##### Table of Contents









UNITED STATES SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549


Form 10-Q/ A


Amendment No. 1


|           |  |                                                                                             
|---------- |  | --------------------------------------------------------------------------------------------
|(Mark One) |  |                                                                                             
|þ          |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934 
|          
|           |  | For the quarterly period ended December 31, 2004                                            
|          
|OR        
|          
|o          |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934
|          
|           |  | For the transition period
    from           to                                             

Commission file number: 0-27234


PHOTON DYNAMICS, INC.


(Exact name of registrant as specified in its charter)


|                                                                   |  |                                         
|------------------------------------------------------------------ |  | ----------------------------------------
|California                                                         |  | 94-3007502                              
|(State or other jurisdiction of
    incorporation or organization) |  | (I.R.S. Employer
    Identification No.)

5970 Optical Court


San Jose, California 95138-1400


(Address of principal executive offices including zip
code)


(408) 226-9900


(Registrants telephone number, including area code)


o þ


þ o












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##### Table of Contents



PHOTON DYNAMICS, INC.


QUARTERLY REPORT ON FORM 10-Q/ A


FOR THE THREE MONTH PERIOD ENDED DECEMBER 31, 2004


EXPLANATORY NOTE TO FORM 10-Q/ A AMENDMENT 1






2



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INDEX


|                             |  |                                                                                                               |    |      |    | 
|---------------------------- |  | ------------------------------------------------------------------------------------------------------------- | -- | ---- | -- | 
|                             |  |                                                                                                               |    | Page |   
|                             |  |                                                                                                               |    |      |   
|PART I FINANCIAL INFORMATION
|Item 1.                      |  | Financial Statements (unaudited)                                                                              |    |      | 4  | 
|                             |  | Condensed Consolidated Balance Sheets as of
    December 31, 2004 and September 30, 2004                      |    |      | 4  | 
|                             |  | Condensed Consolidated Statements of
    Operations for the Three Months Ended December 31, 2004 and
    2003 |    |      | 5  | 
|                             |  | Condensed Consolidated Statements of Cash
    Flows for the Three Months Ended December 31, 2004 and
    2003 |    |      | 6  | 
|                             |  | Notes to Condensed Consolidated Financial
    Statements                                                      |    |      | 7  | 
|Item 2.                      |  | Managements Discussion and Analysis
    of Financial Condition and Results of Operations                     |    |      | 25 | 
|Item 4.                      |  | Controls and Procedures                                                                                       |    |      | 46 | 
|                            
|PART II OTHER INFORMATION   
|Item 6.                      |  | Exhibits                                                                                                      |    |      | 49 | 
|Signatures                   |  |                                                                                                               | 50 |     
|EXHIBIT 31.1                
|EXHIBIT 31.2                
|EXHIBIT 32.1                



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PART I. FINANCIAL INFORMATION







|        |                     
|------- | --------------------
|ITEM 1. | Financial Statements

PHOTON DYNAMICS, INC.





CONDENSED CONSOLIDATED BALANCE SHEETS


|                                     |                                        |                                            |        |          |               |  |        |          |         | 
|------------------------------------ | -------------------------------------- | ------------------------------------------ | ------ | -------- | ------------- |  | ------ | -------- | ------- | 
|                                     |                                        | December 31,                               |        |          | September 30, | 
|                                     |                                        | 2004                                       |        |          | 2004          | 
|                                     |                                        |                                            |        |          |               | 
|                                     |                                        | (Restated)                                 |        |          | (Restated)    | 
|                                     |                                        | (Unaudited)                                |       
|                                     |                                        | (In thousands)                             |       
|ASSETS                              
|Current assets:                      |                                        |                                            |        |          |               |  |        |         
|                                     | Cash and cash equivalents              |                                            | $      | 34,487   |               |  | $      | 25,483   |        
|                                     | Short-term investments                 |                                            |        | 64,932   |               |  |        | 58,672   |        
|                                     | Accounts receivable, net               |                                            |        | 35,826   |               |  |        | 58,341   |        
|                                     | Inventories                            |                                            |        | 33,708   |               |  |        | 31,716   |        
|                                     | Other current assets                   |                                            |        | 4,337    |               |  |        | 4,536    |        
|                                     |                                        |                                            |        |          |               | 
|                                     |                                        | Total current assets                       |        |          | 173,290       |  |        |          | 178,748 | 
|Land, property and equipment, net    |                                        |                                            | 20,235 |          |               |  | 20,337 |         
|Other assets                         |                                        |                                            | 4,510  |          |               |  | 3,909  |         
|Intangible assets, net               |                                        |                                            | 4,356  |          |               |  | 4,753  |         
|Goodwill                             |                                        |                                            | 153    |          |               |  | 153    |         
|                                     |                                        |                                            |        |          |               | 
|                                     |                                        | Total assets                               |        | $        | 202,544       |  |        | $        | 207,900 | 
|                                     |                                        |                                            |        |          |               | 
|                                    
|LIABILITIES AND SHAREHOLDERS EQUITY
|Current liabilities:                 |                                        |                                            |        |          |               |  |        |         
|                                     | Accounts payable                       |                                            | $      | 11,959   |               |  | $      | 18,485   |        
|                                     | Warranty                               |                                            |        | 6,231    |               |  |        | 6,194    |        
|                                     | Other current liabilities              |                                            |        | 10,866   |               |  |        | 10,231   |        
|                                     | Deferred gross margin                  |                                            |        | 10,994   |               |  |        | 11,503   |        
|                                     |                                        |                                            |        |          |               | 
|                                     |                                        | Total current liabilities                  |        |          | 40,050        |  |        |          | 46,413  | 
|Other liabilities                    |                                        |                                            | 1,512  |          |               |  | 1,528  |         
|Commitments and contingencies        |                                        |                                            |        |          |               |  |        |         
|Shareholders equity:                |                                        |                                            |        |          |               |  |        |         
|                                     | Common stock, no par value             |                                            |        | 286,324  |               |  |        | 285,790  |        
|                                     | Accumulated deficit                    |                                            |        | (125,661 | )             |  |        | (126,178 | )      
|                                     | Accumulated other comprehensive income |                                            |        | 319      |               |  |        | 347      |        
|                                     |                                        |                                            |        |          |               | 
|                                     |                                        | Total shareholders equity                 |        |          | 160,982       |  |        |          | 159,959 | 
|                                     |                                        |                                            |        |          |               | 
|                                     |                                        | Total liabilities and shareholders equity |        | $        | 202,544       |  |        | $        | 207,900 | 
|                                     |                                        |                                            |        |          |               | 



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PHOTON DYNAMICS, INC.





CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


|                                                                                      |                                     |                          |        |        |            |   |        |        |        | 
|------------------------------------------------------------------------------------- | ----------------------------------- | ------------------------ | ------ | ------ | ---------- | - | ------ | ------ | ------ | 
|                                                                                      |                                     | Three Months Ended       |       
|                                                                                      |                                     | December 31,             |       
|                                                                                      |                                     |                          |       
|                                                                                      |                                     | 2004                     |        |        | 2003       |  
|                                                                                      |                                     |                          |        |        |            |  
|                                                                                      |                                     | (Restated)               |        |        | (Restated) |  
|                                                                                      |                                     | (Unaudited)              |       
|                                                                                      |                                     | (In thousands, except    |       
|                                                                                      |                                     | per share data)          |       
|Revenue                                                                               |                                     | $                        | 36,639 |        |            | $ | 24,375 |       
|Cost of revenue                                                                       |                                     |                          | 22,781 |        |            |   | 13,412 |       
|                                                                                      |                                     |                          |        |        |            |  
|Gross margin                                                                          |                                     |                          | 13,858 |        |            |   | 10,963 |       
|                                                                                      |                                     |                          |        |        |            |  
|Operating expenses:                                                                   |                                     |                          |        |        |            |   |        |       
|                                                                                      | Research and development            |                          |        | 9,470  |            |   |        | 5,810  |       
|                                                                                      | Selling, general and administrative |                          |        | 4,684  |            |   |        | 4,598  |       
|                                                                                      | Amortization of intangible assets   |                          |        | 397    |            |   |        | 201    |       
|                                                                                      | Goodwill impairment charge          |                          |        |       |            |   |        | 665    |       
|                                                                                      | Impairment of purchased intangibles |                          |        |       |            |   |        | 2,089  |       
|                                                                                      | Gain on sale of fixed assets        |                          |        |       |            |   |        | (10    | )     
|                                                                                      | Impairment of fixed assets          |                          |        |       |            |   |        | 234    |       
|                                                                                      |                                     |                          |        |        |            |  
|                                                                                      |                                     | Total operating expenses |        |        | 14,551     |   |        |        | 13,587 | 
|                                                                                      |                                     |                          |        |        |            |  
|Loss from operations                                                                  |                                     |                          | (693   | )      |            |   | (2,624 | )     
|Interest income and other, net                                                        |                                     |                          | 1,255  |        |            |   | 3,771  |       
|                                                                                      |                                     |                          |        |        |            |  
|Income from continuing operations before income taxes and
    discontinued operations |                                     |                          | 562    |        |            |   | 1,147  |       
|Provision for income taxes                                                            |                                     |                          | 39     |        |            |   | 362    |       
|                                                                                      |                                     |                          |        |        |            |  
|Income from continuing operations before discontinued operations                      |                                     |                          | 523    |        |            |   | 785    |       
|Income (loss) from discontinued operations                                            |                                     |                          | (6     | )      |            |   | 47     |       
|                                                                                      |                                     |                          |        |        |            |  
|Net income                                                                            |                                     | $                        | 517    |        |            | $ | 832    |       
|                                                                                      |                                     |                          |        |        |            |  
|Income (loss) per share from continuing operations:                                   |                                     |                          |        |        |            |   |        |       
|                                                                                      | Basic                               |                          | $      | 0.03   |            |   | $      | 0.05   |       
|                                                                                      |                                     |                          |        |        |            |  
|                                                                                      | Diluted                             |                          | $      | 0.03   |            |   | $      | 0.05   |       
|                                                                                      |                                     |                          |        |        |            |  
|Income (loss) per share from discontinued operations:                                 |                                     |                          |        |        |            |   |        |       
|                                                                                      | Basic                               |                          | $      | (0.00  | )          |   | $      | 0.00   |       
|                                                                                      |                                     |                          |        |        |            |  
|                                                                                      | Diluted                             |                          | $      | (0.00  | )          |   | $      | 0.00   |       
|                                                                                      |                                     |                          |        |        |            |  
|Net income per share:                                                                 |                                     |                          |        |        |            |   |        |       
|                                                                                      | Basic                               |                          | $      | 0.03   |            |   | $      | 0.05   |       
|                                                                                      |                                     |                          |        |        |            |  
|                                                                                      | Diluted                             |                          | $      | 0.03   |            |   | $      | 0.05   |       
|                                                                                      |                                     |                          |        |        |            |  
|Weighted average number of shares:                                                    |                                     |                          |        |        |            |   |        |       
|                                                                                      | Basic                               |                          |        | 16,872 |            |   |        | 16,461 |       
|                                                                                      | Diluted                             |                          |        | 17,009 |            |   |        | 17,174 |       



