsolete or excess inventory and inventory that is not of saleable quality. The determination of obsolete or excess inventory requires us to estimate the future demand for our products within specific time horizons, generally twelve months or less. If our demand forecast for specific products is greater than actual demand and we fail to reduce manufacturing output accordingly, we could be required to record additional inventory reserves, which would have a negative impact on our gross margin.

We review the adequacy of our inventory valuation on a quarterly basis. For production inventory, our methodology involves matching our on-hand inventory with our build forecast over the next twelve months on a part-by-part basis. We then evaluate the parts found to be in excess of the twelve-month demand and take appropriate write-downs to reflect the risk of obsolescence. This methodology is significantly affected by the usage assumption. Using a longer time period of estimated usage could result in reduced inventory adjustment requirements. Based on our past experience, we believe the twelve-month time period to best reflect the reasonable and relative obsolescence risks. If actual demand or usage were to be substantially lower than estimated, additional inventory adjustments for excess or obsolete inventory may be required.

Warranty. Our warranty policy generally states that we will provide warranty coverage for a period of one year from final acceptance. We record the estimated cost of warranty coverage, primarily material and labor to repair and service the equipment, upon product shipment, when the related revenue is recognized. Our warranty obligation is affected by product failure rates, consumption of field service parts and the efficiency by which the product failure is corrected. Our estimated warranty cost is based on historical data related to these factors.

Our liability for warranty coverage was approximately $4.1 million and $2.3 million at June 30, 2004 and September 30, 2003. Should actual product failure rates, material usage and labor efficiencies differ from our estimates, revisions to the estimated warranty liability would be required.

Goodwill and Intangible Assets. We have accounted for goodwill and other intangible assets resulting from our acquisitions in accordance with Statement of Financial Accounting Standards No. 142 “Goodwill and Other Intangible Assets” (“FAS142”). FAS 142 prohibits the amortization of goodwill and intangible assets with indefinite useful lives and requires that these assets be reviewed for impairment at least annually, and more frequently if there are indicators of impairment. The process for evaluating the potential impairment of goodwill is highly subjective and requires significant judgment at many points during the analysis. Should actual results differ from our estimates, revisions to the recorded amount of goodwill could be reported.

Intangible assets with finite lives and other long-lived assets are amortized over their estimated useful lives and are also subject to evaluation for impairment. We review long-lived assets including intangible assets with finite lives for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable, such as a significant industry downturn, significant decline in the market value of the company, or significant reductions in projected future cash flows. An impairment loss would be recognized when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount. Impairment, if any, is determined using discounted cash flows. In assessing the recoverability of long-lived assets, including intangible assets, we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, we may be required to record additional impairment charges for these assets.

We have recently recorded both goodwill and intangible impairment charges as part of our transition to a singular focus on our core business of developing yield management solutions for the flat panel display industry. In the fourth quarter of fiscal 2003, due to limited opportunities in the inverter market and uncertainty as to the adoption of LTPS technology, management performed an impairment analysis of the goodwill and intangible assets associated with our Akcron and RTP reporting units. As a result of this analysis, we recorded a goodwill impairment charge of $10.0 million and an intangible asset impairment charge of $3.5 million. As of December 2003, due to continued deterioration in the inverter market, management performed an impairment analysis of the remaining goodwill associated with Akcron and the remaining intangible assets associated with RTP and Akcron. As a result of this analysis, we recorded a goodwill impairment charge of approximately $365,000 and an intangible asset impairment charge of $2.1 million. These charges were reflected in our results of operations for the three months ended December 31, 2003. In October 2003, $1.7 million of the $2.0 million escrow related to the purchase of the RTP Assets was settled in our favor, and $300,000 was settled in favor of Intevac, resulting in an additional goodwill impairment charge in the three months ended December 31, 2003. Goodwill as of June 30, 2004, was approximately $153,000, related entirely to our purchase of assets from Summit Imaging. Intangible assets as of June 30, 2004 were approximately $4.0 million, related to patents and acquired core technology resulting from our purchase of assets from Summit Imaging, the assignment and license agreement signed with IHI in March 2004 and the purchase of Quantum Composers in June 2004.

Contingencies and Litigation. We make an assessment of the probability of an adverse judgment resulting from current and threatened litigation. We accrue the cost of an adverse judgment if, in our estimation and based on the advice of legal counsel, the adverse settlement is probable and we can reasonably estimate the ultimate cost of such a judgment. We are engaged in two significant litigation matters as of June 30, 2004, as described in Note 10 to the Condensed Consolidated Financial Statements in this Form 10-Q, in which the plaintiffs are collectively seeking a total of approximately $20.8 million. We have made our requisite assessments and accruals, as warranted, as of June 30, 2004. If either of these matters are not resolved in our favor, we could incur substantial charges that could materially and adversely affect our future operating results.

The percentage of net revenue represented by certain line items in our condensed consolidated statements of operations for the periods indicated, are set forth in the table below.

The increase in revenue was primarily due to the continued customer expansion of manufacturing capacity. Flat panel display manufacturers continue to increase capacity to meet computer notebook and monitor demand. In addition, price elasticity is creating strong demand for 22” – 26” television displays. Generation 5 capacity additions continue in Korea and Taiwan as flat panel display manufacturers continue to invest to keep pace with the AMLCD demand. In addition, Generation 6 factories are now coming on line and several manufacturers have either broken ground or announced their Generation 7 factories.

Sales of our Generation 6 products represented 50% and 34% of revenue in the three and nine months ended June 30, 2004, respectively. Our products in each new generation contain new performance and control features designed specifically to enhance yield improvement and process control. As a result, we have historically experienced increases in our average selling prices (“ASPs”) of between 20% and 50% in each new generation product. As with prior generation products, our Generation 6 products have greater ASPs than previous generations. However, there is no assurance that we will be successful in achieving or sustaining these levels of increases on our Generation 6 and future generation products.

The increase in revenue in the three and nine months ended June 30, 2004, as compared to the same periods in the prior fiscal year was due to increased shipments of both our ArrayChecker and ArrayRepair products shipped. Sales of our ArrayChecker products represented approximately 84% and 82% of our total revenue for the three and nine month periods ended June 30, 2004, as compared to approximately 87% and 84% for the same periods in the prior fiscal year. Sales of our test products increased primarily due to the continued customer expansion of manufacturing capacity. Sales of our ArrayRepair products represented approximately 11% of our total revenue for both the three and nine month periods ended June 30, 2004, as compared to approximately 2% in both the same periods in the prior fiscal year. Sales of our repair products have increased partly in response to the larger glass size of Generation 6 and to expansion of customer manufacturing facilities. The cost of yield loss associated with large monitor or television panels is driving flat panel display manufacturers to increase the number of repair systems used in the manufacturing process in an effort to maximize yields. We also experienced an increase in revenue related to the receipt of final customer acceptances following completed installation of our products over the same period in our prior fiscal year. Spare part sales represented approximately 3% and 5% of our total revenue for the three and nine month periods ended June 30, 2004, as compared to approximately 10% and 7% for the same periods in the prior fiscal year.

Sales of our rapid thermal processing products, which are based on the technology we acquired in November 2002, represented $651,000, or 2% and 1% of our revenue for the three and nine month periods ended June 30, 2004, respectively, and $159,000 and $3.6 million, or 1% and 8% of our revenue, in the three and nine month periods ended June 30, 2003, respectively. The revenue reported in 2004 represented an upgrade to an existing product and we do not expect sales of this product line to be a significant portion of revenue in the foreseeable future. While we continue to support systems in the field, we are not pursuing new business for this product offering.

Our international revenue is derived primarily from customers in Korea, Taiwan and Japan. International revenue represented 100% of our revenue in the three and nine month periods ended June 30, 2004 and 2003. For the nine month period ended June 30, 2004, revenue from Korea increased approximately $7.9 million, or 22%, revenue from Taiwan increased approximately $28.2 million, or 334%, and revenue from Japan increased approximately $7.1 million, or 858%, compared to the same period of the prior fiscal year.

