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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549




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FORM 10-Q

|  |  |                                                                                        
|- |  | ---------------------------------------------------------------------------------------
|x |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2003

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



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PHOTON DYNAMICS, INC.

(Exact name of registrant as specified in its charter)


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

17 Great Oaks Blvd.
San Jose, California 95119
(Address of principal executive offices including zip code)
(408) 360-3550
(Registrants telephone number, including area code)



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

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Securities Exchange Act of 1934, as amended). Yes
x No o

As of April 30, 2003, there were 15,975,007 shares outstanding of the
Registrants Common Stock, no par value.



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TABLE OF CONTENTS



|                              |                                                                                               |                                                      |  |  |  |  |  | 
|----------------------------- | --------------------------------------------------------------------------------------------- | ---------------------------------------------------- |  |  |  |  |  | 
|PART I. FINANCIAL INFORMATION
|                              | ITEM 1. Financial Statements                                                                 
|                              |                                                                                               | CONDENSED CONSOLIDATED BALANCE SHEETS               
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS     
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                              |                                                                                               | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
|                              | Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                              | Item 3. Quantitative and Qualitative Disclosures About Market Risk                           
|                              | Item 4. Controls and Procedures                                                              
|PART II. OTHER INFORMATION   
|                              | Item 1. Legal Proceedings                                                                    
|                              | Item 2. Changes in Securities and Use of Proceeds                                            
|                              | Item 3. Defaults Upon Senior Securities                                                      
|                              | Item 4. Submission of Matters to a Vote of Security Holders                                  
|                              | Item 5. Other Information                                                                    
|                              | Item 6. Exhibits and Reports on Form 8-K                                                     
|SIGNATURES                   
|CERTIFICATIONS               
|EXHIBIT 10.22                
|EXHIBIT 10.26                
|EXHIBIT 10.27                
|EXHIBIT 10.28                
|EXHIBIT 99.1                 



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INDEX

|               |  |                                                                                                                   |  |     
|-------------- |  | ----------------------------------------------------------------------------------------------------------------- |  | ----
|               |  |                                                                                                                   |  | Page
|               |  |                                                                                                                   |  |     
|PART I         |  | FINANCIAL INFORMATION                                                                                             |  |     
|Item 1.        |  | Financial Statements (unaudited)                                                                                  |  |     
|               |  | Condensed Consolidated Balance Sheets as of March 31,
2003 and September 30, 2002                                 |  | 3   
|               |  | Condensed Consolidated Statements of Operations for the
Three and Six Month Periods Ended March 31, 2003 and 2002 |  | 4   
|               |  | Condensed Consolidated Statements of Cash Flows for the
Six Months Ended March 31, 2003 and 2002                  |  | 5   
|               |  | Notes to Condensed Consolidated Financial Statements                                                              |  | 6   
|Item 2.        |  | Managements Discussion and Analysis of Financial
Condition and Results of Operations                             |  | 17  
|Item 3.        |  | Quantitative and Qualitative Disclosures About Market
Risk                                                        |  | 31  
|Item 4.        |  | Controls and Procedures                                                                                           |  | 31  
|PART II        |  | OTHER INFORMATION                                                                                                 |  |     
|Item 1.        |  | Legal Proceedings                                                                                                 |  | 33  
|Item 2.        |  | Changes in Securities and Use of Proceeds                                                                         |  | 33  
|Item 3.        |  | Defaults Upon Senior Securities                                                                                   |  | 33  
|Item 4.        |  | Submission of Matters to a Vote of Security Holders                                                               |  | 33  
|Item 5.        |  | Other Information                                                                                                 |  | 34  
|Item 6.        |  | Exhibits and Reports on Form 8-K                                                                                  |  | 34  
|Signatures     |  |                                                                                                                   |  | 36  
|Certifications |  |                                                                                                                   |  | 37  

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PART I. FINANCIAL INFORMATION




ITEM 1.Financial Statements




PHOTON DYNAMICS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)