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PHOTON DYNAMICS, INC.





CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


|                                      |                                                                                                                                                           |                                                      |                           |        |            |        |   |        |          |        |  
|------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------- | ------------------------- | ------ | ---------- | ------ | - | ------ | -------- | ------ | -
|                                      |                                                                                                                                                           | Three Months Ended                                   |                          
|                                      |                                                                                                                                                           | December 31,                                         |                          
|                                      |                                                                                                                                                           |                                                      |                          
|                                      |                                                                                                                                                           | 2004                                                 |                           |        | 2003       |       
|                                      |                                                                                                                                                           |                                                      |                           |        |            |       
|                                      |                                                                                                                                                           | (Restated)                                           |                           |        | (Restated) |       
|                                      |                                                                                                                                                           | (Unaudited)                                          |                          
|                                      |                                                                                                                                                           | (In thousands)                                       |                          
|Cash flows from operating activities: |                                                                                                                                                           |                                                      |                           |        |            |        |   |       
|                                      | Net income from continuing operations                                                                                                                     |                                                      | $                         | 523    |            |        | $ | 785    |         
|                                      | Adjustments to reconcile net income from continuing operations
    to net cash provided by (used in) operating activities from
    continuing operations: |                                                      |                           |        |            |        |   |        |         
|                                      |                                                                                                                                                           | Depreciation                                         |                           |        | 1,024      |        |   |        | 1,020    |       
|                                      |                                                                                                                                                           | Amortization of intangible assets                    |                           |        | 397        |        |   |        | 201      |       
|                                      |                                                                                                                                                           | Impairment of goodwill                               |                           |        |           |        |   |        | 665      |       
|                                      |                                                                                                                                                           | Impairment of purchased intangibles and fixed assets |                           |        |           |        |   |        | 2,323    |       
|                                      |                                                                                                                                                           | Stock ownership expense                              |                           |        | 35         |        |   |        |         |       
|                                      |                                                                                                                                                           | Accretion of non-interest bearing notes payable      |                           |        | 19         |        |   |        |         |       
|                                      |                                                                                                                                                           | Changes in assets and liabilities:                   |                           |        |            |        |   |        |          |       
|                                      |                                                                                                                                                           |                                                      | Accounts receivable       |        |            | 22,515 |   |        |          | (5,189 | )
|                                      |                                                                                                                                                           |                                                      | Inventories               |        |            | (1,990 | ) |        |          | (709   | )
|                                      |                                                                                                                                                           |                                                      | Other current assets      |        |            | 268    |   |        |          | 2,417  |  
|                                      |                                                                                                                                                           |                                                      | Other assets              |        |            | (601   | ) |        |          | (407   | )
|                                      |                                                                                                                                                           |                                                      | Accounts payable          |        |            | (6,526 | ) |        |          | 413    |  
|                                      |                                                                                                                                                           |                                                      | Other current liabilities |        |            | 526    |   |        |          | (852   | )
|                                      |                                                                                                                                                           |                                                      | Deferred gross margin     |        |            | (509   | ) |        |          | (784   | )
|                                      |                                                                                                                                                           |                                                      | Other liabilities         |        |            | (16    | ) |        |          | (53    | )
|                                      |                                                                                                                                                           |                                                      |                           |        |            |       
|                                      | Net cash provided by (used in) operating activities from
    continuing operations                                                                        |                                                      |                           | 15,665 |            |        |   | (170   | )       
|                                      | Net cash provided by operating activities from discontinued
    operations                                                                                |                                                      |                           | 50     |            |        |   | 653    |         
|                                      |                                                                                                                                                           |                                                      |                           |        |            |       
|                                      | Net cash provided by operating activities                                                                                                                 |                                                      |                           | 15,715 |            |        |   | 483    |         
|                                      |                                                                                                                                                           |                                                      |                           |        |            |       
|Cash flows from investing activities: |                                                                                                                                                           |                                                      |                           |        |            |        |   |       
|                                      |                                                                                                                                                           | Purchase of property and equipment                   |                           |        | (922       | )      |   |        | (5,402   | )     
|                                      |                                                                                                                                                           | Purchase of short-term investments                   |                           |        | (17,244    | )      |   |        | (143,149 | )     
|                                      |                                                                                                                                                           | Redemption of short-term investments                 |                           |        | 10,828     |        |   |        | 143,963  |       
|                                      |                                                                                                                                                           |                                                      |                           |        |            |       
|                                      | Net cash used in investing activities from continuing operations                                                                                          |                                                      |                           | (7,338 | )          |        |   | (4,588 | )       
|                                      |                                                                                                                                                           |                                                      |                           |        |            |       
|Cash flows from financing activities: |                                                                                                                                                           |                                                      |                           |        |            |        |   |       
|                                      |                                                                                                                                                           | Issuance of common stock                             |                           |        | 499        |        |   |        | 1,360    |       
|                                      |                                                                                                                                                           |                                                      |                           |        |            |       
|                                      | Net cash provided by financing activities from continuing
    operations                                                                                  |                                                      |                           | 499    |            |        |   | 1,360  |         
|                                      |                                                                                                                                                           |                                                      |                           |        |            |       
|                                      | Effect of exchange rate changes on cash and cash equivalents                                                                                              |                                                      |                           | 128    |            |        |   | (147   | )       
|                                      |                                                                                                                                                           |                                                      |                           |        |            |       
|                                      | Net increase (decrease) in cash and cash equivalents from
    continuing operations                                                                       |                                                      |                           | 8,954  |            |        |   | (3,545 | )       
|                                      | Net increase in cash and cash equivalents from discontinued
    operations                                                                                |                                                      |                           | 50     |            |        |   | 653    |         
|                                      |                                                                                                                                                           |                                                      |                           |        |            |       
|                                      | Net increase (decrease) in cash and cash equivalents                                                                                                      |                                                      |                           | 9,004  |            |        |   | (2,892 | )       
|                                      | Cash and cash equivalents at beginning of period                                                                                                          |                                                      |                           | 25,483 |            |        |   | 18,305 |         
|                                      |                                                                                                                                                           |                                                      |                           |        |            |       
|                                      | Cash and cash equivalents at end of period                                                                                                                |                                                      | $                         | 34,487 |            |        | $ | 15,413 |         
|                                      |                                                                                                                                                           |                                                      |                           |        |            |       



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PHOTON DYNAMICS, INC.





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)




|         |                                                                         
|-------- | ------------------------------------------------------------------------
|NOTE 1  | Basis of Presentation and Summary of Significant Accounting
    Policies

Restatement of Financial Statements.






| |                                                                                                                                                                                                                                                                                                                                                                 
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1) Incomplete documentation of sales arrangements:
    Certain elements of certain sales arrangements with customers
    were not reflected in the Companys customary sales
    documents and, as a result, the Company overstated revenue for
    the value of the undelivered elements within those arrangements.                                            
|
| | 2) Unidentified elements in sales arrangements:
    Certain elements of certain sales arrangements with customers
    contained in the Companys customary sales documents were
    either not identified or not properly analyzed and, as a result,
    the Company overstated revenue for the value of the undelivered
    elements within those arrangements.
|
| | 3) Inappropriate amounts deferred: Certain
    undelivered elements within certain sales arrangements were not
    deferred at the appropriate amount and, as a result, the Company
    did not recognize the appropriate amount of revenue for the
    undelivered elements.                                                                                   