We are experiencing a greater growth in sales of our ArrayRepair products in the fourth quarter of fiscal 2004 compared to the growth in sales of our ArrayChecker products. Consequently, we expect that our revenue will increase substantially in the fourth quarter of fiscal 2004 compared to the recently completed third quarter. As discussed below we believe that this shift in product mix will have a negative impact on our gross margin as a percentage of our revenue.

In addition to the year over year improvement in gross margins, our gross margins improved in the current year from 45% in our first quarter to 46% in our second and third quarters. Our current-year gross margins reflect the benefits of:

We anticipate that our gross margins for our fourth quarter of fiscal 2004 will decline to 38-39% from our gross margins in our third quarter of fiscal 2004 of 46%, primarily due to a higher weighted product mix of lower-margin ArraySaver systems. However, we expect that as a result of our projected increase in revenue, our gross margin in absolute dollars for the fourth quarter of fiscal 2004 will not be negatively impacted despite this decrease in gross margin rate.

For the nine months ended June 30, 2003, we experienced lower margins from end-of-life pricing on the ArrayChecker 2000 systems and certain manufacturing inefficiencies resulting from the delayed introduction of our ArrayChecker 3500 product. In addition, non-recurring charges related to the amortization of backlog acquired in our acquisition of rapid thermal processing backlog from Intevac, Inc. had a negative impact on gross margin of approximately 1% for the nine months ended June 30, 2003. Neither of these factors affected our operations for the three months ended June 30, 2003.

Our research and development expenses consisted primarily of salaries, related personnel costs, depreciation, prototype materials and fees paid to consultants and outside service providers, all of which relate to the design, development, testing, pre-manufacturing and improvement of our products. We increased our overall research and development spending in fiscal 2003 to support simultaneous development of Generation 5, 6 and 7 test and repair products, primarily related to higher spending on prototype materials and engineering headcount. This spending increased again through the first nine months of fiscal 2004 due to additional timing demands placed on both the ArrayTest and ArrayRepair Generation 6 and 7 product development groups, as well as our cell/module inspection systems group.

We expect our research and development expenses to be higher in absolute dollars during our fourth quarter of fiscal 2004 as we add the technical staff from our purchase of Quantum Composers and we continue to expand our research and development efforts to address three areas:

We will continue to invest in R&D to maintain technology leadership in our products. Our customers must continually improve their display quality performance and production costs in order to be successful in the display market. To meet our customers’ needs, we must improve our product performance in defect detection, repair success, cost of ownership, ease of use and throughput for each of our product generations.

Our selling, general and administrative expenses consisted primarily of salaries and related expenses for marketing, sales, finance, administration and human resources personnel, accounting, commissions, insurance, legal and other corporate expenses. The increase in selling, general and administrative expenses in absolute dollars was primarily attributed to increases in expenses related to corporate governance requirements, severance expenses, legal costs and increased headcount. We saw these expenses decline from approximately $4.6 million in our first fiscal quarter of 2004 to approximately $4.0 million in our second quarter. These expenses increased to approximately $4.6 million in our third quarter due to recruitment costs, the cost of certain key new hires and professional fees. We expect these expenses to remain relatively flat in absolute dollars in our fourth quarter.

As discussed in the overview and critical accounting policies above, we have exited all business lines other than the flat panel display products market and within the flat panel display market we have suspended operations of the LTPS and inverter products. As a result, we determined that all of our goodwill and long-lived assets related to LTPS and inverter products we had made had been impaired, resulting in goodwill and intangible impairment charges of approximately $665,000 and $2.1 million, respectively, in our first fiscal quarter of 2004.

In June 2004, we acquired from Quantum Composers all of the assets of Quantum Composers related to the design and manufacture of laser assembly products for flat panel display LCD manufacturing and repair. In May 2003, we acquired all of the assets of Summit Imaging related to the design and manufacture of “cooled” cameras for us. In November 2002, we completed our acquisition of certain assets from Intevac, Inc. related to Intevac’s rapid thermal processing technology. The purchase price of these acquisitions were allocated in accordance with FAS 141, “Business Combinations,” including in-process research and development charges of approximately $210,000, $625,000 and $1.8 million, respectively. These charges were expensed on the acquisition date as they represented ongoing research and development projects that had not yet reached technological feasibility and had no alternative future uses.

Acquired in-process research and development was identified and valued through interviews with executives of the companies from which the assets were acquired, analysis of data concerning developmental products and their stage of development, the time and resources needed to complete the projects, their expected income generating ability, target markets and associated risks. The income approach, which includes an analysis of the markets, cash flows and risks associated with achieving such cash flows, was the primary technique we utilized in valuing in-process research and development. We discounted back to their present value projected incremental cash flows using discount rates of 30%, 25% and 50% for the Quantum Composers, Intevac technology and Summit Imaging asset purchases, respectively, which was determined after consideration of our weighted average cost of capital and the weighted average return on assets.

In-process research and development related to Quantum Composers involves the design of the next generation laser cutting/ablation systems for our LCD panel repair products. At the time of acquisition, the project was approximately 75% complete, and is expected to be completed by the end of fiscal 2004. We expect to incur approximately $25,000 of additional expenditures to complete this development.

In-process research and development projects related to Intevac included a new transport system for more efficient handling of larger glass, redesign of the lamphouse for selective heating of the film and enhancement of low oxygen technology. These projects were substantially complete as of June 30, 2003.

In-process research and development related to Summit Imaging involved the design of the next generation cooled cameras for our ArrayChecker tools. This project was substantially complete as of September 30, 2003.

Risks associated with our acquired in-process research and development include the inherent difficulties and uncertainties in completing each project and thereby achieving technological feasibility, anticipated levels of market acceptance and penetration, market growth rates and risks related to the impact of potential changes in future target markets. The nature of the efforts required to develop the acquired in-process research and development into commercially viable products principally relate to the completion of all planning, designing, prototyping, verification and testing activities that are necessary to establish that the products can be produced to meet their design specifications, including functions, features and technical performance requirements. As such, the timing of completion and ultimate commercial application are affected by the successful completion of these activities and ultimately, market acceptance.

Through December 31, 2003, our identified intangible assets associated with the RTP Assets, Akcron and Summit Imaging acquisitions were being amortized over a two to five year period, commencing on the date of the acquisitions. As of December 31, 2003, all intangible assets associated with the RTP Assets and Akcron acquisitions had been written off. In March of 2004, we acquired additional intangible assets related to our termination and assignment agreement with Ishikawajima-Harima Heavy Industries. In June of 2004, we acquired certain intangible assets related to Quantum Composers. As a result, we expect amortization of existing intangibles to be approximately $330,000 per quarter through the second quarter of fiscal 2005. We then expect amortization of our existing intangibles to be approximately $307,000 in our third and fourth quarters of fiscal 2005. These estimates do not include any amounts that may be associated with our fourth-quarter purchase of Tucson Optical Research Corporation or for any acquisitions that may occur in fiscal 2005.

Interest income and other, net consisted primarily of interest income, foreign currency exchange gains and losses, changes in the fair value of derivative financial instruments and other miscellaneous income and expense. The increase in “Interest income and other, net,” in the nine months ended June 30, 2004, as compared to the same period in prior year, was primarily attributable to the receipt of a technology license fee resulting from a litigation settlement in the first quarter of fiscal 2004, the terms of which were confidential. In addition, in May 2004, we sold all of our assets in Korea related to our TFT-LCD Backlight Inverter business for approximately $481,000. The assets include inventory and production equipment, intellectual property and certain employees related to the inverter business. In the three months ended June 30, 2004, we recorded a gain on the transaction of approximately $419,000. The decrease in “Interest income and other, net,” in the three months ended June 30, 2004, as compared to the same period in prior year, was primarily attributable to declining cash balances and the general decline in interest rates.