|                                     |                                        |                                            |        |                |         |               |        |         |         | 
|------------------------------------ | -------------------------------------- | ------------------------------------------ | ------ | -------------- | ------- | ------------- | ------ | ------- | ------- | 
|                                     |                                        |                                            |        | March 31,      |         | September 30,
|                                     |                                        |                                            |        | 2003           |         | 2002         
|                                     |                                        |                                            |        |                |         |              
|                                     |                                        |                                            |        | (in thousands)
|ASSETS                               |                                        |                                            |        |                |         |               |        |        
|Current assets:                      |                                        |                                            |        |                |         |               |        |        
|                                     | Cash and cash equivalents              |                                            | $      | 13,380         |         |               | $      | 25,580  |        
|                                     | Short-term investments                 |                                            |        | 104,480        |         |               |        | 144,563 |        
|                                     | Accounts receivable, net               |                                            |        | 16,314         |         |               |        | 16,579  |        
|                                     | Inventories                            |                                            |        | 13,458         |         |               |        | 18,650  |        
|                                     | Other current assets                   |                                            |        | 6,268          |         |               |        | 6,367   |        
|                                     |                                        |                                            |        |                |         |               |        |        
|                                     |                                        | Total current assets                       |        |                | 153,900 |               |        |         | 211,739 | 
|Land, property and equipment, net    |                                        |                                            | 12,584 |                |         |               | 12,404 |        
|Other assets                         |                                        |                                            | 2,613  |                |         |               | 2,925  |        
|Intangible assets, net               |                                        |                                            | 6,287  |                |         |               | 3,554  |        
|Goodwill                             |                                        |                                            | 10,520 |                |         |               | 18,537 |        
|                                     |                                        |                                            |        |                |         |               |        |        
|                                     |                                        | Total assets                               |        | $              | 185,904 |               |        | $       | 249,159 | 
|                                     |                                        |                                            |        |                |         |               |        |         |        
|LIABILITIES AND SHAREHOLDERS EQUITY |                                        |                                            |        |                |         |               |        |        
|Current liabilities:                 |                                        |                                            |        |                |         |               |        |        
|                                     | Accounts payable                       |                                            | $      | 6,942          |         |               | $      | 10,610  |        
|                                     | Other current liabilities              |                                            |        | 10,044         |         |               |        | 10,637  |        
|                                     | Deferred revenue                       |                                            |        | 5,554          |         |               |        | 304     |        
|                                     |                                        |                                            |        |                |         |               |        |        
|                                     |                                        | Total current liabilities                  |        |                | 22,540  |               |        |         | 21,551  | 
|Other liabilities                    |                                        |                                            | 1,155  |                |         |               | 1,465  |        
|Commitments and contingencies        |                                        |                                            |        |                |         |               |        |        
|Shareholders equity:                |                                        |                                            |        |                |         |               |        |        
|                                     | Common stock, no par value             |                                            |        | 272,783        |         |               |        | 288,833 |        
|                                     | Accumulated deficit                    |                                            |        | (111,531       | )       |               |        | (63,500 | )      
|                                     | Accumulated other comprehensive income |                                            |        | 957            |         |               |        | 810     |        
|                                     |                                        |                                            |        |                |         |               |        |        
|                                     |                                        | Total shareholders equity                 |        |                | 162,209 |               |        |         | 226,143 | 
|                                     |                                        |                                            |        |                |         |               |        |        
|                                     |                                        | Total liabilities and shareholders equity |        | $              | 185,904 |               |        | $       | 249,159 | 
|                                     |                                        |                                            |        |                |         |               |        |         |        

See accompanying notes to condensed consolidated financial statements.

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PHOTON DYNAMICS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

|                                                       |                                              |                          |         |                                       |        |                  |        |       |       |      |         |        |        |   |        |       |        | 
|------------------------------------------------------ | -------------------------------------------- | ------------------------ | ------- | ------------------------------------- | ------ | ---------------- | ------ | ----- | ----- | ---- | ------- | ------ | ------ | - | ------ | ----- | ------ | 
|                                                       |                                              |                          |         | Three months ended                    |        | Six months ended
|                                                       |                                              |                          |         | March 31,                             |        | March 31,       
|                                                       |                                              |                          |         |                                       |        |                 
|                                                       |                                              |                          |         | 2003                                  |        | 2002             |        | 2003  |       | 2002
|                                                       |                                              |                          |         |                                       |        |                  |        |       |       |     
|                                                       |                                              |                          |         | (in thousands, except per share data)