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PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)








|                                 |                                            |              |   |                |                 |  |   |             |   |              |             |      |   |  |   |          |  
|-------------------------------- | ------------------------------------------ | ------------ | - | -------------- | --------------- |  | - | ----------- | - | ------------ | ----------- | ---- | - |  | - | -------- | -
|                                 |                                            |              |   | Cumulative     |                 |  |   |             |  
|                                 |                                            | December 31, |   |                | Effect of Prior |  |   |             |   | December 31, |            
|                                 |                                            | 2004         |   |                | Period          |  |   |             |   | 2004         |            
|                                 |                                            | As Reported  |   |                | Restatement*    |  |   | Adjustments |   |              | As Restated |     
|                                 |                                            |              |   |                |                 |  |   |             |   |              |             |     
|                                 |                                            |              |   | (In thousands) |                 |  |  
|Consolidated Balance Sheet Data: |                                            |              |   |                |                 |  |   |             |   |              |             |      |   |  |   |         
|                                 | Total current assets                       |              | $ | 173,290        |                 |  | $ |            |   |              | $           |     |   |  | $ | 173,290  |  
|                                 | Total assets                               |              |   | 202,544        |                 |  |   |            |   |              |             |     |   |  |   | 202,544  |  
|                                 | Other current liabilities                  |              |   | 10,895         |                 |  |   | (29         | ) |              |             |     |   |  |   | 10,866   |  
|                                 | Deferred gross margin                      |              |   | 9,878          |                 |  |   | 1,399       |   |              |             | (283 | ) |  |   | 10,994   |  
|                                 | Total current liabilities                  |              |   | 38,963         |                 |  |   | 1,370       |   |              |             | (283 | ) |  |   | 40,050   |  
|                                 | Accumulated deficit                        |              |   | (124,574       | )               |  |   | (1,370      | ) |              |             | 283  |   |  |   | (125,661 | )
|                                 | Total liabilities and shareholders equity |              |   | 202,544        |                 |  |   |            |   |              |             |     |   |  |   | 202,544  |  

|                                                      |  |                                       |        |   |             |   |     |             |  |   |        |  
|----------------------------------------------------- |  | ------------------------------------- | ------ | - | ----------- | - | --- | ----------- |  | - | ------ | -
|                                                      |  | Three Months Ended December 31, 2004  |       
|                                                      |  |                                       |       
|                                                      |  | As Reported                           |        |   | Adjustments |   |     | As Restated | 
|                                                      |  |                                       |        |   |             |   |     |             | 
|                                                      |  | (In thousands, except per share data) |       
|Consolidated Statement of Operations Data:            |  |                                       |        |   |             |   |     |             |  |   |        |  
|Revenue                                               |  | $                                     | 36,356 |   |             | $ | 283 |             |  | $ | 36,639 |  
|Loss from operations                                  |  |                                       | (976   | ) |             |   | 283 |             |  |   | (693   | )
|Interest income and other, net                        |  |                                       | 1,255  |   |             |   |    |             |  |   | 1,255  |  
|                                                      |  |                                       |        |   |             |   |     |             | 
|Income from continuing operations before income taxes |  |                                       | 279    |   |             |   | 283 |             |  |   | 562    |  
|Provision for income taxes                            |  |                                       | 39     |   |             |   |    |             |  |   | 39     |  
|                                                      |  |                                       |        |   |             |   |     |             | 
|Income from continuing operations                     |  |                                       | 240    |   |             |   | 283 |             |  |   | 523    |  
|Loss from discontinued operations                     |  |                                       | (6     | ) |             |   |    |             |  |   | (6     | )
|                                                      |  |                                       |        |   |             |   |     |             | 
|Net income                                            |  | $                                     | 234    |   |             | $ | 283 |             |  | $ | 517    |  
|                                                      |  |                                       |        |   |             |   |     |             | 

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PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)


|                                                 |         |                                       |   |        |             |  |   |             |   |  |   |        |  
|------------------------------------------------ | ------- | ------------------------------------- | - | ------ | ----------- |  | - | ----------- | - |  | - | ------ | -
|                                                 |         | Three Months Ended December 31, 2004  |  
|                                                 |         |                                       |  
|                                                 |         | As Reported                           |   |        | Adjustments |  |   | As Restated |  
|                                                 |         |                                       |   |        |             |  |   |             |  
|                                                 |         | (In thousands, except per share data) |  
|Net income per share from continuing operations: |         |                                       |   |        |             |  |   |             |   |  |   |       
|                                                 | Basic   |                                       | $ | 0.01   |             |  | $ | 0.02        |   |  | $ | 0.03   |  
|                                                 |         |                                       |   |        |             |  |   |             |  
|                                                 | Diluted |                                       | $ | 0.01   |             |  | $ | 0.02        |   |  | $ | 0.03   |  
|                                                 |         |                                       |   |        |             |  |   |             |  
|Net loss per share from discontinued operations: |         |                                       |   |        |             |  |   |             |   |  |   |       
|                                                 | Basic   |                                       | $ | (0.00  | )           |  | $ | (0.00       | ) |  | $ | (0.00  | )
|                                                 |         |                                       |   |        |             |  |   |             |  
|                                                 | Diluted |                                       | $ | (0.00  | )           |  | $ | (0.00       | ) |  | $ | (0.00  | )
|                                                 |         |                                       |   |        |             |  |   |             |  
|Net income per share:                            |         |                                       |   |        |             |  |   |             |   |  |   |       
|                                                 | Basic   |                                       | $ | 0.01   |             |  | $ | 0.02        |   |  | $ | 0.03   |  
|                                                 |         |                                       |   |        |             |  |   |             |  
|                                                 | Diluted |                                       | $ | 0.01   |             |  | $ | 0.02        |   |  | $ | 0.03   |  
|                                                 |         |                                       |   |        |             |  |   |             |  
|Weighted average number of shares:               |         |                                       |   |        |             |  |   |             |   |  |   |       
|                                                 | Basic   |                                       |   | 16,872 |             |  |   | 16,872      |   |  |   | 16,872 |  
|                                                 | Diluted |                                       |   | 17,009 |             |  |   | 17,009      |   |  |   | 17,009 |  






|  |                                                                                                                                                                                                          
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|* | Amount consists of the cumulative effect of prior period
    adjustments as reported on the Companys Annual Report on
    Form 10-K/ A, Amendment No. 3 for the fiscal year
    ended September 30, 2004



Basis of Presentation.






Description of Operations and Principles of
Consolidation.


9



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




Management Estimates.


Fair Value of Financial Instruments.


Inventories.


Concentration of Credit and Other Risk.






10



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)








Revenue Recognition.










11



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)


Shipping Costs.


Research and Development Cost.


Interest Income.


Stock-Based Compensation Plans.




|                     |                                  |              |  |      |      |  |  |      |  
|-------------------- | -------------------------------- | ------------ |  | ---- | ---- |  |  | ---- | -
|                     |                                  | Three Months | 
|                     |                                  | Ended        | 
|                     |                                  | December 31, | 
|                     |                                  |              | 
|                     |                                  | 2004         |  |      | 2003 | 
|                     |                                  |              |  |      |      | 
|Stock option plan:   |                                  |              |  |      |      |  |  |     
|                     | Expected stock price volatility  |              |  | 0.72 |      |  |  | 0.92 |  
|                     | Risk free interest rate          |              |  | 2.89 | %    |  |  | 2.46 | %
|                     | Expected life of options (years) |              |  | 5.5  |      |  |  | 5.3  |  
|Stock purchase plan: |                                  |              |  |      |      |  |  |     
|                     | Expected stock price volatility  |              |  | 0.80 |      |  |  | 0.96 |  
|                     | Risk free interest rate          |              |  | 1.70 | %    |  |  | 2.13 | %
|                     | Expected life of plan (years)    |              |  | 1.6  |      |  |  | 2.0  |  



12



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|                                           |                                                                                                                               |                           |        |        |            |   |        |        |  
|------------------------------------------ | ----------------------------------------------------------------------------------------------------------------------------- | ------------------------- | ------ | ------ | ---------- | - | ------ | ------ | -
|                                           |                                                                                                                               | Three Months              |       
|                                           |                                                                                                                               | Ended                     |       
|                                           |                                                                                                                               | December 31,              |       
|                                           |                                                                                                                               |                           |       
|                                           |                                                                                                                               | 2004                      |        |        | 2003       |  
|                                           |                                                                                                                               |                           |        |        |            |  
|                                           |                                                                                                                               | (Restated)                |        |        | (Restated) |  
|                                           |                                                                                                                               | (In thousands, except per |       
|                                           |                                                                                                                               | share data)               |       
|Net income  as reported                   |                                                                                                                               | $                         | 517    |        |            | $ | 832    |       
|                                           | Less: total stock-based employee compensation expense determined
    under fair value based method for all awards, net of tax |                           |        | (2,017 | )          |   |        | (2,131 | )
|                                           |                                                                                                                               |                           |        |        |            |  
|Net loss  pro forma                       |                                                                                                                               | $                         | (1,500 | )      |            | $ | (1,299 | )     
|                                           |                                                                                                                               |                           |        |        |            |  
|Basic net income per share  as reported   |                                                                                                                               | $                         | 0.03   |        |            | $ | 0.05   |       
|Diluted net income per share  as reported |                                                                                                                               | $                         | 0.03   |        |            | $ | 0.05   |       
|Basic net loss per share  pro forma       |                                                                                                                               | $                         | (0.09  | )      |            | $ | (0.08  | )     
|Diluted net loss per share  pro forma     |                                                                                                                               | $                         | (0.09  | )      |            | $ | (0.08  | )     

Recent Accounting Pronouncements.