The effective tax rates for the three and nine month periods ended June 30, 2004 were 2.4% and 6.0%, respectively while these effective rates were 0% and 0.4% in the same periods in the prior year. Our provision for income taxes for the nine months ended June 30, 2004 included a foreign withholding tax related to a technology license fee resulting from a litigation settlement in the first quarter of fiscal 2004. The effective tax rate in both periods of fiscal 2004 is lower than the statutory rate due primarily to tax benefits arising from net operating losses and primarily relate to alternative minimum taxes.

Our future effective income tax rate depends on various factors, such as tax legislation, the geographic composition of our pre-tax income, amount of and access to tax loss carryforwards, expenses incurred in connection with acquisitions that are not deductible for tax purposes, amounts of tax-exempt interest income and research and development credits as a percentage of aggregate pre-tax income, and the effectiveness of our tax planning strategies.

In January 2003, we implemented a plan to exit the printed circuit board assembly inspection business. The loss from discontinued operations related to the disposition of the printed circuit board assembly inspection business for the nine months ended June 30, 2004 included approximately $1.4 million in litigation costs for settlement of prior inventory purchase commitments and for settlement of a lawsuit brought by a former employee. The loss from discontinued operations for the nine months ended June 30, 2003 included a write-off of inventory of approximately $7.8 million, a write-off of accounts receivable of approximately $1.7 million, and write-off of licensed technology of approximately $1.9 million, and impairment charges of approximately $15.1 million of goodwill, approximately $2.9 million of purchased intangibles and approximately $2.5 million of long-lived assets. These charges were as a result of management’s assessment of indicators of impairment that existed prior to our formal decision to discontinue the operations of this segment. These impairment charges were recorded in accordance with the provisions of FAS 142 and FAS 144. In addition, the loss from discontinued operations for the nine months ended June 30, 2003 includes losses from operations that were incurred prior to the implementation of the plan to exit the business. We do not expect losses from the printed circuit board assembly inspection business to be material in the foreseeable future.

In June 2003, we implemented a plan to exit the cathode ray tube display and high quality glass inspection business. The loss from discontinued operations related to the disposition of the cathode ray tube display and high quality inspection business for the nine months ended June 30, 2003, included a write-off of inventory of approximately $2.0 million, a write-off of accounts receivable of approximately $460,000, and a write-off of operating leases of approximately $388,000 related to fixed assets. We do not expect losses from the cathode ray tube display and high quality glass inspection business to be material in the foreseeable future.

We have historically financed our operating and capital resource requirements through a combination of cash flows from operations and public stock offerings. Our last significant external financing was in February 2002, when we sold common stock for net proceeds of approximately $107.0 million.

Our primary source of funds as of June 30, 2004 consisted of approximately $86.9 million in cash, cash equivalents and short-term investments. This amount represents a decrease of approximately $29.6 million from the September 30, 2003 balance of approximately $116.5 million.

For the first nine months of fiscal 2004, cash used in operating activities from continuing operations was approximately $16.9 million, compared with approximately $4.4 million for the first nine months of fiscal 2003. Cash was provided by net income adjusted for non-cash related items. However, changes in assets and liabilities consumed approximately $32.1 million of cash, resulting in a net use of cash in operations. Working capital sources of cash, primarily a $15.3 million increase in accounts payable related primarily to inventory purchases, were more than offset by working capital uses of cash. The primary reductions in cash from changes in our working capital levels were: (a) an increase of approximately $32.1 million in our net accounts receivable, resulting primarily from sales increasing from approximately $21.0 million in the fourth quarter of fiscal 2003 to approximately $24.5 million, $26.5 million and $38.5 million in our first, second and third quarters of fiscal 2004, respectively and the timing of shipments in our third quarter; and (b) an increase of approximately $16.8 million in our net inventory, which increased as a result of our ramping up inventory in preparation for our fourth quarter build schedules.

We have moved into our new facility and in our second quarter we began increasing our operations staff in order to meet market demand and to gain market share. We also saw in our second and third fiscal quarters an increase in operating expenses and certain working capital items, such as inventory and accounts receivable during this ramp up period, which has caused our use of cash in operating activities to increase. We expect to continue to use cash in operating activities in our fourth quarter, but we expect that we will be able to fund these increasing operating expenses and changes in working capital components with our cash, cash equivalents and short-term investments. We expect that inventory levels will stabilize in our fiscal 2005 and that our use of cash in operations will decline.

For the first nine months of fiscal 2004, cash provided by investing activities from continuing operations was approximately $17.9 million as compared to approximately $22.8 million for the nine months of fiscal 2003. Cash provided by investing activities was primarily the result of approximately $32.8 million of net redemptions of short-term investments. This was partially offset by the acquisition of substantially all of the assets of Quantum Composer for approximately $1.0 million and by approximately $12.5 million in capital expenditures, of which approximately $6.3 million was related to expenditures on leasehold improvements associated with our new facility in San Jose, California. Capital expenditures related to the facility move-in for leasehold improvements were substantially complete at March 31, 2004.

For the first nine months of fiscal 2004, cash provided by financing activities was approximately $4.2 million as compared to approximately $14.3 million of cash used in financing activities in the first nine months of fiscal 2003. Cash provided by financing activities from continuing operations in fiscal 2004 was the result of stock option exercises by employees.

The timing of and amounts received from employee stock option exercises are dependent upon the decisions of the respective option holders, and are not controlled by us. Therefore, funds raised from the issuance of common stock upon the exercise of employee stock options should not be considered an indication of additional funds to be received in future periods.

The following table summarizes the approximate contractual obligations that we have at June 30, 2004. Such obligations include both non-cancelable obligations and other obligations that are generally non-cancelable except under certain limited conditions.

In August 2003, we signed a lease agreement for a 128,520 square-foot building in San Jose, California into which we consolidated our former San Jose facilities, effective January 5, 2004. The lease on our prior San Jose location terminated concurrently with the inception date of the new lease. The new facility is leased under a non-cancelable operating lease that expires in 2010, with two renewal options at fair market value for additional five year periods and is reflected in the “operating lease obligations” in the table above.

We maintain certain open inventory purchase commitments with our suppliers to ensure a smooth and continuous supply chain for key components. Our liability under these purchase arrangements is generally restricted to purchase commitments over a forecasted time horizon as mutually agreed upon between the parties and is reflected in “purchase obligations” in the table above. The majority of these purchase commitments are covered by confirmed customer orders.

We believe that cash generated from operations, together with the liquidity provided by existing cash balances and borrowing capability, will be sufficient to meet our operating and capital requirements and obligations for at least the next twelve months. However, this forward-looking statement is based upon our current plans and assumptions, which may change, and our capital requirements may increase in future periods. In addition, we believe that success in our industry requires substantial capital in order to maintain the flexibility to take advantage of opportunities as they may arise. We may, from time to time, invest in or acquire complementary businesses, products or technologies and may seek additional equity or debt financing to fund such activities. There can be no assurance that such funding will be available to us on commercially reasonable terms, if at all, and if we were to proceed with acquisitions without this funding or with limited funding it would decrease our capital resources. The sale of additional equity or convertible debt securities could result in dilution to our existing shareholders.

Cash used in discontinued operations during the nine month period ended June 30, 2004 and 2003 is as follows:

Cash used in discontinued operations in the nine month period ended June 30, 2004 consisted primarily of changes in working capital balances, payments for settlement of prior inventory purchase commitments, and the settlement a lawsuit.