|Revenue                                                |                                              | $                        | 10,133  |                                       |        | $                | 13,932 |       |       | $    | 30,005  |        |        | $ | 25,301 |      
|Cost of revenue                                        |                                              |                          | 8,658   |                                       |        |                  | 7,392  |       |       |      | 20,725  |        |        |   | 14,370 |      
|                                                       |                                              |                          |         |                                       |        |                  |        |       |       |      |         |        |        |   |        |      
|Gross margin                                           |                                              |                          | 1,475   |                                       |        |                  | 6,540  |       |       |      | 9,280   |        |        |   | 10,931 |      
|Operating expenses:                                    |                                              |                          |         |                                       |        |                  |        |       |       |      |         |        |        |   |        |      
|                                                       | Research and development                     |                          |         | 5,594                                 |        |                  |        | 3,293 |       |      |         | 10,241 |        |   |        | 6,226 |       
|                                                       | Selling, general and administrative          |                          |         | 4,110                                 |        |                  |        | 3,095 |       |      |         | 7,608  |        |   |        | 5,829 |       
|                                                       | Long-lived asset impairment charge           |                          |         |                                      |        |                  |        |      |       |      |         | 303    |        |   |        |      |       
|                                                       | Acquired in-process research and
development |                          |         |                                      |        |                  |        |      |       |      |         | 1,849  |        |   |        |      |       
|                                                       | Amortization of intangible assets            |                          |         | 367                                   |        |                  |        |      |       |      |         | 627    |        |   |        |      |       
|                                                       |                                              |                          |         |                                       |        |                  |        |       |       |      |         |        |        |   |        |      
|                                                       |                                              | Total operating expenses |         |                                       | 10,071 |                  |        |       | 6,388 |      |         |        | 20,628 |   |        |       | 12,055 | 
|Income (loss) from operations                          |                                              |                          | (8,596  | )                                     |        |                  | 152    |       |       |      | (11,348 | )      |        |   | (1,124 | )    
|Interest income and other, net                         |                                              |                          | 680     |                                       |        |                  | 639    |       |       |      | 1,494   |        |        |   | 1,161  |      
|                                                       |                                              |                          |         |                                       |        |                  |        |       |       |      |         |        |        |   |        |      
|Income (loss) from continuing operations               |                                              |                          | (7,916  | )                                     |        |                  | 791    |       |       |      | (9,854  | )      |        |   | 37     |      
|Loss from discontinued operations                      |                                              |                          | (15,099 | )                                     |        |                  | (2,403 | )     |       |      | (38,177 | )      |        |   | (5,013 | )    
|                                                       |                                              |                          |         |                                       |        |                  |        |       |       |      |         |        |        |   |        |      
|Net loss                                               |                                              | $                        | (23,015 | )                                     |        | $                | (1,612 | )     |       | $    | (48,031 | )      |        | $ | (4,976 | )    
|                                                       |                                              |                          |         |                                       |        |                  |        |       |       |      |         |        |        |   |        |      
|Net income (loss) per share from continuing
operations |                                              |                          |         |                                       |        |                  |        |       |       |      |         |        |        |   |        |      
|Basic                                                  |                                              | $                        | (0.50   | )                                     |        | $                | 0.05   |       |       | $    | (0.61   | )      |        | $ | 0.00   |      
|                                                       |                                              |                          |         |                                       |        |                  |        |       |       |      |         |        |        |   |        |      
|Diluted                                                |                                              | $                        | (0.50   | )                                     |        | $                | 0.05   |       |       | $    | (0.61   | )      |        | $ | 0.00   |      
|                                                       |                                              |                          |         |                                       |        |                  |        |       |       |      |         |        |        |   |        |      
|Loss per share from discontinued operations            |                                              |                          |         |                                       |        |                  |        |       |       |      |         |        |        |   |        |      
|Basic and diluted                                      |                                              | $                        | (0.94   | )                                     |        | $                | (0.15  | )     |       | $    | (2.38   | )      |        | $ | (0.34  | )    
|                                                       |                                              |                          |         |                                       |        |                  |        |       |       |      |         |        |        |   |        |      
|Net loss per share                                     |                                              |                          |         |                                       |        |                  |        |       |       |      |         |        |        |   |        |      
|Basic and diluted                                      |                                              | $                        | (1.44   | )                                     |        | $                | (0.10  | )     |       | $    | (2.99   | )      |        | $ | (0.34  | )    
|                                                       |                                              |                          |         |                                       |        |                  |        |       |       |      |         |        |        |   |        |      
|Weighted average number of shares:                     |                                              |                          |         |                                       |        |                  |        |       |       |      |         |        |        |   |        |      
|Basic                                                  |                                              |                          | 15,944  |                                       |        |                  | 15,746 |       |       |      | 16,052  |        |        |   | 14,831 |      
|Diluted                                                |                                              |                          | 15,944  |                                       |        |                  | 16,788 |       |       |      | 16,052  |        |        |   | 15,806 |      