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PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|         |                               
|-------- | ------------------------------
|NOTE 2  | Financial Statement Components

|                     |                                 |                |   |        |               |  |   |        |        | 
|-------------------- | ------------------------------- | -------------- | - | ------ | ------------- |  | - | ------ | ------ | 
|                     |                                 | December 31,   |   |        | September 30, | 
|                     |                                 | 2004           |   |        | 2004          | 
|                     |                                 |                |   |        |               | 
|                     |                                 | (In thousands) |  
|Accounts receivable: |                                 |                |   |        |               |  |   |       
|                     | Accounts receivable, gross      |                | $ | 36,322 |               |  | $ | 58,838 |       
|                     | Allowance for doubtful accounts |                |   | (496   | )             |  |   | (497   | )     
|                     |                                 |                |   |        |               | 
|                     |                                 | Total          |   | $      | 35,826        |  |   | $      | 58,341 | 
|                     |                                 |                |   |        |               | 
|Inventories:         |                                 |                |   |        |               |  |   |       
|                     | Raw materials                   |                | $ | 18,650 |               |  | $ | 15,529 |       
|                     | Work-in-process                 |                |   | 14,354 |               |  |   | 15,046 |       
|                     | Finished goods                  |                |   | 704    |               |  |   | 1,141  |       
|                     |                                 |                |   |        |               | 
|                     |                                 | Total          |   | $      | 33,708        |  |   | $      | 31,716 | 
|                     |                                 |                |   |        |               | 

|                                        |                                                                                        |            |   |       |            |  |   |       |        | 
|--------------------------------------- | -------------------------------------------------------------------------------------- | ---------- | - | ----- | ---------- |  | - | ----- | ------ | 
|                                        |                                                                                        | (Restated) |   |       | (Restated) | 
|Other current liabilities:              |                                                                                        |            |   |       |            |  |   |      
|                                        | Compensation                                                                           |            | $ | 3,958 |            |  | $ | 3,984 |       
|                                        | Obligation to a manufacturing subcontractor in connection with
    inventory purchases |            |   | 623   |            |  |   | 623   |       
|                                        | Accrued closing costs associated with discontinued operations                          |            |   | 443   |            |  |   | 449   |       
|                                        | Notes Payable                                                                          |            |   | 1,508 |            |  |   | 1,534 |       
|                                        | Other accrued expenses                                                                 |            |   | 4,334 |            |  |   | 3,641 |       
|                                        |                                                                                        |            |   |       |            | 
|                                        |                                                                                        | Total      |   | $     | 10,866     |  |   | $     | 10,231 | 
|                                        |                                                                                        |            |   |       |            | 
|Accumulated other comprehensive income: |                                                                                        |            |   |       |            |  |   |      
|                                        | Foreign currency translation adjustments                                               |            | $ | 661   |            |  | $ | 533   |       
|                                        | Unrealized losses on available for sale securities                                     |            |   | (342  | )          |  |   | (186  | )     
|                                        |                                                                                        |            |   |       |            | 
|                                        |                                                                                        | Total      |   | $     | 319        |  |   | $     | 347    | 
|                                        |                                                                                        |            |   |       |            | 



|         |                        
|-------- | -----------------------
|NOTE 3  | Discontinued Operations



| |                                                   
| | --------------------------------------------------
| | Printed Circuit Board Assembly Inspection Business



14



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|                                           |                                     |                          |    |   |      |   |    |    |    | 
|------------------------------------------ | ----------------------------------- | ------------------------ | -- | - | ---- | - | -- | -- | -- | 
|                                           |                                     | Three Months             |   
|                                           |                                     | Ended                    |   
|                                           |                                     | December 31,             |   
|                                           |                                     |                          |   
|                                           |                                     | 2004                     |    |   | 2003 |  
|                                           |                                     |                          |    |   |      |  
|                                           |                                     | (In thousands)           |   
|Revenue                                    |                                     | $                        |   |   |      | $ | 83 |   
|Cost of revenue                            |                                     |                          |   |   |      |   | 9  |   
|                                           |                                     |                          |    |   |      |  
|Gross margin                               |                                     |                          |   |   |      |   | 74 |   
|                                           |                                     |                          |    |   |      |  
|Operating expenses:                        |                                     |                          |    |   |      |   |    |   
|                                           | Selling, general and administrative |                          |    | 4 |      |   |    | 62 |   
|                                           |                                     |                          |    |   |      |  
|                                           |                                     | Total operating expenses |    |   | 4    |   |    |    | 62 | 
|                                           |                                     |                          |    |   |      |  
|Income (loss) from discontinued operations |                                     | $                        | (4 | ) |      | $ | 12 |   
|                                           |                                     |                          |    |   |      |  



|                     |                           |                           |    |     |               |  |     |     |     | 
|-------------------- | ------------------------- | ------------------------- | -- | --- | ------------- |  | --- | --- | --- | 
|                     |                           | December 31,              |    |     | September 30, | 
|                     |                           | 2004                      |    |     | 2004          | 
|                     |                           |                           |    |     |               | 
|                     |                           | (In thousands)            |   
|ASSETS              
|Current assets:      |                           |                           |    |     |               |  |     |    
|                     | Other current assets      |                           | $  | 977 |               |  | $   | 908 |    
|                     |                           |                           |    |     |               | 
|                     |                           | Total assets              |    | $   | 977           |  |     | $   | 908 | 
|                     |                           |                           |    |     |               | 
|                    
|LIABILITIES         
|Current liabilities: |                           |                           |    |     |               |  |     |    
|                     | Accounts payable          |                           | $  | 5   |               |  | $   | 5   |    
|                     | Other current liabilities |                           |    | 707 |               |  |     | 707 |    
|                     |                           |                           |    |     |               | 
|                     |                           | Total current liabilities |    |     | 712           |  |     |     | 712 | 
|Other liabilities    |                           |                           | 96 |     |               |  | 113 |    
|                     |                           |                           |    |     |               | 
|                     |                           | Total liabilities         |    | $   | 808           |  |     | $   | 825 | 
|                     |                           |                           |    |     |               | 





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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|                             |                               |                |      |   |             |   |       |       |  |   |        |     | 
|---------------------------- | ----------------------------- | -------------- | ---- | - | ----------- | - | ----- | ----- |  | - | ------ | --- | 
|                             |                               | 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, 2004 |                |      |  |             |   |       | 537   |  |   |        | 537 | 
|Cash expenditures            |                               |                |     |   |             |   |      |       |  |   |       |    
|Adjustments to the liability |                               |                |     |   |             |   |      |       |  |   |       |    
|                             |                               |                |      |   |             |   |       |       | 
|                             | Balance at December 31, 2004  |                | $    |  |             |   | $     | 537   |  |   | $      | 537 | 
|                             |                               |                |      |   |             |   |       |       | 





| |                                                                        
| | -----------------------------------------------------------------------
| | Cathode Ray Tube Display and High Quality
    Glass Inspection Business





|                                                     |                          |                |    |   |      |   |     |     |  
|---------------------------------------------------- | ------------------------ | -------------- | -- | - | ---- | - | --- | --- | -
|                                                     |                          | Three Months   |   
|                                                     |                          | Ended          |   
|                                                     |                          | December 31,   |   
|                                                     |                          |                |   
|                                                     |                          | 2004           |    |   | 2003 |  
|                                                     |                          |                |    |   |      |  
|                                                     |                          | (In thousands) |   
|Selling, general and administrative                  |                          | $              | 2  |   |      | $ | 35  |    
|Impairment of purchased intangibles and fixed assets |                          |                |   |   |      |   | (70 | )  
|                                                     |                          |                |    |   |      |  
|                                                     | Total operating expenses |                |    | 2 |      |   |     | (35 | )
|                                                     |                          |                |    |   |      |  
|Income (loss) from discontinued operations           |                          | $              | (2 | ) |      | $ | 35  |    
|                                                     |                          |                |    |   |      |  



|                     |                           |                |     |     |               |   |     |     | 
|-------------------- | ------------------------- | -------------- | --- | --- | ------------- | - | --- | --- | 
|                     |                           | December 31,   |     |     | September 30, |  
|                     |                           | 2004           |     |     | 2004          |  
|                     |                           |                |     |     |               |  
|                     |                           | (In thousands) |    
|LIABILITIES          |                           |                |     |     |               |   |     |    
|Current liabilities: |                           | $              | 782 |     |               | $ | 797 |    
|                     |                           |                |     |     |               |  
|                     | Other current liabilities |                | $   | 782 |               |   | $   | 797 | 
|                     |                           |                |     |     |               |  

16



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






|                             |                               |                |        |   |             |   |      |             |  |   |       |   |  |   |        |     | 
|---------------------------- | ----------------------------- | -------------- | ------ | - | ----------- | - | ---- | ----------- |  | - | ----- | - |  | - | ------ | --- | 
|                             |                               | One-Time       |        |   | Contract    |   |      |             |  |  
|                             |                               | Termination    |        |   | Termination |   |      |             |  |  
|                             |                               | Benefits       |        |   | Costs       |   |      | Other Costs |  |   | Total |  
|                             |                               |                |        |   |             |   |      |             |  |   |       |  
|                             |                               | (In thousands) |       
|Inception of liability       |                               | $              | 1,116  |   |             | $ | 771  |             |  | $ | 11    |   |  | $ | 1,898  |    
|Cash expenditures            |                               |                | (1,116 | ) |             |   | (322 | )           |  |   | (61   | ) |  |   | (1,499 | )  
|Adjustments to the liability |                               |                |       |   |             |   |     |             |  |   | 50    |   |  |   | 50     |    
|                             |                               |                |        |   |             |   |      |             |  |   |       |  
|                             | Balance at September 30, 2004 |                |        |  |             |   |      | 449         |  |   |       |  |  |   |        | 449 | 
|Cash expenditures            |                               |                |       |   |             |   | (6   | )           |  |   |      |   |  |   | (6     | )  
|                             |                               |                |        |   |             |   |      |             |  |   |       |  
|                             | Balance at December 31, 2004  |                | $      |  |             |   | $    | 443         |  |   | $     |  |  |   | $      | 443 | 
|                             |                               |                |        |   |             |   |      |             |  |   |       |  





|         |                                               
|-------- | ----------------------------------------------
|NOTE 4  | Goodwill and Other Purchased Intangible Assets



| |         
| | --------
| | Goodwill









17



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)








| |                  
| | -----------------
| | Intangible Assets



|                                 |                                |                |     |     |            |   |       |           |   |   |          |     |   |       |     |     |   |   |       |      |  
|-------------------------------- | ------------------------------ | -------------- | --- | --- | ---------- | - | ----- | --------- | - | - | -------- | --- | - | ----- | --- | --- | - | - | ----- | ---- | -
|                                 |                                |                |     |     |            |   |       | Non       |   |   |         
|                                 |                                | Developed      |     |     | Core       |   |       | License   |   |   | Compete  |     |   |      
|                                 |                                | Technology     |     |     | Technology |   |       | Agreement |   |   | Contract |     |   | Total |    
|                                 |                                |                |     |     |            |   |       |           |   |   |          |     |   |       |    
|                                 |                                | (In thousands) |    
|Balance as of September 30, 2004 |                                | $              | 932 |     |            | $ | 2,109 |           |   | $ | 949      |     |   | $     | 763 |     |   | $ | 4,753 |     
|                                 | Amortization during the period |                |     | (63 | )          |   |       | (150      | ) |   |          | (95 | ) |       |     | (89 | ) |   |       | (397 | )
|                                 |                                |                |     |     |            |   |       |           |   |   |          |     |   |       |    
|Balance as of December 31, 2004  |                                | $              | 869 |     |            | $ | 1,959 |           |   | $ | 854      |     |   | $     | 674 |     |   | $ | 4,356 |     
|                                 |                                |                |     |     |            |   |       |           |   |   |          |     |   |       |    









|         |                                 
|-------- | --------------------------------
|NOTE 5  | Derivative Financial Instruments