We reported net losses for each of the fiscal years ended September 30, 2003, 2002 and 2001. Although we reported profits in each of the first three quarters of fiscal 2004, and expect to report a profit in the fourth quarter of fiscal 2004, in the future, our revenue may decline, remain flat or grow at a rate slower than expected. Our ability to maintain profitability is dependent in part on the success of our efforts to increase revenues and to reduce operating expenses as a percentage of revenue through our ongoing cost-cutting measures and our gross margin improvement programs. However, we are increasing our manufacturing capacity to meet increased demand for our products, and this is causing us to experience increased operating expenses. If the increase in demand for our products is not sustained, or if we are not able to increase our manufacturing capacity in a cost-efficient manner, this would impair our ability to maintain our recently achieved profitability. For all of these reasons, there is no assurance that we will be successful in achieving or maintaining increased revenue, reduced operating expenses, positive cash flows or profitability.

Our operating results are difficult to predict and may vary from investors’ expectations, which could cause our stock price to fall.

We have experienced, and expect to continue to experience, significant fluctuations in our quarterly results. Consequently, past financial results may not be indicative of future financial results. A substantial percentage of our revenue is derived from the sale of a small number of yield management systems ranging in price from $400,000 to $2.5 million. Therefore, the timing of the sale of a single system could have a significant impact on our quarterly results. Moreover, customers may cancel or reschedule shipments, and production difficulties could delay shipments. For example, as we announced in December 2002, we experienced technical delays with respect to the introduction of our next generation ArrayChecker 3500 system. This delay had a significant impact on the timing of both our revenue and net income for the second quarter of fiscal 2003.

Other factors which may influence our operating results in a particular quarter include:

Our operating results also could be affected by sudden changes in customer requirements, currency exchange rate fluctuations and other economic conditions affecting customer demand and the cost of operations in the global markets in which we do business. As a result of these or other factors, our operating results could be significantly and adversely affected and our stock price could decline. In addition, it is possible that in some future quarter our operating results may be below the expectations of public market analysts and investors, which could cause our stock price to fall.

If our products experience performance, reliability or quality problems, our customers may reduce their orders.

We believe that future orders of our products will depend in part on our ability to satisfy the performance, reliability and quality standards required by our customers. Particularly as customers seek increased yields, greater throughput and higher quality end products, we must continually redesign our products to meet the needs of our customers. As with the introduction of any new product, our customers may experience yield loss. For example, with our ArrayChecker 3500, certain customers experienced yield loss higher than expected when the product was first introduced. If our products have performance, reliability or quality problems, then we may experience:

If we are unable to meet the requirements of our customers, our revenue may decrease and our business could be harmed.

In addition, we typically provide a limited warranty on our products for a period of one year from final acceptance by customers. We may incur substantial warranty claim expenses on our products and actual warranty claims may exceed recorded allowances, resulting in harm to our business.

Capital investment by manufacturers of flat panel display products can be highly cyclical and may decline in the future.

Our business depends in large part on capital expenditures by manufacturers of flat panel display products, which in turn depends on the current and anticipated market demand for the end products in that industry. The market for flat panel display products is highly cyclical and has experienced periods of oversupply resulting in significantly reduced demand for capital equipment. For example, the flat panel display industry experienced a downturn in 1998, which led many flat panel display manufacturers to delay or cancel capital expenditures. Additionally, in 2001, due to the general deteriorating economic environment, flat panel display

manufacturers reduced capital expenditures resulting in a decrease in our revenue. If the flat panel display markets in which we sell our products experience further slowdowns in the future, it could cause our revenue to decrease significantly. We do not control the timing or volume of orders placed by our customers. Whether and to what extent our customers place orders for any specific products, as well as the mix and quantities of products included in those orders, are factors beyond our control. Insufficient orders, especially in a down cycle, will result in under-utilization of our manufacturing facilities and infrastructure and will negatively affect our operating results and financial condition. In addition, the need to invest in the engineering, research and development, and marketing required to penetrate targeted foreign markets and maintain extensive service and support capabilities limits our ability to reduce expenses during these downturns.

We depend on sales to a few large customers in the flat panel display industry, and if we lose any of our large customers our revenue could decrease significantly.

The flat panel display industry is extremely concentrated with a small number of manufacturers producing the majority of the world’s flat panel displays. If one or more of our major customers ceased or significantly curtailed their purchases, our revenue could drop significantly. We may be unable to replace sales to these customers. Sales of flat panel display products to our two largest customers collectively represented approximately 50% of our revenue, and each in excess of 10% of our total revenue, for the nine months ended June 30, 2004. Our two largest customers collectively accounted for approximately 75% of our total revenue, and each in excess of 10% of our total revenue, for the nine months ended June 30, 2003.

We rely upon sales of a limited range of products, and if demand for one product decreases for any reason it could cause our revenue to decline significantly.

All of our revenue is expected to come from a limited range of products for the flat panel display industry. As a result, we are heavily reliant on the flat panel display industry, particularly given our recent exits from the printed circuit board assembly inspection business and the cathode ray tube display and high quality glass inspection businesses. Any decline in demand for, or failure to achieve continued market acceptance of, our primary products or any new version of these products could harm our business. Continued market acceptance of our array test and array repair products is critical to our success.

We may not be able to develop and introduce new products that respond to evolving industry requirements in a timely manner, which could reduce our ability to compete effectively.

The markets for our products are characterized by rapidly changing technologies and frequent new product introductions. The failure to develop new products and introduce them successfully and in a timely manner could harm our competitive position and results of operations. We believe that our future success will depend in part upon our ability to continue to enhance our existing products and to develop and manufacture new products. For example, the size of glass plates for flat panel displays and the resolution of flat panel displays have changed frequently and may continue to change, requiring us to redesign or reconfigure our flat panel display products.

We expect to continue to incur significant research and development costs. There can be no assurance that we will be successful in the introduction, marketing and cost effective manufacture of any of our new products, that we will be able to timely develop and introduce new products and enhance our existing products and processes to satisfy customer needs or achieve market acceptance, or that the new markets for which we are developing new products or expect to sell current products will develop sufficiently. For example, we experienced technical delays relating to the introduction of our ArrayChecker 3500 system causing us to reschedule several shipments from the first quarter to the second quarter of fiscal 2003.

In addition, we depend on close relationships with our customers and the willingness of those customers to share information with us, and the failure to maintain these relationships could harm our product development efforts.

If we are not able to obtain critical components from our single or limited source suppliers, we may experience significant delays in producing our products, which could decrease our revenue for an extended period of time.

We obtain some equipment for our systems from a single source or a limited group of suppliers. For example, we currently obtain materials handling platforms from a single source supplier. Although we seek to reduce dependence on our sole and limited source suppliers, alternative sources of supply for this equipment may not be available or may be available on unfavorable terms. The partial or complete loss of our sole and limited source suppliers could at least temporarily delay our shipments or otherwise harm our results of operations and damage customer relationships. Further, a significant increase in the price of one or more of these pieces of equipment could harm our results of operations.

All of our revenue is derived from sales to companies located outside the United States, which exposes us to risks that we would not experience with domestic sales.

We expect sales to customers in foreign countries to continue to represent 100% of our revenue in the foreseeable future. A number of factors may adversely affect our international sales and operations, including:

If any of these factors occur, our operating results and revenue could be materially and adversely affected.

We may have difficulty integrating the businesses or assets we have acquired and may acquire in the future, and we may not realize the benefits that we expect from these acquisitions.

In addition to our efforts to develop new technologies from internal sources, we also may seek to acquire new technologies from external sources. For example, in June 2004, we acquired from Quantum Composers, Inc., all of the assets of Quantum Composers related to the design and manufacture of laser assembly products for flat panel display LCD manufacturing and repair. In May, 2003, we acquired all of the assets of Summit Imaging related to the design and manufacture of “cooled” cameras for us. Both of these acquisitions were to purchase technology that we use in our products, so that we are not dependent on these suppliers for providing this technology and related components used in our products. In the future, we may make additional acquisitions of, or significant investments in, businesses with complementary products, services and/or technologies. Integrating businesses can be a complex, time-consuming and expensive process. If we are not able to do so effectively, we will not be able to realize the benefits that we expect to receive from either our past or future acquisitions. For each acquisition, we must integrate separate technologies, product lines, business cultures and practices, employees and systems. Acquisitions are subject to numerous risks, including:

Any of these difficulties could increase our operating costs or result in impairment of purchased assets, which could harm our financial performance.