See accompanying notes to condensed consolidated financial statements.

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PHOTON DYNAMICS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

|                                      |                                                                                                                                            |  |                                                                                  |         |                  |          |      |         |     |          |  
|------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------ |  | -------------------------------------------------------------------------------- | ------- | ---------------- | -------- | ---- | ------- | --- | -------- | -
|                                      |                                                                                                                                            |  |                                                                                  |         | Six months ended
|                                      |                                                                                                                                            |  |                                                                                  |         | March 31,       
|                                      |                                                                                                                                            |  |                                                                                  |         |                 
|                                      |                                                                                                                                            |  |                                                                                  |         | 2003             |          | 2002
|                                      |                                                                                                                                            |  |                                                                                  |         |                  |          |     
|                                      |                                                                                                                                            |  |                                                                                  |         | (in thousands)  
|Cash flows from operating activities: |                                                                                                                                            |  |                                                                                  |         |                  |          |      |        
|                                      | Net income (loss) from continuing operations                                                                                               |  | $                                                                                | (9,854  | )                |          | $    | 37      |    
|                                      | Adjustments to reconcile net income (loss) from continuing operations
to net cash used in operating activities from continuing operations: |  |                                                                                  |         |                  |          |      |         |    
|                                      |                                                                                                                                            |  | Depreciation                                                                     |         |                  | 1,305    |      |         |     | 980      |  
|                                      |                                                                                                                                            |  | Amortization of intangible assets                                                |         |                  | 1,184    |      |         |     |         |  
|                                      |                                                                                                                                            |  | Acquired in-process research and development                                     |         |                  | 1,849    |      |         |     |         |  
|                                      |                                                                                                                                            |  | Long-lived asset impairment charge                                               |         |                  | 303      |      |         |     |         |  
|                                      |                                                                                                                                            |  | Stock ownership expense                                                          |         |                 |          |      |         | 275 |         
|Changes in assets and liabilities:    |                                                                                                                                            |  |                                                                                  |         |                  |          |      |        
|                                      |                                                                                                                                            |  | Accounts receivable                                                              |         |                  | (3,239   | )    |         |     | (3,855   | )
|                                      |                                                                                                                                            |  | Inventories                                                                      |         |                  | (569     | )    |         |     | 3,149    |  
|                                      |                                                                                                                                            |  | Other current assets                                                             |         |                  | 1,251    |      |         |     | (2,458   | )
|                                      |                                                                                                                                            |  | Other assets                                                                     |         |                  | 155      |      |         |     | 230      |  
|                                      |                                                                                                                                            |  | Accounts payable                                                                 |         |                  | (2,370   | )    |         |     | 1,778    |  
|                                      |                                                                                                                                            |  | Other current liabilities                                                        |         |                  | (2,193   | )    |         |     | 1,071    |  
|                                      |                                                                                                                                            |  | Deferred revenue                                                                 |         |                  | 5,354    |      |         |     | (2,008   | )
|                                      |                                                                                                                                            |  |                                                                                  |         |                  |          |      |         |    
|                                      |                                                                                                                                            |  | Net cash used in operating activities from continuing operations                 |         |                  | (6,824   | )    |         |     | (801     | )
|                                      |                                                                                                                                            |  | Net cash used in operating activities from discontinued operations               |         |                  | (8,129   | )    |         |     | (4,244   | )
|                                      |                                                                                                                                            |  |                                                                                  |         |                  |          |      |         |    
|                                      |                                                                                                                                            |  | Net cash used by operating activites                                             |         |                  | (14,953  | )    |         |     | (5,045   | )
|                                      |                                                                                                                                            |  |                                                                                  |         |                  |          |      |         |    
|Cash flows from investing activities: |                                                                                                                                            |  |                                                                                  |         |                  |          |      |        
|                                      |                                                                                                                                            |  | Purchase of property and equipment                                               |         |                  | (1,240   | )    |         |     | (312     | )
|                                      |                                                                                                                                            |  | Acquisition of Rapid Thermal
Processing Division from Intevac, Inc.              |         |                  | (20,000  | )    |         |     |         |  
|                                      |                                                                                                                                            |  | Purchase of short-term investments                                               |         |                  | (279,530 | )    |         |     | (234,051 | )
|                                      |                                                                                                                                            |  | Redemption of short-term investments                                             |         |                  | 319,687  |      |         |     | 265,271  |  
|                                      |                                                                                                                                            |  |                                                                                  |         |                  |          |      |         |    
|                                      |                                                                                                                                            |  | Net cash provided by investing activities from continuing operations             |         |                  | 18,917   |      |         |     | 30,908   |  
|                                      |                                                                                                                                            |  | Net
cash provided by (used) in investing activities from discontinued
operations |         |                  | (165     | )    |         |     | 1,195    |  
|                                      |                                                                                                                                            |  |                                                                                  |         |                  |          |      |         |    
|                                      | Net cash provided by investing activities                                                                                                  |  |                                                                                  | 18,752  |                  |          |      | 32,103  |    
|                                      |                                                                                                                                            |  |                                                                                  |         |                  |          |      |         |    
|Cash flows from financing activities: |                                                                                                                                            |  |                                                                                  |         |                  |          |      |        
|                                      | Issuance of common stock, net                                                                                                              |  |                                                                                  | 1,629   |                  |          |      | 110,771 |    
|                                      | Repurchase of common stock                                                                                                                 |  |                                                                                  | (17,678 | )                |          |      |        |    
|                                      | Repayment of lease obligations                                                                                                             |  |                                                                                  | (23     | )                |          |      | (26     | )  
|                                      |                                                                                                                                            |  |                                                                                  |         |                  |          |      |         |    
|                                      |                                                                                                                                            |  | Net
cash provided by (used in) financing activities from continuing
operations   |         |                  | (16,072  | )    |         |     | 110,745  |  
|                                      |                                                                                                                                            |  |                                                                                  |         |                  |          |      |         |    
|                                      | Effect of exchange rate changes on cash and cash equivalents                                                                               |  |                                                                                  | 73      |                  |          |      | (39     | )  
|                                      |                                                                                                                                            |  |                                                                                  |         |                  |          |      |         |    
|                                      | Net increase (decrease) in cash and cash equivalents from continuing
operations                                                            |  |                                                                                  | (3,906  | )                |          |      | 140,813 |    
|                                      | Net decrease in cash and cash equivalents from discontinued operations                                                                     |  |                                                                                  | (8,294  | )                |          |      | (3,049  | )  
|                                      |                                                                                                                                            |  |                                                                                  |         |                  |          |      |         |    
|                                      | Net increase (decrease) in cash and cash equivalents                                                                                       |  |                                                                                  | (12,200 | )                |          |      | 137,764 |    
|                                      |                                                                                                                                            |  |                                                                                  |         |                  |          |      |         |    
|                                      | Cash and cash equivalents at beginning of period                                                                                           |  |                                                                                  | 25,580  |                  |          |      | 16,528  |    
|                                      |                                                                                                                                            |  |                                                                                  |         |                  |          |      |         |    
|                                      | Cash and cash equivalents at end of period                                                                                                 |  | $                                                                                | 13,380  |                  |          | $    | 154,292 |    
|                                      |                                                                                                                                            |  |                                                                                  |         |                  |          |      |         |    

See accompanying notes to condensed
consolidated financial statements.

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PHOTON DYNAMICS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 1Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of
Photon Dynamics, Inc. (the Company) have been prepared in accordance with
accounting principles generally accepted in the United States for interim
financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by accounting principles generally accepted in the United
States for complete financial statements. In the opinion of management, all
adjustments (consisting only of normal recurring accruals) considered necessary
for a fair presentation have been included. Operating results for the three and
six months ended March 31, 2003 are not necessarily indicative of the results
that may be expected for the year ending September 30, 2003. This financial
information should be read in conjunction with the financial statements and the
notes thereto included in the Companys Annual Report on Form 10-K for the
fiscal year ended September 30, 2002.