18



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






|         |                     
|-------- | --------------------
|NOTE 6  | Comprehensive Income



|                           |                                                |                          |     |      |            |   |     |      |      |  
|-------------------------- | ---------------------------------------------- | ------------------------ | --- | ---- | ---------- | - | --- | ---- | ---- | -
|                           |                                                | Three Months             |    
|                           |                                                | Ended                    |    
|                           |                                                | December 31,             |    
|                           |                                                |                          |    
|                           |                                                | 2004                     |     |      | 2003       |  
|                           |                                                |                          |     |      |            |  
|                           |                                                | (Restated)               |     |      | (Restated) |  
|                           |                                                | (In thousands)           |    
|Net income                 |                                                | $                        | 517 |      |            | $ | 832 |     
|Other comprehensive loss:  |                                                |                          |     |      |            |   |     |     
|                           | Net change in unrealized losses on investments |                          |     | (156 | )          |   |     | (130 | )   
|                           | Change in foreign currency translation         |                          |     | 128  |            |   |     | (147 | )   
|                           |                                                |                          |     |      |            |  
|                           |                                                | Other comprehensive loss |     |      | (28        | ) |     |      | (277 | )
|                           |                                                |                          |     |      |            |  
|Total comprehensive income |                                                | $                        | 489 |      |            | $ | 555 |     
|                           |                                                |                          |     |      |            |  



|         |                     
|-------- | --------------------
|NOTE 7  | Net Income Per Share



19



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|                    |                                                                          |                                                          |   |        |            |  |   |        |        | 
|------------------- | ------------------------------------------------------------------------ | -------------------------------------------------------- | - | ------ | ---------- |  | - | ------ | ------ | 
|                    |                                                                          | Three Months                                             |  
|                    |                                                                          | Ended                                                    |  
|                    |                                                                          | December 31,                                             |  
|                    |                                                                          |                                                          |  
|                    |                                                                          | 2004                                                     |   |        | 2003       | 
|                    |                                                                          |                                                          |   |        |            | 
|                    |                                                                          | (Restated)                                               |   |        | (Restated) | 
|                    |                                                                          | (In thousands, except per                                |  
|                    |                                                                          | share data)                                              |  
|Numerator:          |                                                                          |                                                          |   |        |            |  |   |       
|                    | Net income from continuing operations before discontinued
    operations |                                                          | $ | 523    |            |  | $ | 785    |       
|                    | Net income (loss) from discontinued operations                           |                                                          |   | (6     | )          |  |   | 47     |       
|                    |                                                                          |                                                          |   |        |            | 
|                    |                                                                          | Net income                                               |   | $      | 517        |  |   | $      | 832    | 
|                    |                                                                          |                                                          |   |        |            | 
|Denominator:        |                                                                          |                                                          |   |        |            |  |   |       
|                    | Weighted average shares for basic net income per share                   |                                                          |   | 16,872 |            |  |   | 16,461 |       
|                    | Effect of dilutive securities: Employee stock options                    |                                                          |   | 137    |            |  |   | 713    |       
|                    |                                                                          |                                                          |   |        |            | 
|                    |                                                                          | Weighted average shares for diluted net income per share |   |        | 17,009     |  |   |        | 17,174 | 
|                    |                                                                          |                                                          |   |        |            | 
|Earnings per share: |                                                                          |                                                          |   |        |            |  |   |       
|                    | Basic net income per share:                                              |                                                          |   |        |            |  |   |        |       
|                    |                                                                          | Net income from continuing operations                    |   | $      | 0.03       |  |   | $      | 0.05   | 
|                    |                                                                          | Net income (loss) from discontinued operations           |   |        | 0.00       |  |   |        | 0.00   | 
|                    |                                                                          |                                                          |   |        |            | 
|                    |                                                                          | Net income per share                                     |   | $      | 0.03       |  |   | $      | 0.05   | 
|                    |                                                                          |                                                          |   |        |            | 
|                    | Diluted net income per share:                                            |                                                          |   |        |            |  |   |        |       
|                    |                                                                          | Net income from continuing operations                    |   | $      | 0.03       |  |   | $      | 0.05   | 
|                    |                                                                          | Net income (loss) from discontinued operations           |   |        | 0.00       |  |   |        | 0.00   | 
|                    |                                                                          |                                                          |   |        |            | 
|                    |                                                                          | Net income per share                                     |   | $      | 0.03       |  |   | $      | 0.05   | 
|                    |                                                                          |                                                          |   |        |            | 





|         |                              
|-------- | -----------------------------
|NOTE 8  | Commitments and Contingencies



| |                    
| | -------------------
| | Purchase Agreements





| |                     
| | --------------------
| | Warranty Obligations



20



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






|                  |                                                                             |                |       |        |      |   |       |      |  
|----------------- | --------------------------------------------------------------------------- | -------------- | ----- | ------ | ---- | - | ----- | ---- | -
|                  |                                                                             | Three Months   |      
|                  |                                                                             | Ended          |      
|                  |                                                                             | December 31,   |      
|                  |                                                                             |                |      
|                  |                                                                             | 2004           |       |        | 2003 |  
|                  |                                                                             |                |       |        |      |  
|                  |                                                                             | (In thousands) |      
|Beginning balance |                                                                             | $              | 6,194 |        |      | $ | 2,363 |     
|                  | Estimated warranty cost of new shipments during the period                  |                |       | 1,500  |      |   |       | 960  |  
|                  | Warranty costs during the period                                            |                |       | (1,538 | )    |   |       | (906 | )
|                  | Changes in liability for pre-existing warranties, including
    expirations |                |       | 75     |      |   |       | 423  |  
|                  |                                                                             |                |       |        |      |  
|Ending balance    |                                                                             | $              | 6,231 |        |      | $ | 2,840 |     
|                  |                                                                             |                |       |        |      |  



| |                  
| | -----------------
| | Legal Proceedings





21



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




2






|         |                       
|-------- | ----------------------
|NOTE 9  | Geographic Information



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PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|         |        |                |   |        |            |  |   |        |        | 
|-------- | ------ | -------------- | - | ------ | ---------- |  | - | ------ | ------ | 
|         |        | Three Months   |  
|         |        | Ended          |  
|         |        | December 31,   |  
|         |        |                |  
|         |        | 2004           |   |        | 2003       | 
|         |        |                |   |        |            | 
|         |        | (Restated)     |   |        | (Restated) | 
|         |        | (In thousands) |  
|Revenue: |        |                |   |        |            |  |   |       
|         | Korea  |                | $ | 6,380  |            |  | $ | 11,172 |       
|         | Taiwan |                |   | 8,339  |            |  |   | 7,271  |       
|         | Japan  |                |   | 11,533 |            |  |   | 5,932  |       
|         | China  |                |   | 10,387 |            |  |   |       |       
|         |        |                |   |        |            | 
|         |        | Total          |   | $      | 36,639     |  |   | $      | 24,375 | 
|         |        |                |   |        |            | 



|         |                  |              |  |    |            |   |  |    |     |  
|-------- | ---------------- | ------------ |  | -- | ---------- | - |  | -- | --- | -
|         |                  | Three Months | 
|         |                  | Ended        | 
|         |                  | December 31, | 
|         |                  |              | 
|         |                  | 2004         |  |    | 2003       |  
|         |                  |              |  |    |            |  
|         |                  | (Restated)   |  |    | (Restated) |  
|Revenue: |                  |              |  |    |            |   |  |   
|         | ArrayCheckertm   |              |  | 64 | %          |   |  | 79 | %  
|         | ArraySavertm     |              |  | 29 | %          |   |  | 14 | %  
|         | Spares and other |              |  | 7  | %          |   |  | 7  | %  
|         |                  |              |  |    |            |  
|         |                  | Total        |  |    | 100        | % |  |    | 100 | %
|         |                  |              |  |    |            |  



|           |  |              |    |   |            |  |    |  
|---------- |  | ------------ | -- | - | ---------- |  | -- | -
|           |  | Three Months |   
|           |  | Ended        |   
|           |  | December 31, |   
|           |  |              |   
|           |  | 2004         |    |   | 2003       | 
|           |  |              |    |   |            | 
|           |  | (Restated)   |    |   | (Restated) | 
|Customer A |  |              | 17 | % |            |  | 16 | %
|Customer B |  |              | *  |   |            |  | 25 | %
|Customer C |  |              | 29 | % |            |  | *  |  
|Customer D |  |              | *  |   |            |  | 23 | %
|Customer E |  |              | *  |   |            |  | 16 | %
|Customer F |  |              | 31 | % |            |  | *  |  
|Customer G |  |              | 18 | % |            |  | 13 | %






|  |                                                                         
|- | ------------------------------------------------------------------------
|* | Customer accounted for less than 10% of total revenue for the
    period