In addition, we may also elect to change our strategic direction and may no longer have need for certain acquired businesses or technologies. For example, in 2003, we exited the printed circuit board assembly inspection and high quality glass inspection businesses. As a result, some or all of the technologies acquired in connection with certain of our prior acquisitions, including Advanced Research Technologies Inc., Intelligent Reasoning Systems, Inc. and Image Processing Systems, Inc. have been abandoned. Future acquisitions may also result in potentially dilutive issuances of equity securities, incurrence of debt and contingent liabilities and amortization expenses related to acquired intangible assets, which could harm our profitability.

Any failure of, or other problems at or with our third party manufacturers could delay shipments of our flat panel display products, harm our relationships with our customers or otherwise negatively impact our business.

We use a wide range of materials in the production of our products, including custom electronic and mechanical components, and we use numerous suppliers to supply these materials. If any third party that we use to manufacture our products is unable to satisfy our quality requirements or provide us with the products and services in a timely manner, our shipments of these products may be delayed, our customer relationships may be harmed and our results of operations may be adversely impacted. There can be no assurance that our relationship with any third party that we use to manufacture our products will result in a reduction of our expenses or enable us to satisfy our customers’ quality requirements or to deliver our products to our customers in a timely manner.

If we do not compete effectively in our target markets, we will lose market share.

The markets for yield management systems in the flat panel display industry are highly competitive. We face substantial competition from established competitors that have greater financial, engineering and manufacturing resources than us and have larger service organizations and long-standing customer relationships. Our competitors can be expected to continue to improve the design and performance of their products and to introduce new products with competitive price and performance characteristics. Competitive pressures may force price reductions that could harm our results of operations. Our customers may also develop technology and equipment that may reduce or eliminate their need to purchase our products. Although we believe we have certain technological and other advantages over our competitors, maintaining and capitalizing on these advantages will require us to continue a high level of investment in engineering, research and development, marketing and customer service support. There can be no assurance that we will have sufficient resources to continue to make these investments or that we will be able to make the technological advances necessary to maintain our competitive advantages.

We have renegotiated our contract with Ishikawajima-Harima Heavy Industries (“IHI”),who will supply limited services as a value-added reseller of flat panel display products in Japan. We have previously relied on our relationship with IHI to sell all our flat panel display products in Japan, and if we are not able to continue to access this important market, our business will be harmed.

We believe that Japanese companies competing with us in sales to the flat panel display industry have a competitive advantage in Japan because of the preference of some local customers for local equipment suppliers. Foreign companies frequently have found it difficult to penetrate the Japanese market and often depend upon local sales channels to sell their products in Japan.

Historically, IHI has been a significant value-added reseller with respect to sales of our flat panel display products in Japan. In fiscal 2003, fiscal 2002 and fiscal 2001, 2%, 10% and 24% of our total revenue came from sales to IHI, respectively. In the nine months ended June 30, 2004 and 2003, IHI represented 7% and 2% of our total revenue, respectively. We renegotiated our agreement with IHI in February 2004, which will now sell and support our flat panel display products in a limited fashion in Japan in the future. If we are unable to support existing customers or develop new customers in Japan without IHI, our business will be harmed.

Our success depends in large part on the strength of the active matrix liquid crystal display in the flat panel display industry.

While our technology is applicable to other flat panel display technologies, our experience has been focused on applications for active matrix liquid crystal displays, the most prevalent and one of the highest performance flat panel displays available today. In fiscal 2003 and the nine months ended June 30, 2004, we derived 100% of our revenue from sales of flat panel display products, substantially all of which were based on the active matrix liquid crystal display technology. An industry shift away from active matrix liquid crystal display technology to existing or new competing technologies could reduce the demand for our existing products and require significant expenditures to develop new products, each of which could harm our business.

Our business could be harmed if we fail to properly protect our intellectual property.

Our success depends largely on our ability to protect our intellectual property. While we attempt to protect our intellectual property through patents, copyrights and trade secrets in the United States and other countries, there can be no assurance that we will successfully protect our technology or that competitors will not be able to develop similar technology independently. We cannot assure you that the claims allowed on any patents held by us will be sufficiently broad to protect our technology against competition from third parties with similar technologies or products. In addition, we cannot assure you that any patents issued to us will not be challenged, invalidated or circumvented or that the rights granted there under will provide competitive advantages to us. Moreover, the laws of some foreign countries do not protect intellectual property rights to the same extent as the laws of the United States and we could experience various obstacles and high costs in protecting our intellectual property rights in foreign countries. If we are unable to obtain or maintain these protections, we may not be able to prevent third parties from using our intellectual property.

We also rely on trade secrets, proprietary know-how and continuing technological innovation to remain competitive. We have taken measures to protect our trade secrets and know-how, including the use of confidentiality agreements with our employees. It is possible that these agreements may be breached and that the available remedies for any breach will not be sufficient to compensate us for damages incurred.

Litigation may be necessary to enforce or defend against claims of intellectual property infringement, which could be expensive and, if we lose, could prevent us from selling our products.

Litigation may be necessary in the future to enforce our patents and other intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Any litigation, regardless of the outcome, could be costly and require significant time and attention of key members of our management and technical personnel.

Our domestic and international competitors, many of which have substantially greater resources and have made substantial investments in competing technologies, may have patents that will prevent, limit or interfere with our ability to manufacture and sell our products. We have not conducted an independent review of patents issued to third parties. Third parties may assert infringement claims, successful or otherwise, against us, and litigation may be necessary to defend against claims of infringement or invalidity. An adverse outcome in the defense of a patent suit could subject us to significant liabilities to third parties, require disputed rights to be licensed from third parties or require us to cease selling our products. Even successful defenses of patent suits can be costly and time-consuming.

We must attract and retain key employees and our management team and employees must work effectively together to maintain and grow our business.

Our future success depends in part on our ability to retain key personnel, particularly senior management and engineers. We also need to attract additional skilled personnel in significant areas of our business to grow. There can be no assurance that we will be able to retain our existing personnel or attract additional qualified employees in the future. We generally do not have employment contracts with our employees and do not maintain key person life insurance on any of our employees.

In addition, our management team recently has experienced significant personnel changes. Jeffrey A. Hawthorne, previously Chief Operating Officer, became our President and Chief Executive Officer in October 2003. Richard Okumoto became our Chief Financial Officer and Secretary in May 2003. Steve Song, previously Director of Korean operations, recently became our Vice President of Worldwide Sales. If our management team continues to experience high attrition or does not work effectively together, it could seriously harm our business.

Terrorism and international political instability may negatively affect our operations.

The threat of terrorism targeted at the regions of the world in which we do business increases the uncertainty in our markets and may delay any recovery in the general economy, which could threaten our business.

Increased international political instability, particularly resulting from the threat of terrorist attacks, and further enhanced security measures as a result of the threat of terrorist attacks may hinder our ability to do business and may increase our costs of operations. Such continuing instability could cause us to incur increased costs in transportation, make such transportation unreliable, increase our insurance costs and cause international markets to fluctuate. This instability could have the same effects on our suppliers and their ability to timely deliver their products to us. If this international political instability continues or increases, our business and results of operations could be harmed.

The outbreak of severe acute respiratory syndrome, or other infectious diseases, may impact our operations or adversely affect our customers and therefore harm our business.