The condensed consolidated balance sheet as of September 30, 2002, is
derived from the Companys audited consolidated financial statements as of
September 30, 2002, included in the Companys Annual Report on Form 10-K filed
with the Securities and Exchange Commission, but does not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements.

Basis of Presentation

Through January 14, 2003, the Company has conducted business in three
operating segments: flat panel display products, cathode ray tube display and
high quality glass inspection products and printed circuit board assembly
inspection products. The Companys flat panel display products include test,
repair, inspection and rapid thermal process equipment. The Companys flat
panel display test and inspection equipment identifies and characterizes
defects at early stages of the manufacturing process so that the panels may be
repaired before the next stage, or, if necessary, discarded, minimizing the
loss of time and materials. The Companys flat panel display test and
inspection products gather comprehensive data that enable flat panel display
manufacturers to control and refine their manufacturing processes. The
Companys rapid thermal process equipment enables manufacturers of flat panel
displays to thermally activate low temperature poly-silicon films at
temperatures that would otherwise distort or destroy underlying glass
substrates. The Companys cathode ray tube display and high quality glass
inspection products allow cathode ray tube display manufacturers to locate and
characterize defects and glass manufacturers to detect and identify defects
such as scratches, pits, bubbles, stones, inclusions and distortions, thereby
increasing yields and quality and reducing costs. The Companys printed circuit
board assembly inspection products enable printed circuit board assembly
inspection manufacturers to detect and identify defects, thereby increasing
yields and quality and reducing costs. In January 2003, the Company implemented
a plan to exit the printed circuit board assembly inspection business.
Accordingly, the operating results of this business segment have been presented
as discontinued operations in accordance with the provisions of Statement of
Financial Accounting Standards No. 144, Accounting for the Impairment or
Disposal of Long-lived Assets, (FAS 144) and the Companys statements of
operations and cash flows have been reclassified to conform with the current
periods basis of presentation.

Revenue Recognition

The Company recognizes revenue when persuasive evidence of an arrangement
exists, delivery has occurred or services have been rendered, the selling price
is fixed or determinable and collectibility is reasonably assured.

The Company accounts for certain of its product sales, including sales to
a value added reseller, in its flat panel display and cathode ray tube display
and high quality glass inspection product segments as arrangements with

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multiple deliverables. For arrangements with multiple deliverables, the
Company recognizes revenue for the delivered items if the delivered items have
value to the customer on a standalone basis, the amount of revenue for
delivered elements is not subject to refund, the Company has met defined
customer acceptance experience levels for the delivered items, and the fair
value of undelivered items, such as installation and system upgrade rights, can
be reliably determined. The Company allocates revenue to the delivered items
based on the amount due and billable upon shipment, with the remaining amount
recognized after installation and acceptance when the final amount becomes due.
The Company recognizes all other product sales upon customer acceptance. The
Company recognizes revenue from the sale of spare parts upon shipment.

The Company records a provision for estimated sales returns in the same
period as the related revenue is recorded, which is netted against revenue.
These estimates are based on historical sales returns and other known factors.
If the historical data the Company uses to calculate these estimates does not
properly reflect future returns, additional provisions may be required.

NOTE 2Discontinued Operations

The Companys printed circuit board assembly inspection products enable
printed circuit board assembly inspection manufacturers to detect and identify
defects, thereby increasing yields and quality and reducing costs. The Company
previously sold its products for the printed circuit board assembly industry
primarily through sales representatives and distributors. The Company
generally recognized revenue from the sale of its printed circuit board
assembly inspection products upon shipment, as such product sales were not
subject to customer acceptance provisions. In January 2003, the Company
implemented a plan to exit the printed circuit board assembly inspection
business. Accordingly, the operating results of this business segment have
been reclassified as a discontinued operation and the Company now conducts
business in two segments. The Company is attempting to sell the assets and to
sublease the facilities associated with the discontinued operations, but there
can be no assurances that the Company will be successful in recovering any
costs associated with the discontinued operations.

The following table summarizes the results of discontinuing the printed
circuit board assembly inspection products reporting segment:

|                                  |                                                               |                          |         |                    |       |                  |        |       |       |      |         |        |        |   |        |       |       | 
|--------------------------------- | ------------------------------------------------------------- | ------------------------ | ------- | ------------------ | ----- | ---------------- | ------ | ----- | ----- | ---- | ------- | ------ | ------ | - | ------ | ----- | ----- | 
|                                  |                                                               |                          |         | Three months ended |       | Six months ended
|                                  |                                                               |                          |         | March 31,          |       | March 31,       
|                                  |                                                               |                          |         |                    |       |                 
|                                  |                                                               |                          |         | 2003               |       | 2002             |        | 2003  |       | 2002
|                                  |                                                               |                          |         |                    |       |                  |        |       |       |     
|                                  |                                                               |                          |         | (in thousands)    
|Revenue                           |                                                               | $                        | 972     |                    |       | $                | 3,365  |       |       | $    | 2,827   |        |        | $ | 6,201  |      
|Cost of revenue                   |                                                               |                          | 9,302   |                    |       |                  | 2,676  |       |       |      | 11,175  |        |        |   | 4,910  |      
|                                  |                                                               |                          |         |                    |       |                  |        |       |       |      |         |        |        |   |        |      
|Gross margin                      |                                                               |                          | (8,330  | )                  |       |                  | 689    |       |       |      | (8,348  | )      |        |   | 1,291  |      
|Operating expenses:               |                                                               |                          |         |                    |       |                  |        |       |       |      |         |        |        |   |        |      
|                                  | Research and development                                      |                          |         | 2,618              |       |                  |        | 907   |       |      |         | 3,693  |        |   |        | 1,900 |      
|                                  | Selling, general and administrative                           |                          |         | 4,151              |       |                  |        | 1,898 |       |      |         | 5,453  |        |   |        | 3,831 |      
|                                  | Goodwill impairment charge                                    |                          |         |                   |       |                  |        |      |       |      |         | 15,083 |        |   |        |      |      
|                                  | Purchased intangibles and
long-lived assets
impairment charge |                          |         |                   |       |                  |        |      |       |      |         | 5,405  |        |   |        |      |      
|                                  | Amortization of intangible assets                             |                          |         |                   |       |                  |        | 287   |       |      |         | 195    |        |   |        | 573   |      
|                                  |                                                               |                          |         |                    |       |                  |        |       |       |      |         |        |        |   |        |      
|                                  |                                                               | Total operating expenses |         |                    | 6,769 |                  |        |       | 3,092 |      |         |        | 29,829 |   |        |       | 6,304 | 
|Loss from discontinued operations |                                                               | $                        | (15,099 | )                  |       | $                | (2,403 | )     |       | $    | (38,177 | )      |        | $ | (5,013 | )    
|                                  |                                                               |                          |         |                    |       |                  |        |       |       |      |         |        |        |   |        |      

The loss
from discontinued operations for the three months ended March 31,
2003, includes a write-off of inventory of approximately $7.8 million, a
write-off of accounts receivable of approximately $1.7 million, and a write-off
of licensed technology of approximately $1.9 million. The loss from
discontinued operations for the six

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months ended March 31, 2003, also includes impairment charges of approximately
$15.1 million of goodwill, $2.9 million of purchase intangibles and $2.5
million of long-lived assets recorded in the three months ended December 31,
2002, as a result of managements assessment of indicators of impairment that
existed prior to the Companys formal decision to discontinue the operations of
this segment. Such impairment charges were recorded in accordance with the
provisions of Statement of Financial Accounting Standards No. 142, Goodwill
and Other Intangible Assets, (FAS 142) and FAS 144.

The following summarizes the assets and liabilities of discontinued
operations:

|                                  |                           |                           |     |                |       |               |        |       |        | 
|--------------------------------- | ------------------------- | ------------------------- | --- | -------------- | ----- | ------------- | ------ | ----- | ------ | 
|                                  |                           |                           |     | March 31,      |       | September 30,
|                                  |                           |                           |     | 2003           |       | 2002         
|                                  |                           |                           |     |                |       |              
|                                  |                           |                           |     | (unaudited)   
|                                  |                           |                           |     | (in thousands)
|ASSETS                            |                           |                           |     |                |       |               |        |      
|Current assets:                   |                           |                           |     |                |       |               |        |      
|                                  | Accounts receivable, net  |                           | $   | 818            |       |               | $      | 4,916 |       
|                                  | Inventories               |                           |     |               |       |               |        | 4,844 |       
|                                  | Other current assets      |                           |     | 603            |       |               |        | 1,443 |       
|                                  |                           |                           |     |                |       |               |        |      
|                                  |                           | Total current assets      |     |                | 1,421 |               |        |       | 11,203 | 
|Land, property and equipment, net |                           |                           |    |                |       |               | 1,896  |      
|Intangible assets, net            |                           |                           |    |                |       |               | 3,076  |      
|Goodwill                          |                           |                           |    |                |       |               | 15,083 |      
|                                  |                           |                           |     |                |       |               |        |       |       
|                                  |                           | Total assets              |     | $              | 1,421 |               |        | $     | 31,258 | 
|                                  |                           |                           |     |                |       |               |        |       |       
|LIABILITIES                       |                           |                           |     |                |       |               |        |      
|Current liabilities:              |                           |                           |     |                |       |               |        |      
|                                  | Accounts payable          |                           | $   | 524            |       |               | $      | 1,827 |       
|                                  | Other current liabilities |                           |     | 1,533          |       |               |        | 467   |       
|                                  | Deferred revenue          |                           |     |               |       |               |        | 104   |       
|                                  |                           |                           |     |                |       |               |        |       |       
|                                  |                           | Total current liabilities |     |                | 2,057 |               |        |       | 2,398  | 
|Other liabilities                 |                           |                           | 609 |                |       |               | 883    |      
|                                  |                           |                           |     |                |       |               |        |       |       
|                                  |                           | Total liabilities         |     | $              | 2,666 |               |        | $     | 3,281  | 
|                                  |                           |                           |     |                |       |               |        |       |       