23



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|           |  |             |    |   |              |  |    |  
|---------- |  | ----------- | -- | - | ------------ |  | -- | -
|           |  | December 31 |    |   | September 30 | 
|           |  | 2004        |    |   | 2004         | 
|           |  |             |    |   |              | 
|Customer A |  |             | 17 | % |              |  | 29 | %
|Customer B |  |             | 23 | % |              |  | *  |  
|Customer E |  |             | *  |   |              |  | 16 | %
|Customer F |  |             | 26 | % |              |  | 13 | %
|Customer G |  |             | 10 | % |              |  | *  |  
|Customer H |  |             | *  |   |              |  | 12 | %






|  |                                                                                           
|- | ------------------------------------------------------------------------------------------
|* | Customer accounted for less than 10% of total gross accounts
    receivable for the period



|              |       |                |        |        |              |   |        |        | 
|------------- | ----- | -------------- | ------ | ------ | ------------ | - | ------ | ------ | 
|              |       | December 31    |        |        | September 30 |  
|              |       | 2004           |        |        | 2004         |  
|              |       |                |        |        |              |  
|              |       | (In thousands) |       
|United States |       | $              | 22,400 |        |              | $ | 22,889 |       
|Canada        |       |                | 1,897  |        |              |   | 1,947  |       
|Other         |       |                | 447    |        |              |   | 407    |       
|              |       |                |        |        |              |  
|              | Total |                | $      | 24,744 |              |   | $      | 25,243 | 
|              |       |                |        |        |              |  



|          |                           
|--------- | --------------------------
|NOTE 10  | Related Party Transactions





|          |                           
|--------- | --------------------------
|NOTE 11  | Provision for Income Taxes



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|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|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, 2004, contained in our Annual Report on
Form 10-K, as amended.


Restatement of Financial Statements








| |                         
| | ------------------------
| | Results of Investigation





| |                                                                                                                                                                                                                                                                                                                                
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1) Incomplete documentation of sales arrangements:
    Certain elements of certain sales arrangements with customers
    were not reflected in Photon Dynamics customary sales
    documents and, as a result, Photon Dynamics overstated revenue
    for the value of the undelivered elements within those
    arrangements.

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##### Table of Contents





| |                                                                                                                                                                                                                                                                                                                                                                        
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 2) Unidentified elements in sales arrangements:
    Certain elements of certain sales arrangements with customers
    contained in Photon Dynamics customary sales documents
    were either not identified or not properly analyzed and, as a
    result, Photon Dynamics overstated revenue for the value of the
    undelivered elements within those arrangements.
|
| | 3) Inappropriate amounts deferred: Certain
    undelivered elements within certain sales arrangements were not
    deferred at the appropriate amount and, as a result, Photon
    Dynamics did not recognize the appropriate amount of revenue for
    the undelivered elements.                                                                                      











Overview




| |            
| | -----------
| | Our Company



26



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| |   |                                                                                                                                                                                                      
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The level of capital expenditures of flat panel display
    manufacturers, which in turn depends on the current and
    anticipated market demand for products utilizing flat panel
    displays, and
|
| |  | The relative competitiveness of our products and services.                                                                                                                                           





| |                                     
| | ------------------------------------
| | Focus on Flat Panel Display Industry











| |   |                                                                                                                                                                                                                                                                                                                                                                                 
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Product Focus: We continue to improve our product
    performance in defect detection, repair success, cost of
    ownership, ease of use and throughput for each of our product
    generations. We seek to couple this improved system performance
    with our expert applications engineering services to provide the
    best possible business solutions to our customers.
|
| |  | Quality Focus: We are continuing to implement processes
    to drive product quality improvement and ease of use for our
    customers.                                                                                                                                                                                                                                         
|
| |  | Technology Leadership: We are continuing to emphasize our
    research and development to maintain our technology leadership
    in our products. We have formed an advance technology
    organization to                                                                                                                                                                      

27



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##### Table of Contents



| |   |                                                                                                                                                                                                                                                                                                                          
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |   | focus on our ArrayTest product, our camera development for all
    of our products, and our repair and defect classification
    algorithms for the
    ArraySavertm
    and
    PanelMastertm
    products.                                                                                                             
|
| |  | Financial Improvement: We are continuing to improve
    financial performance. To achieve these goals, we will continue
    to look for vertical integration opportunities, source certain
    raw materials and certain system integration in Asia, and expand
    sales and marketing of our service product offerings.



| |                              
| | -----------------------------
| | Acquisitions and Dispositions







| |         
| | --------
| | Industry









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| |        
| | -------
| | Backlog



Critical Accounting Policies and Estimates










Revenue Recognition.






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Allowance for Doubtful Accounts.




Inventories.




Warranty.




Goodwill and Intangible Assets.




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Contingencies and Litigation.


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Results of Operations




| |                        
| | -----------------------
| | Selected Financial Data



|                                                                                      |                                     |                          |       |      |            |  |       |      |      | 
|------------------------------------------------------------------------------------- | ----------------------------------- | ------------------------ | ----- | ---- | ---------- |  | ----- | ---- | ---- | 
|                                                                                      |                                     | Three Months             |      
|                                                                                      |                                     | Ended                    |      
|                                                                                      |                                     | December 31,             |      
|                                                                                      |                                     |                          |      
|                                                                                      |                                     | 2004                     |       |      | 2003       | 
|                                                                                      |                                     |                          |       |      |            | 
|                                                                                      |                                     | (Restated)               |       |      | (Restated) | 
|Revenue                                                                               |                                     |                          | 100.0 | %    |            |  | 100.0 | %   
|Cost of revenue                                                                       |                                     |                          | 62.2  |      |            |  | 55.0  |     
|                                                                                      |                                     |                          |       |      |            | 
|Gross margin                                                                          |                                     |                          | 37.8  |      |            |  | 45.0  |     
|                                                                                      |                                     |                          |       |      |            | 
|Operating expenses:                                                                   |                                     |                          |       |      |            |  |       |     
|                                                                                      | Research and development            |                          |       | 25.8 |            |  |       | 23.8 |     
|                                                                                      | Selling, general and administrative |                          |       | 12.8 |            |  |       | 18.9 |     
|                                                                                      | Amortization of intangible assets   |                          |       | 1.1  |            |  |       | 0.8  |     
|                                                                                      | Goodwill impairment charge          |                          |       |     |            |  |       | 2.7  |     
|                                                                                      | Impairment of purchased intangibles |                          |       |     |            |  |       | 8.6  |     
|                                                                                      | Impairment of fixed assets          |                          |       |     |            |  |       | 1.0  |     
|                                                                                      |                                     |                          |       |      |            | 
|                                                                                      |                                     | Total operating expenses |       |      | 39.7       |  |       |      | 55.8 | 
|                                                                                      |                                     |                          |       |      |            | 
|Loss from operations                                                                  |                                     |                          | (1.9  | )    |            |  | (10.8 | )   
|Interest income and other, net                                                        |                                     |                          | 3.4   |      |            |  | 15.5  |     
|                                                                                      |                                     |                          |       |      |            | 
|Income from continuing operations before income taxes and
    discontinued operations |                                     |                          | 1.5   |      |            |  | 4.7   |     
|Provision for income taxes                                                            |                                     |                          | 0.1   |      |            |  | 1.5   |     
|                                                                                      |                                     |                          |       |      |            | 
|Income from continuing operations                                                     |                                     |                          | 1.4   |      |            |  | 3.2   |     
|Income (loss) from discontinued operations                                            |                                     |                          | 0.0   |      |            |  | 0.2   |     
|                                                                                      |                                     |                          |       |      |            | 
|Net income                                                                            |                                     |                          | 1.4   |      |            |  | 3.4   |     
|                                                                                      |                                     |                          |       |      |            | 



| |        
| | -------
| | Revenue

|        |  |                       |      |  |        |  |            |      |  |   |      | 
|------- |  | --------------------- | ---- |  | ------ |  | ---------- | ---- |  | - | ---- | 
|        |  | Three Months          |     
|        |  | Ended                 |     
|        |  | December 31,          |     
|        |  |                       |     
|        |  | 2004                  |      |  | Change |  |            | 2003 | 
|        |  |                       |      |  |        |  |            |      | 
|        |  | (Restated)            |      |  |        |  | (Restated) |     
|        |  | (Dollars in millions) |     
|Revenue |  | $                     | 36.6 |  |        |  | 50         | %    |  | $ | 24.4 | 