Our ability to address normal business transaction issues in Asia may still be at risk due to the potential reoccurrence of a Severe Acute Respiratory Syndrome (SARS) outbreak or outbreaks of other infectious diseases. Risks related to an outbreak include but are not limited to temporary closure of operating facilities in affected locations, travel restrictions and delays, difficulties generating new business opportunities and increased political and social tension. Especially if any of our employees, or any of the employees of our customers, become infected with SARS or another outbreak of infectious disease, we may experience reduced sales and increased costs and our operating results may be harmed.

Our manufacturing facilities may be subject to disruption from natural disasters.

Operations at our manufacturing facilities are subject to disruption for a variety of reasons, including work stoppages, acts of war, terrorism, fire, earthquake, energy shortages, flooding or other natural disasters. Our corporate and manufacturing facilities in California are located near major earthquake faults which have experienced earthquakes in the past. Such disruption could cause delays in shipments of products to our customers. We cannot ensure that alternate production capacity would be available if a major disruption were to occur or that, if it were available, it could be obtained on favorable terms. Such disruption could result in cancellation of orders or loss of customers and could seriously harm our business. It could also significantly delay our research and engineering efforts for the development of new products, most of which is conducted at our California facilities.

In addition, some of our customers in Asia are located near fault lines. A major earthquake in Asia could disrupt our operations or the operations of our customers, which could reduce demand for our products.

The market price of our common stock could fluctuate significantly in response to variations in quarterly operating results and other factors, such as:

In addition, the stock market has in recent years experienced significant price fluctuations. These fluctuations often have been unrelated to the operating performance of the specific companies whose stock is traded. Broad market fluctuations, general economic condition and specific conditions in the flat panel display industry may adversely affect the market price of our common stock.

Our Amended and Restated Articles of Incorporation authorize our board of directors to issue up to 5,000,000 shares of preferred stock. The board also has the authority to determine the price, rights, preferences and privileges, including voting rights, of those shares without any further vote or action by the shareholders. The rights of our shareholders will be subject to, and may be impaired by, the rights of the holders of any preferred stock that may be issued in the future. These and other provisions contained in our charter documents and applicable provisions of California law could serve to depress our stock price or discourage a hostile bid in which shareholders could receive a premium for their shares. In addition, these provisions could make it more difficult for a third party to acquire a majority of our outstanding voting stock or otherwise effect a change in control of us.

We have never declared or paid any cash dividends on our capital stock and do not anticipate paying cash dividends in the foreseeable future. We have also agreed not to pay cash dividends under our current bank line of credit. Instead, we intend to apply any earnings to the expansion and development of our business.

A change in accounting standards or practices or a change in existing taxation rules or practices can have a significant effect on our reported results and may even affect our reporting of transactions completed before the change is effective. New accounting pronouncements and taxation rules and varying interpretations of accounting pronouncements and taxation practice have occurred and may occur in the future. Changes to existing rules or the questioning of current practices may adversely affect our reported financial results or the way we conduct our business.

For example, any changes requiring that we record compensation expense in the statement of operations for employee stock options using the fair value method or changes in existing taxation rules related to stock options could have a significant negative effect on our reported results. Several agencies and entities are considering, and the FASB has announced, proposals to change generally accepted accounting principles in the United States that, if implemented, would require us to record charges to earnings for employee stock option grants. This pending requirement would negatively impact our earnings.

We are exposed to changes in foreign currency exchange rates primarily related to the operating results of our foreign affiliates. Actual changes in foreign exchange rates could adversely affect our operating results or financial condition. The potential impact depends upon the magnitude of the rate change. We believe our exposure to changes in foreign currency exchange rates for our cash, accounts receivable and accounts payable is limited as substantially all of our cash, accounts receivable and accounts payable are denominated in U.S. dollars.

As of June 30, 2004 and September 30, 2003, we had forward exchange contracts to sell approximately $2.9 million and $2.8 million, respectively, in foreign currency in order to hedge certain anticipated foreign currency denominated transactions expected to occur during the next year. None of these contracts were held for trading purposes. Details of these securities is included in Note 6 of our “Notes to Condensed Consolidated Financial Statements” included under Part I, Item 1. “Financial Statements.” Gains and losses on these contracts are recognized in income.

Our forward exchange contracts are subject to exchange rate risk and will fluctuate with the changes in exchange rates. A hypothetical 10% immediate and uniform adverse move in all currency exchange rates affecting the contracts from the rates at June 30, 2004 would decrease the fair value of the contracts by approximately $344,000.

The primary objective of our investment activities is to preserve principal while maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we may invest in may be subject to market risk. To minimize this risk, we maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, government and non-government debt securities and certificates of deposit.

Our exposure to market risk relates primarily to interest rate fluctuations in connection with our cash and cash equivalents and short-term investment portfolios. We enter into financial instruments for non-trading purposes and do not have derivative financial instruments in our portfolio. The following tables present principal amounts and related weighted average interest rates by year of maturity for our short-term investment portfolio, substantially all of which is held in U.S. dollars, as of June 30, 2004 and September 30, 2003, respectively:

These securities, as with all fixed income instruments, are subject to interest rate risk and will fall in value if market interest rates increase.

Evaluation of Disclosure Controls and Procedures. Based on our management’s evaluation (with the participation of our chief executive officer and chief financial officer), as of the end of the period covered by this report, our chief executive officer and chief financial officer have concluded that, subject to limitations described below, our disclosure controls and procedures (as defined in Securities Exchange Act Rules 13a-15(e) and 15d-15(e)) are effective to provide reasonable assurance that the information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

Changes in Internal Control Over Financial Reporting. There was no change in our internal control over financial reporting during the quarter ended June 30, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. However, during the quarter ended June 30, 2004, we did add additional personnel to further strengthen our team.

Limitations on the Effectiveness of Disclosure Controls and Procedures. Our management, including the chief executive officer and chief financial officer, do not expect that our disclosure controls and procedures or internal control over financial reporting will prevent all error and all fraud. A control system no matter how well designed and implemented, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues within a company are detected. The inherent limitations include the realities of judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistakes. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

Photon Dynamics and certain of our directors and officers have been named as defendants in a lawsuit captioned Amtower v. Photon Dynamics, Inc., No. CV797876, filed on April 30, 2001 in the Superior Court of the State of California, County of Santa Clara. The plaintiff, who previously served as one of the Company’s officers, has asserted several causes of action arising out of alleged misrepresentations made to plaintiff regarding the existence and enforcement of our insider trading policy. The plaintiff is seeking damages of approximately $17.7 million for our alleged refusal to allow plaintiff to sell shares of the Company’s stock in May of 2000, plus unspecified emotional distress and punitive damages. On December 6, 2001, the court granted our motion to dismiss the complaint for failure to allege facts sufficient to state a cause of action, with leave to file an amended complaint. On January 17, 2002, plaintiff filed his amended complaint and we again moved to dismiss the action. On June 27, 2002, the court issued an order granting in part and denying in part the motion, and further granted plaintiff an opportunity to restate certain claims. On October 1, 2002, plaintiff filed his Second Amended Complaint, which was heard on April 8, 2003, and we again moved to dismiss the action. On April 21, 2003, the court granted in part and denied in part our motion. The pleadings have been finalized and certain claims against the Company and the individual defendants will proceed. The parties currently are engaged in discovery, and a court-mandated mediation session on July 30, 2004 did not resolve the case. No trial date has been set, although we expect the Court to set a trial date at the next Status Conference on August 19, 2004. We believe the plaintiff’s case is without merit and intend to defend this action vigorously. Although we cannot predict the outcome of this litigation, we believe that any adverse judgment in this litigation could have a material adverse effect on our financial condition or results of operations.