NOTE 3 Stock Ownership Expense

In December 2002, the Financial Accounting Standards Board (FASB) issued
Statement No. 148) Accounting for Stock Based CompensationTransition and
Disclosure (FAS 148). FAS 148 amends FAS 123, Accounting for Stock Based
Compensation, to provide alternative methods of transition for a voluntary
change to the fair-value based method of accounting for stock-based employee
compensation. In addition, FAS 148 amends the disclosure requirements of FAS
123 to require more prominent disclosures in both annual and interim financial
statements about the method of accounting for stock-based employee compensation
and the effect of the method used on reported results. The additional
disclosure requirements of FAS 148 are effective for fiscal years ending after
December 15, 2002. We have elected to continue to follow the intrinsic value
method under Accounting Principles Board Opinion No. 25, Accounting for Stock
Issued to Employees (APB 25), to account for stock options issued to employees
under its employee stock option and stock purchase plans and amortizes deferred
compensation, if any, over the vesting period of the options. The stock
ownership expense resulting from issuance of fixed term stock option awards is
measured as the difference between the exercise price of the option and the
fair market value of the underlying share of common stock subject to the option
on the awards grant date. The Company has elected to make pro forma
disclosures as permitted by FAS 123. The Company estimates the fair value of
its stock-based awards to employees using the Black-Scholes multiple option
approach pricing model.

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

8



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For purposes of pro forma disclosures required by FAS 123, the estimated
fair value of the options is amortized to expense over the vesting periods
applicable to the options. The Companys pro forma information for three and
six months ended March 31, 2003 and 2002, is as follows:

|                     |                                  |  |                    |      |                  |  |      |      |      |  |  |      |  |  |  |      | 
|-------------------- | -------------------------------- |  | ------------------ | ---- | ---------------- |  | ---- | ---- | ---- |  |  | ---- |  |  |  | ---- | 
|                     |                                  |  | Three months ended |      | Six months ended
|                     |                                  |  | March 31,          |      | March 31,       
|                     |                                  |  |                    |      |                 
|                     |                                  |  | 2003               |      | 2002             |  | 2003 |      | 2002
|                     |                                  |  |                    |      |                  |  |      |      |     
|Stock option plan:   |                                  |  |                    |      |                  |  |      |      |      |  |  |      |  |  |  |     
|                     | Expected stock price volatility  |  |                    | 0.95 |                  |  |      | 0.96 |      |  |  | 0.95 |  |  |  | 0.96 | 
|                     | Risk free interest rate          |  |                    | 2.16 |                  |  |      | 3.52 |      |  |  | 2.22 |  |  |  | 3.29 | 
|                     | Expected life of options (years) |  |                    | 3.0  |                  |  |      | 3.0  |      |  |  | 3.0  |  |  |  | 3.0  | 
|Stock purchase plan: |                                  |  |                    |      |                  |  |      |      |      |  |  |      |  |  |  |     
|                     | Expected stock price volatility  |  |                    | 0.90 |                  |  |      | 0.97 |      |  |  | 0.90 |  |  |  | 1.02 | 
|                     | Risk free interest rate          |  |                    | 2.15 |                  |  |      | 4.85 |      |  |  | 2.15 |  |  |  | 4.39 | 
|                     | Expected life of options (years) |  |                    | 1.2  |                  |  |      | 1.4  |      |  |  | 1.2  |  |  |  | 1.3  | 

|                                                    |  |                    |         |                  |  |      |        |      |  |   |         |   |  |   |        |  
|--------------------------------------------------- |  | ------------------ | ------- | ---------------- |  | ---- | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                                                    |  | Three months ended |         | Six months ended
|                                                    |  | March 31,          |         | March 31,       
|                                                    |  |                    |         |                 
|                                                    |  | 2003               |         | 2002             |  | 2003 |        | 2002
|                                                    |  |                    |         |                  |  |      |        |     
|Net loss  as reported                              |  | $                  | (23,015 | )                |  | $    | (1,612 | )    |  | $ | (48,031 | ) |  | $ | (4,976 | )
|Plus: stock ownership expense recorded under
APB 25 |  |                    | 42      |                  |  |      | 275    |      |  |   | 42      |   |  |   | 275    |  
|Less: SFAS 123 stock ownership expense              |  |                    | (509    | )                |  |      | (2,025 | )    |  |   | (2,934  | ) |  |   | (4,602 | )
|                                                    |  |                    |         |                  |  |      |        |      |  |   |         |   |  |   |        |  
|Net loss  pro forma                                |  | $                  | (23,482 | )                |  | $    | (3,362 | )    |  | $ | (50,965 | ) |  | $ | (9,303 | )
|                                                    |  |                    |         |                  |  |      |        |      |  |   |         |   |  |   |        |  
|Basic net loss per share  as reported              |  | $                  | (1.44   | )                |  | $    | (0.10  | )    |  | $ | (2.99   | ) |  | $ | (0.34  | )
|Dilutive net loss per share  as reported           |  | $                  | (1.44   | )                |  | $    | (0.10  | )    |  | $ | (2.99   | ) |  | $ | (0.34  | )
|Basic net loss per share  pro forma                |  | $                  | (1.49   | )                |  | $    | (0.21  | )    |  | $ | (3.17   | ) |  | $ | (0.63  | )
|Dilutive net loss per share  pro forma             |  | $                  | (1.49   | )                |  | $    | (0.21  | )    |  | $ | (3.17   | ) |  | $ | (0.63  | )