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tm tm


tm tm tm tm






| |             
| | ------------
| | Gross Margin

|             |  |              |    |   |        |  |            |      |  |  |    |  
|------------ |  | ------------ | -- | - | ------ |  | ---------- | ---- |  |  | -- | -
|             |  | Three Months |   
|             |  | Ended        |   
|             |  | December 31, |   
|             |  |              |   
|             |  | 2004         |    |   | Change |  |            | 2003 | 
|             |  |              |    |   |        |  |            |      | 
|             |  | (Restated)   |    |   |        |  | (Restated) |     
|Gross Margin |  |              | 38 | % |        |  | (16        | )%   |  |  | 45 | %

tm tm tm


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| |   |                                                                                                                                              
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------
| |  | Our revenue mix between higher margin
    ArrayCheckertm
    systems and lower margin
    ArraySavertm
    and
    PanelMastertm
    systems;
|
| |  | The costs of increasing customer service staff to support the
    increased demands of our customers;                                        
|
| |  | The additional costs in connection with developing new products;                                                                             
|
| |  | Competitive pricing pressures, particularly in the array repair
    market; and                                                              
|
| |  | Fluctuations in the level of revenue due to the cyclical nature
    of customers capital expenditures.                                      



| |                         
| | ------------------------
| | Research and Development

|                   |  |                       |     |   |        |  |    |      |  |   |     |  
|------------------ |  | --------------------- | --- | - | ------ |  | -- | ---- |  | - | --- | -
|                   |  | Three Months          |    
|                   |  | Ended                 |    
|                   |  | December 31,          |    
|                   |  |                       |    
|                   |  | 2004                  |     |   | Change |  |    | 2003 | 
|                   |  |                       |     |   |        |  |    |      | 
|                   |  | (Dollars in millions) |    
|Expense            |  | $                     | 9.5 |   |        |  | 63 | %    |  | $ | 5.8 |  
|Percent of Revenue |  |                       | 26  | % |        |  |    |      |  |   | 24  | %







| |   |                                                                                                                   
| | - | ------------------------------------------------------------------------------------------------------------------
| |  | Ramp up our cell and module program to address mass production
    requirements;                                  
|
| |  | Increase our efforts on Generation 7 products and launch
    development programs for Generation 7.5 products; and
|
| |  | Expand our repair product offering.                                                                               





| |                                    
| | -----------------------------------
| | Selling, General and Administrative

|                   |  |                       |     |   |        |  |   |      |  |   |     |  
|------------------ |  | --------------------- | --- | - | ------ |  | - | ---- |  | - | --- | -
|                   |  | Three Months          |    
|                   |  | Ended                 |    
|                   |  | December 31,          |    
|                   |  |                       |    
|                   |  | 2004                  |     |   | Change |  |   | 2003 | 
|                   |  |                       |     |   |        |  |   |      | 
|                   |  | (Dollars in millions) |    
|Expense            |  | $                     | 4.7 |   |        |  | 2 | %    |  | $ | 4.6 |  
|Percent of Revenue |  |                       | 13  | % |        |  |   |      |  |   | 19  | %



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| |                            
| | ---------------------------
| | Amortization of Intangibles

|                   |  |              |         |   |        |  |    |      |  |   |         |  
|------------------ |  | ------------ | ------- | - | ------ |  | -- | ---- |  | - | ------- | -
|                   |  | Three Months |        
|                   |  | Ended        |        
|                   |  | December 31, |        
|                   |  |              |        
|                   |  | 2004         |         |   | Change |  |    | 2003 | 
|                   |  |              |         |   |        |  |    |      | 
|Expense            |  | $            | 397,000 |   |        |  | 98 | %    |  | $ | 201,000 |  
|Percent of Revenue |  |              | 1       | % |        |  |    |      |  |   | 1       | %





| |                                                                   
| | ------------------------------------------------------------------
| | Impairment of Goodwill, Purchased Intangibles and Fixed
    Assets





| |                               
| | ------------------------------
| | Interest Income and Other, Net

|                   |  |                       |     |   |        |  |     |      |  |   |     |  
|------------------ |  | --------------------- | --- | - | ------ |  | --- | ---- |  | - | --- | -
|                   |  | Three Months          |    
|                   |  | Ended                 |    
|                   |  | December 31,          |    
|                   |  |                       |    
|                   |  | 2004                  |     |   | Change |  |     | 2003 | 
|                   |  |                       |     |   |        |  |     |      | 
|                   |  | (Dollars in millions) |    
|Income             |  | $                     | 1.3 |   |        |  | (67 | )%   |  | $ | 3.8 |  
|Percent of Revenue |  |                       | 3   | % |        |  |     |      |  |   | 16  | %





| |                           
| | --------------------------
| | Provision for Income Taxes

|                   |  |              |        |   |        |  |     |      |  |   |         |  
|------------------ |  | ------------ | ------ | - | ------ |  | --- | ---- |  | - | ------- | -
|                   |  | Three Months |       
|                   |  | Ended        |       
|                   |  | December 31, |       
|                   |  |              |       
|                   |  | 2004         |        |   | Change |  |     | 2003 | 
|                   |  |              |        |   |        |  |     |      | 
|Expense            |  | $            | 39,000 |   |        |  | (89 | )%   |  | $ | 362,000 |  
|Percent of Revenue |  |              | 0      | % |        |  |     |      |  |   | 2       | %



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| |                        
| | -----------------------
| | Discontinued Operations

|              |  |              |        |   |      |   |        | 
|------------- |  | ------------ | ------ | - | ---- | - | ------ | 
|              |  | Three Months |       
|              |  | Ended        |       
|              |  | December 31, |       
|              |  |              |       
|              |  | 2004         |        |   | 2003 |  
|              |  |              |        |   |      |  
|Income (loss) |  | $            | (6,000 | ) |      | $ | 47,000 | 



Liquidity and Capital Resources






| |                                              
| | ---------------------------------------------
| | Operating Activities of Continuing Operations





| |                                              
| | ---------------------------------------------
| | Investing Activities of Continuing Operations





| |                                              
| | ---------------------------------------------
| | Financing Activities of Continuing Operations



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| |                                                                             
| | ----------------------------------------------------------------------------
| | Operating, Investing and Financing Activities of
    Discontinued Operations



|                                                                        |                                              |                |     |    |      |   |     |     | 
|----------------------------------------------------------------------- | -------------------------------------------- | -------------- | --- | -- | ---- | - | --- | --- | 
|                                                                        |                                              | Three Months   |    
|                                                                        |                                              | Ended          |    
|                                                                        |                                              | December 31,   |    
|                                                                        |                                              |                |    
|                                                                        |                                              | 2004           |     |    | 2003 |  
|                                                                        |                                              |                |     |    |      |  
|                                                                        |                                              | (In thousands) |    
|Printed circuit board business                                          |                                              | $              | (94 | )  |      | $ | 397 |    
|Cathode ray tube display and high quality glass inspection
    business |                                              |                | 144 |    |      |   | 256 |    
|                                                                        |                                              |                |     |    |      |  
|                                                                        | Net cash provided by discontinued operations |                | $   | 50 |      |   | $   | 653 | 
|                                                                        |                                              |                |     |    |      |  



| |                        
| | -----------------------
| | Contractual Obligations



|                            |       |                             |        |        |      |   |        |        |  |   |       |       |  |      |       |       |      |   |       |            |  |   |       |       |  |   |       |       | 
|--------------------------- | ----- | --------------------------- | ------ | ------ | ---- | - | ------ | ------ |  | - | ----- | ----- |  | ---- | ----- | ----- | ---- | - | ----- | ---------- |  | - | ----- | ----- |  | - | ----- | ----- | 
|                            |       | Payments Due by Fiscal Year |       
|                            |       |                             |       
|Contractual Obligations     |       | Total                       |        |        | 2005 |   |        | 2006   |  |   | 2007  |       |  | 2008 |       |       | 2009 |   |       | Thereafter | 
|                            |       |                             |        |        |      |   |        |        |  |   |       |       |  |      |       |       |      |   |       |            | 
|                            |       | (In thousands)              |       
|Notes payable               |       | $                           | 2,638  |        |      | $ | 1,255  |        |  | $ | 1,383 |       |  | $    |      |       |      | $ |      |            |  | $ |      |       |  | $ |      |      
|Operating lease obligations |       |                             | 18,019 |        |      |   | 2,802  |        |  |   | 3,533 |       |  |      | 3,007 |       |      |   | 2,652 |            |  |   | 2,627 |       |  |   | 3,398 |      
|Purchase obligations        |       |                             | 25,604 |        |      |   | 20,515 |        |  |   | 1,568 |       |  |      | 2,805 |       |      |   | 715   |            |  |   | 1     |       |  |   |      |      
|                            |       |                             |        |        |      |   |        |        |  |   |       |       |  |      |       |       |      |   |       |            | 
|                            | Total |                             | $      | 46,261 |      |   | $      | 24,572 |  |   | $     | 6,484 |  |      | $     | 5,812 |      |   | $     | 3,367      |  |   | $     | 2,628 |  |   | $     | 3,398 | 
|                            |       |                             |        |        |      |   |        |        |  |   |       |       |  |      |       |       |      |   |       |            | 







| |                
| | ---------------
| | Working Capital



37



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Impact of Accounting Pronouncements








Factors Affecting Operating Results




| |                                                                      
| | ---------------------------------------------------------------------
| | We have sustained losses and we may sustain losses in the
    future.



38



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

tm






| |   |                                                                                                                                                               
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the timing of the receipt of orders from major customers;                                                                                                     
|
| |  | our product mix;                                                                                                                                              
|
| |  | competitive pricing pressures;                                                                                                                                
|
| |  | our ability to obtain components from our single or limited
    source suppliers in a timely manner;                                                          
|
| |  | global economic uncertainty;                                                                                                                                  
|
| |  | changing international economic conditions;                                                                                                                   
|
| |  | worldwide political instability;                                                                                                                              
|
| |  | our ability to design, manufacture and introduce new products on
    a cost-effective and timely basis;                                                       
|
| |  | the delay between expenses to further develop marketing and
    service capabilities and the realization of benefits from those
    improved capabilities; and
|
| |  | the introduction of new products by our competitors.                                                                                                          





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

tm tm tm


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| |   |                                          
| | - | -----------------------------------------
| |  | delays in collecting accounts receivable;
|
| |  | reduced orders;                          
|
| |  | additional service expenses; and         
|
| |  | higher manufacturing costs.              







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







| |                                                                                                                                                                            
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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.