We have been named as a defendant in a lawsuit captioned Sanmina SCI Corporation v. Photon Dynamics, Inc., No. CV 013715, filed on February 3, 2004 in the Superior Court of the State of California, County of Santa Clara. The plaintiff in this action, who previously was a third-party manufacturer of Photon Dynamics, has asserted several causes of action arising out of our alleged nonperformance of our manufacturing outsourcing agreement with the plaintiff and is seeking approximately $3.1 million in compensatory damages and punitive damages in a unknown amount. We responded to the complaint on March 19, 2004, by filing an answer and cross complaint seeking damages of at least $135,000. We amended our cross complaint on June 26, 2004. The parties are currently seeking to mediate this dispute. Although we cannot predict the outcome of this litigation, we believe that any adverse judgment in this litigation would not have a material adverse effect on our financial condition or results of operations.

We were named as defendant in a lawsuit captioned Thomason v. Photon Dynamics, Inc. et al., No. 02CC03568, filed on February 28, 2002 in the Superior Court of the State of California, County of Orange. The plaintiff in this action purported to assert that he was wrongly not allowed to exercise certain stock options and sought damages of approximately $1.1 million and punitive damages in an unknown sum. On April 23, 2004, the parties to the litigation settled all litigation between them and we paid $750,000 to the plaintiff as part of the settlement agreement. The charge for this settlement is included in discontinued operations for the Printed Circuit Board Assembly Inspection Business in the Condensed Consolidated Statement of Operations.

ITEM 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

On April 28, 2004, we furnished a Current Report on Form 8-K, furnishing under item 12 the press release announcing our preliminary results for the quarter ended March 31, 2004, which press release includes our condensed consolidated balance sheets and statements of operations for the periods presented.

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


PHOTON DYNAMICS, INC.

By:		/s/ RICHARD OKUMOTO
		Richard Okumoto Chief Financial Officer and Secretary (Duly authorized and principal financial and accounting officer)


		Page
PART I	FINANCIAL INFORMATION
Item 1.	Financial Statements (Unaudited)
	Condensed Consolidated Balance Sheets as of June 30, 2004 and September 30, 2003	1
	Condensed Consolidated Statements of Operations for the Three and Nine Months Ended June 30, 2004 and 2003	2
	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended June 30, 2004 and 2003	3
	Notes to Condensed Consolidated Financial Statements	4
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	19
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	38
Item 4.	Controls and Procedures	39
PART II	OTHER INFORMATION
Item 1.	Legal Proceedings	39
Item 2.	Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities	40
Item 3.	Defaults Upon Senior Securities	40
Item 4.	Submission of Matters to a Vote of Security Holders	40
Item 5.	Other Information	40
Item 6.	Exhibits and Reports on Form 8-K	40
Signatures		41


	June 30, 2004			September 30, 2003
	(in thousands)
ASSETS
Current assets:
Cash and cash equivalents	$	22,138		$	18,305
Short-term investments		64,757			98,164
Accounts receivable, net		42,366			10,402
Inventories		28,759			9,887
Other current assets		5,294			6,449

Total current assets		163,314			143,207
Land, property and equipment, net		20,153			12,298
Other assets		4,244			3,002
Intangible assets, net		4,028			2,894
Goodwill		153			518

Total assets	$	191,892		$	161,919

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	19,379		$	4,239
Other current liabilities		12,633			10,605
Deferred gross margin		3,113			2,739

Total current liabilities		35,125			17,583
Other liabilities		1,512			193
Commitments and contingencies
Shareholders’ equity:
Common stock, no par value		283,779			279,417
Accumulated deficit		(128,617	)		(135,872	)
Accumulated other comprehensive income		93			598

Total shareholders’ equity		155,255			144,143

Total liabilities and shareholders’ equity	$	191,892		$	161,919


	Three Months Ended June 30,						Nine Months Ended June 30,
	2004			2003			2004			2003
	(in thousands, except per share data)
Revenue	$	38,452		$	17,996		$	89,429		$	46,216
Cost of revenue		20,711			11,789			48,306			31,267

Gross margin		17,741			6,207			41,123			14,949

Operating expenses:
Research and development		8,031			6,313			19,985			16,219
Selling, general and administrative		4,594			3,176			13,158			10,020
Impairment of goodwill		—			—			665			—
Impairment of purchased intangibles		—			—			2,089			—
Impairment of fixed assets		—			—			234			—
Acquired in-process research and development		210			625			210			2,474
Amortization of intangible assets		155			408			416			1,035

Total operating expenses		12,990			10,522			36,757			29,748

Income (loss) from operations		4,751			(4,315	)		4,366			(14,799	)
Interest income and other, net		808			955			4,943			2,496

Income (loss) from continuing operations before income taxes		5,559			(3,360	)		9,309			(12,303	)
Provision for income taxes		134			3			560			51

Income (loss) from continuing operations		5,425			(3,363	)		8,749			(12,354	)
Loss from discontinued operations		(265	)		(5,607	)		(1,494	)		(44,647	)

Net income (loss)	$	5,160		$	(8,970	)	$	7,255		$	(57,001	)

Net income (loss) per share from continuing operations
Basic	$	0.33		$	(0.21	)	$	0.53		$	(0.77	)

Diluted	$	0.32		$	(0.21	)	$	0.51		$	(0.77	)

Net loss per share from discontinued operations
Basic	$	(0.02	)	$	(0.35	)	$	(0.09	)	$	(2.78	)

Diluted	$	(0.02	)	$	(0.35	)	$	(0.09	)	$	(2.78	)

Net income (loss) per share
Basic	$	0.31		$	(0.56	)	$	0.44		$	(3.55	)

Diluted	$	0.30		$	(0.56	)	$	0.42		$	(3.55	)

Weighted average number of shares:
Basic		16,663			16,003			16,565			16,036
Diluted		17,071			16,003			17,141			16,036


	Nine Months Ended June 30,
	2004			2003
	(in thousands)
Cash flows from operating activities:
Net income (loss) from continuing operations	$	8,749		$	(12,354	)
Adjustments to reconcile net income (loss) from continuing operations to net cash used in operating activities from continuing operations:
Depreciation		2,721			1,648
Amortization of intangible assets		416			1,592
Impairment of goodwill		665			—
Impairment of purchased intangibles, and fixed assets		2,323			—
Acquired in-process research and development		210			2,474
Stock ownership expense		164			142
Changes in assets and liabilities:
Accounts receivable		(32,099	)		(2,487	)
Inventories		(16,776	)		1,900
Other current assets		758			(189	)
Other assets		(1,242	)		(463	)
Accounts payable		15,342			(447	)
Other current liabilities		1,592			(2,112	)
Deferred gross margin		374			5,943
Other liabilities		(65	)		—

Net cash used in operating activities from continuing operations		(16,868	)		(4,353	)
Net cash used in operating activities from discontinued operations		(1,453	)		(10,947	)

Net cash used in operating activities		(18,321	)		(15,300	)

Cash flows from investing activities:
Purchase of property and equipment		(12,508	)		(1,588	)
Acquisition of assets of Quantum Composers, Inc.		(1,000	)		—
Acquisition of assets of Summit Imaging, Inc.		—			(1,629	)
Acquisition of Rapid Thermal Processing Division from Intevac, Inc.		(300	)		(20,000	)
Acquisition of certain intangible assets upon termination of a distributor agreement		(1,138	)		—
Purchase of short-term investments		(378,706	)		(419,293	)
Redemption of short-term investments		411,554			465,292

Net cash provided by investing activities from continuing operations		17,902			22,782
Net cash used in investing activities from discontinued operations		—			(923	)

Net cash provided by investing activities		17,902			21,859

Cash flows from financing activities:
Issuance of common stock, net		4,198			3,160
Repurchase of common stock		—			(17,678	)
Long-term debt activity, net		—			253
Capital lease repayments		—			(11	)

Net cash provided by (used in) financing activities from continuing operations		4,198			(14,276	)

Effect of exchange rate changes on cash and cash equivalents		54			(26	)

Net increase in cash and cash equivalents from continuing operations		5,286			4,127
Net decrease in cash and cash equivalents from discontinued operations		(1,453	)		(11,870	)

Net increase (decrease) in cash and cash equivalents		3,833			(7,743	)
Cash and cash equivalents at beginning of period		18,305			25,580

Cash and cash equivalents at end of period	$	22,138		$	17,837


	Three Months Ended June 30,				Nine Months Ended June 30,
	2004		2003		2004		2003
Stock option plan:
Expected stock price volatility	0.80		0.90		0.86		0.94
Risk free interest rate	1.55	%	1.95	%	2.15	%	2.14	%
Expected life of options (years)	5.41		3.0		5.22		3.0
Stock purchase plan:
Expected stock price volatility	0.96		0.96		0.96		0.90
Risk free interest rate	2.13	%	2.13	%	2.13	%	2.15	%
Expected life of plan (years)	2.0		2.0		2.0		1.2


	Three Months Ended June 30,						Nine Months Ended June 30,
	2004			2003			2004			2003
	(in thousands, except per share data)
Net income (loss) – as reported	$	5,160		$	(8,970	)	$	7,255		$	(57,001	)
Plus: stock-based employee compensation expense included in reported net income		—			100			—			142
Less: total stock-based employee compensation expense determined under fair value based method for all awards		(1,605	)		(2,038	)		(5,495	)		(3,804	)

Net income (loss) - pro forma	$	3,555		$	(10,908	)	$	1,760		$	(60,663	)

Basic net income (loss) per share – as reported	$	0.31		$	(0.56	)	$	0.44		$	(3.55	)
Diluted net income (loss) per share – as reported	$	0.30		$	(0.56	)	$	0.42		$	(3.55	)
Basic net income (loss) per share – pro forma	$	0.21		$	(0.68	)	$	0.11		$	(3.78	)
Diluted net income (loss) per share – pro forma	$	0.21		$	(0.68	)	$	0.10		$	(3.78	)


	One-time Termination Benefits			Other Costs			Total
	(in thousands)
Inception of liability	$	696		$	1,326		$	2,022
Cash expenditures		(614	)		(447	)		(1,061	)
Adjustments to the liability		(82	)		(342	)		(424	)

Balance at September 30, 2003		—			537			537
Cash expenditures		—			—			—
Adjustments to the liability		—			—			—

Balance at June 30, 2004	$	—		$	537		$	537


	One-time Termination Benefits			Contract Termination Costs			Other Costs			Total
	(in thousands)
Inception of liability	$	1,116		$	771		$	11		$	1,898
Cash expenditures		(1,085	)		(171	)		(26	)		(1,282	)
Adjustments to the liability		—			—			50			50

Balance at September 30, 2003		31			600			35			666
Cash Expenditures		(31	)		(130	)		(35	)		(196	)

Balance at June 30, 2004	$	—		$	470		$	—		$	470


	Quantum Assets		Summit Assets		RTP Assets
	(in thousands)
Acquired core technology	$	640	$	565	$	3,764
Acquired developed technology		903		—		2,673
Backlog		—		—		557
Acquired in-process research and development		210		625		1,849
Non-compete agreement		958		199		—
Goodwill		—		106		7,386
Net fair value of acquired tangible assets and assumed liabilities		391		163		2,621

Total	$	3,102	$	1,658	$	18,850


	Nine Months Ended June 30,
	2004		2003
	(in thousands, except per share data)
Total revenue	$	92,554	$	48,610
Net income (loss) from continuing operations		9,132		(10,023	)
Net income (loss)		7,638		(54,670	)
Pro forma income (loss) per share from continuing operations:
Basic	$	0.55	$	(0.63	)
Diluted	$	0.53	$	(0.63	)
Pro forma income (loss) loss per share:
Basic	$	0.46	$	(3.41	)
Diluted	$	0.45	$	(3.41	)


	Total
	(in thousands)
Balance as of September 30, 2003	$	518
Adjustments to goodwill		300
Goodwill impairment charge		(665	)

Balance as of June 30, 2004	$	153


	Developed Technology			Core Technology			License Agreements			Non Compete Contract			Total
	(in thousands)
Balance as of September 30, 2003	$	655		$	2,082		$	—		$	157		$	2,894
Acquired during the period		903			640			1,138			958			3,639
Amortization during the period		(66	)		(183	)		(95	)		(72	)		(416	)
Impairment of purchased intangibles		(589	)		(1,500	)		—			—			(2,089	)

Balance as of June 30, 2004	$	903		$	1,039		$	1,043		$	1,043		$	4,028


	June 30, 2004			June 30, 2003
	(in thousands)
Beginning balance	$	2,363		$	2,383
Estimated warranty cost of new shipments during the period		4,030			1,458
Warranty charges during the period		(2,840	)		(1,359	)
Liability assumed as a result of the acquisition of the RTP Assets		—			150
Changes in liability for pre-existing warranties, including expirations		545			(364	)

Ending balance	$	4,098		$	2,268


	June 30, 2004		September 30, 2003
Customer A	62	%	25	%
Customer E	10	%		*
Customer H		*	58	%
Customer J	18	%		*


	Three Months Ended June 30,						Nine Months Ended June 30,
	(dollars in thousands)
	2004		Change		2003		2004		Change		2003
Revenue	$	38,452	114	%	$	17,996	$	89,429	94	%	$	46,216


	Three Months Ended June 30,						Nine Months Ended June 30,
	(in thousands)
	2004			2003			2004			2003
Loss	$	(265	)	$	(5,607	)	$	(1,494	)	$	(44,647	)


	Payments Due by Fiscal Year
Contractual Obligations	Total		2004		2005		2006		2007		2008		Thereafter
	(in thousands)
Operating lease obligations	$	17,864	$	842	$	2,906	$	2,946	$	2,625	$	2,527	$	6,018
Capital lease obligations		1		1		—		—		—		—		—
Purchase obligations		39,975		37,464		1,009		1,502		—		—		—

Total	$	57,840	$	38,307	$	3,915	$	4,448	$	2,625	$	2,527	$	6,018


June 30, 2004	2004			2005			2006	2007	2008	Total		Fair Value
	(dollars in thousands)
Cash equivalents (variable rate)	$	22,138			—		—	—	—	$	22,138	$	22,138
Average interest rate		0.58	%
Short-term investments (variable rate)	$	28,900			—		—	—	—	$	28,900	$	28,900
Average interest rate		1.41	%
Short-term investments (fixed rate)	$	—		$	36,226		—	—	—	$	36,226	$	35,857
Average interest rate					2.03	%


September 30, 2003	2004			2005			2006	2007	2008	Total		Fair Value
	(dollars in thousands)
Cash equivalents (variable rate)	$	18,305			—		—	—	—	$	18,305	$	18,305
Average interest rate		0.63	%
Short-term investments (variable rate)	$	53,750			—		—	—	—	$	53,750	$	53,750
Average interest rate		1.17	%
Short-term investments (fixed rate)	$	—		$	44,224		—	—	—	$	44,224	$	44,414
Average interest rate					2.63	%


Number		Exhibit
3.1(1)		Amended and Restated Articles of Incorporation of the Registrant.

3.2(1)		Certificate of Amendment to Articles of Incorporation of the Registrant.

3.3(2)		Bylaws of the Registrant and amendments thereto.

4.1		Reference is made to Exhibits 3.1, 3.2 and 3.3.

10.37		Confidential Mutual Settlement Agreement and Mutual General Release of All Claims, dated April 22, 2004, between Photon Dynamics, Inc. and Robert L. Thomason, et. al

31.1		Certification required by Rule 13a-14(a) or Rule 15d-14(a).

31.2		Certification required by Rule 13a-14(a) or Rule 15d-14(a).

32.1*		Certifications required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. §1350).