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| |                                                                                                                                                                       
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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.





| |                                                                                                                                                                                               
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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.



tm tm tm tm






| |                                                                                                                                                                                                                                           
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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.





| |                                                                                                                                                                             
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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.





| |   |                                                                                         
| | - | ----------------------------------------------------------------------------------------
| |  | political instability and the possibility of hostilities,
    terrorist attacks, or war;
|
| |  | imposition of governmental controls;                                                    
|
| |  | fluctuations in interest and currency exchange rates;                                   

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| |   |                                                                
| | - | ---------------------------------------------------------------
| |  | export license requirements;                                   
|
| |  | restrictions on the export of technology;                      
|
| |  | limited foreign protection of intellectual property rights;    
|
| |  | trade restrictions;                                            
|
| |  | periodic or local international downturns;                     
|
| |  | changes in tariffs; and                                        
|
| |  | difficulties in staffing and managing international operations.





| |                                                                                                                                                                                                                                                                                                            
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Compliance with new reporting requirements may strain our
    resources and we may be unable to implement in a timely manner
    additional finance and accounting systems, procedures and
    controls in the future to satisfy new reporting requirements,
    which could cause our stock price to fall.







| |                                                                                                                                                                                                    
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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.



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| |   |                                                                                                  
| | - | -------------------------------------------------------------------------------------------------
| |  | difficulty in the assimilation of the technologies and products
    of the acquired company;     
|
| |  | entering markets in which we have no or limited direct prior
    experience;                     
|
| |  | loss of key customers of the acquired company;                                                   
|
| |  | diversion of management resources from the business of the
    combined company;                 
|
| |  | incompatibility of business cultures or practices;                                               
|
| |  | loss of key employees of the acquired company;                                                   
|
| |  | costs and delays in implementing common systems and procedures;                                  
|
| |  | potential inefficiencies in delivering services to the customers
    of the combined company; and
|
| |  | assumption of unknown or undisclosed liabilities.                                                







| |                                                                                                                                                                                                                                         
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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.





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



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





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







| |                                                                                                                                                                                                         
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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.





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





| |                                                                                            
| | -------------------------------------------------------------------------------------------
| | Terrorism and international political instability may
    negatively affect our operations.







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







| |                                             
| | --------------------------------------------
| | Our stock price may fluctuate significantly.





| |   |                                                                                            
| | - | -------------------------------------------------------------------------------------------
| |  | announcements of technological innovations or new products by us
    or by our competitors;
|
| |  | government regulations;                                                                    
|
| |  | developments in patent or other property rights; and                                       
|
| |  | developments in our relationships with our customers.                                      



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| |                                                                            
| | ---------------------------------------------------------------------------
| | Some anti-takeover provisions may affect the price of our
    common stock.





| |                                            
| | -------------------------------------------
| | We do not anticipate paying cash dividends.





| |                                                                                                                                                                                   
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | New regulations related to equity compensation will
    negatively impact our financial statements and could adversely
    affect our ability to attract and retain key personnel.








|        |                        
|------- | -----------------------
|ITEM 4. | Controls and Procedures

Evaluation of Disclosure Controls and Procedures.


Efforts to Address Existing Material Weaknesses and Other
Deficiencies.


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| |   |                                                                                                                                                                                                                                                                        
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | an appropriate level of review of those significant financial
    statement accounts requiring a higher degree of judgment and
    estimates, in part due to the need for more personnel as well as
    more highly skilled and trained personnel in certain positions;
|
| |  | a formal review process of the financial statements and
    supporting schedules of our international subsidiaries; and                                                                                                                                                
|
| |  | consistent processes and controls over revenue transactions
    entered into and recorded by our Japanese subsidiary with those
    processes and controls in place in the U.S.                                                                                        













| |                                                                                             
| | --------------------------------------------------------------------------------------------
| | Changes in Internal Control Over Financial Reporting in
    the First Quarter of Fiscal 2005



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| |                                                                                                        
| | -------------------------------------------------------------------------------------------------------
| | Changes in Internal Control Over Financial Reporting
    Subsequent to the First Quarter of Fiscal 2005





| |   |                                                                                                                                                                                                                                        
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | We hired a new Chief Financial Officer, as of May 31, 2005.                                                                                                                                                                            
|
| |  | We hired a new Vice President of Finance and a new Corporate
    Controller, each of whom began employment with us in July 2005.                                                                                                       
|
| |  | We improved our sales certification program to ensure
    completeness of all documentation relating to complex financial
    transactions, as well as requiring a review of all material
    transactions by senior finance personnel.
|
| |  | We enhanced controls around the close process and consolidation
    to ensure timely reconciliations and reviews of all subsidiary
    and consolidated financial statements.                                                          
|
| |  | We performed additional training for key personnel in the proper
    methodology of revenue allocation for undelivered elements and
    other technical revenue recognition concepts.                                                  
|
| |  | We implemented a revised signature authorization policy to
    ensure that all contractual commitments made by the company are
    properly authorized and accounted for.                                                              
|
| |  | We strengthened our Disclosure Committee process to ensure that
    filings are properly reviewed and reflect all known material
    information required.                                                                             
|
| |  | We hired a new Asia Pacific controller in Korea to oversee Asia
    accounting personnel and ensure policies and procedures are
    followed.                                                                                          
|
| |  | We improved our reviews of all accounting estimates;
    specifically, excess and obsolete inventory, warranty and other
    reserves and accruals.                                                                                    

Limitations on the Effectiveness of Disclosure Controls and
Procedures.


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PART II. OTHER INFORMATION







|        |         
|------- | --------
|ITEM 6. | Exhibits

Exhibits


|       |    |         |  |                                                                                                                                                                
|------ | -- | ------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------
|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 | .41(5)  |  | Amendment to Consulting Agreement between the Registrant and
    Malcolm Thompson dated December 22, 2004.                                                     
|      
|       | 10 | .42(3)  |  | Cash Compensation Policy for the Registrants outside
    directors.                                                                                           
|      
|       | 10 | .43(4)  |  | Form of Indemnification Agreement to be used between the
    Registrant and each of its executive officers and directors.                                      
|      
|       | 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).








|    |                                                                                                                                                                                                                                                                                 
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Previously filed as the like-numbered exhibit to the
    Registrants Registration Statement on Form S-1
    (Commission File No. 333-76650) as filed with the
    Securities and Exchange Commission on January 14, 2002, as
    amended, and incorporated herein by reference.
|   
|(2) | Previously filed as the like-numbered exhibit to the
    Registrants Annual Report on Form 10-KSB for the
    fiscal year ended September 30, 1998 as filed with the
    Securities and Exchange Commission on December 18, 1998,
    and incorporated herein by reference.    
|   
|(3) | Previously filed under the heading Change in Compensation
    of Outside Directors of Item 1.01 of the
    Registrants Current Report on form 8-K as filed with
    the Securities and Exchange Commission on October 25, 2004,
    and incorporated herein by reference.    
|   
|(4) | Previously filed as Exhibit 10.1 to the Registrants
    Current Report on Form 8-K as filed with the Securities and
    Exchange Commission on December 20, 2004, and incorporated
    herein by reference.                                                                    
|   
|(5) | Previously filed as an exhibit to the Registrants
    Quarterly Report on Form 10-Q for the quarter ended
    December 30, 2004 as filed with the SEC on February 9,
    2005, and incorporated here by reference.                                                             



| |   |                                                                                                                                                                                                                                                                                                 
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | * | The certification attached as Exhibit 32.1 accompanies the
    Quarterly Report on Form 10-Q pursuant to Section 906
    of the Sarbanes-Oxley Act of 2002 and shall not be deemed
    filed by the Company for purposes of Section 18
    of the Securities Exchange Act of 1934, as amended.

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SIGNATURES






| |                      
| | ---------------------
| | PHOTON DYNAMICS, INC.



| |     |                    
| | --- | -------------------
| | By: | /s/ Maureen L. Lamb

| |                                                  
| | -------------------------------------------------
| |                                                  
| | Maureen L. Lamb                                  
| | Chief Financial Officer and Secretary            
| | (Duly authorized and principal financial officer)



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Exhibit Index


|       |    |         |  |                                                                                                                                                                
|------ | -- | ------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------
|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 | .41(5)  |  | Amendment to Consulting Agreement between the Registrant and
    Malcolm Thompson dated December 22, 2004.                                                     
|      
|       | 10 | .42(3)  |  | Cash Compensation Policy for the Registrants outside
    directors.                                                                                           
|      
|       | 10 | .43(4)  |  | Form of Indemnification Agreement to be used between the
    Registrant and each of its executive officers and directors.                                      
|      
|       | 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).




Key to Exhibits:




|    |                                                                                                                                                                                                                                                                                 
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Previously filed as the like-numbered exhibit to the
    Registrants Registration Statement on Form S-1
    (Commission File No. 333-76650) as filed with the
    Securities and Exchange Commission on January 14, 2002, as
    amended, and incorporated herein by reference.
|   
|(2) | Previously filed as the like-numbered exhibit to the
    Registrants Annual Report on Form 10-KSB for the
    fiscal year ended September 30, 1998 as filed with the
    Securities and Exchange Commission on December 18, 1998,
    and incorporated herein by reference.    
|   
|(3) | Previously filed under the heading Change in Compensation
    of Outside Directors of Item 1.01 of the
    Registrants Current Report on Form 8-K as filed with
    the Securities and Exchange Commission on October 25, 2004,
    and incorporated herein by reference.    
|   
|(4) | Previously filed as Exhibit 10.1 to the Registrants
    Current Report on Form 8-K as filed with the Securities and
    Exchange Commission on December 20, 2004, and incorporated
    herein by reference.                                                                    
|   
|(5) | Previously filed as an exhibit to the Registrants
    Quarterly Report on Form 10-Q for the quarter ended
    December 30, 2004 as filed with the SEC on February 9,
    2005, and incorporated here by reference.                                                             



| |   |                                                                                                                                                                                                                                                                                                 
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | * | The certification attached as Exhibit 32.1 accompanies the
    Quarterly Report on Form 10-Q pursuant to Section 906
    of the Sarbanes-Oxley Act of 2002 and shall not be deemed
    filed by the Company for purposes of Section 18
    of the Securities Exchange Act of 1934, as amended.

51