NOTE 4Inventories

Inventories are stated at the lower of cost (on a first-in, first-out
basis) or market. The components of inventories were as follows:

|                |       |   |                |        |               |   |       |        | 
|--------------- | ----- | - | -------------- | ------ | ------------- | - | ----- | ------ | 
|                |       |   | March 31,      |        | September 30,
|                |       |   | 2003           |        | 2002         
|                |       |   |                |        |              
|                |       |   | (in thousands)
|Raw materials   |       | $ | 5,242          |        |               | $ | 6,782 |       
|Work-in-process |       |   | 6,365          |        |               |   | 7,008 |       
|Finished goods  |       |   | 1,851          |        |               |   | 4,860 |       
|                |       |   |                |        |               |   |       |       
|                | Total |   | $              | 13,458 |               |   | $     | 18,650 | 
|                |       |   |                |        |               |   |       |        | 

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NOTE 5Other Current Liabilities

The components of other current liabilities were as follows:

|                                                                                   |       |   |                |        |               |   |       |        | 
|---------------------------------------------------------------------------------- | ----- | - | -------------- | ------ | ------------- | - | ----- | ------ | 
|                                                                                   |       |   | March 31,      |        | September 30,
|                                                                                   |       |   | 2003           |        | 2002         
|                                                                                   |       |   |                |        |              
|                                                                                   |       |   | (in thousands)
|Warranty (see Note 12)                                                             |       | $ | 2,335          |        |               | $ | 2,383 |       
|Accrued compensation                                                               |       |   | 2,735          |        |               |   | 4,094 |       
|Commissions                                                                        |       |   | 974            |        |               |   | 998   |       
|Due to Akcron shareholders in
connection with the acquisition of a
business        |       |   | 972            |        |               |   | 1,642 |       
|Obligation to a manufacturing
subcontractor in connection with
inventory purchases |       |   | 1,070          |        |               |   |      |       
|Other accrued expenses                                                             |       |   | 1,958          |        |               |   | 1,520 |       
|                                                                                   |       |   |                |        |               |   |       |       
|                                                                                   | Total |   | $              | 10,044 |               |   | $     | 10,637 | 
|                                                                                   |       |   |                |        |               |   |       |       

NOTE 6Acquisitions

In November 2002, the Company acquired certain assets relating to rapid
thermal processing technology (the RTP Assets) from Intevac, Inc.
(Intevac). The acquired technology is used to activate low temperature
poly-silicon films during the manufacturing process for flat panel displays and
expands the Companys product offerings to its current customer base into
process equipment. As such, this acquisition is being included in our flat
panel display segment. The purchase price was $20.0 million of cash, of which
$18.0 million was paid to Intevac at closing and an additional $2.0 million was
placed into escrow, which can be released either to the Company or to Intevac
depending on the occurrence of certain future events during the escrow period
as follows: $1.2 million related to the attainment of a certain level of sales
by the Company of equipment included in the RTP Assets acquired from Intevac,
$500,000 related to the re-issuance of a former rapid thermal processing patent
in Japan for certain acquired technology and $300,000 for indemnification and
reimbursement should Intevac breach any representations and warranties under
the acquisition agreement. The Companys preliminary allocation of the purchase
consideration (see below) excludes the contingent consideration of $2.0 million
and accordingly, amounts allocated to goodwill may increase based on the
outcome of these events. In addition, the Company assumed approximately
$350,000 of liabilities and incurred approximately $500,000 in acquisition
related expenses, consisting primarily of consulting, legal and accounting
fees. The identifiable assets acquired primarily included accounts receivable,
inventory and fixed assets. The funds used to purchase the RTP Assets came out
of the Companys working capital.

The acquisition of the RTP Assets was accounted for under the purchase
method of accounting. The purchase price was allocated by management to the
assets acquired and liabilities assumed taking into account an independent
appraisal of their fair values. To determine the value of the developed and
core technologies, the expected future cash flows attributed to all existing
technology were discounted, taking into account risks related to the
characteristics and application of the technology, existing and future markets
and assessments of the life cycle stage of the technology. The value attributed
to backlog is related to purchase orders that had been received prior to the
close of the acquisition, determined as the expected discounted cash flow
resulting from the revenue related to the shipment of such orders, less normal
profit margins.

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

The Company applied discount factors to the projected cash flows of the
technology in order to determine the present value, based on discount rates
with inherent risk and expected growth of the developed, core and in-process
technologies. The discount rates used were 15%, 20% and 25% for the developed,
core and in-process technologies,
10Table of Contentsrespectively.A summary of the preliminary allocation of the purchase price is as
follows:

|                                                                   |       |   |                |        | 
|------------------------------------------------------------------ | ----- | - | -------------- | ------ | 
|                                                                   |       |   | RTP           
|                                                                   |       |   |               
|                                                                   |       |   | (in thousands)
|Acquired core technology                                           |       | $ | 3,764          |       
|Acquired developed technology                                      |       |   | 2,673          |       
|Backlog                                                            |       |   | 557            |       
|Acquired in-process research and development                       |       |   | 1,849          |       
|Goodwill                                                           |       |   | 7,386          |       
|Net fair value of acquired tangible assets
and assumed liabilities |       |   | 2,621          |       
|                                                                   |       |   |                |       
|                                                                   | Total |   | $              | 18,850 | 
|                                                                   |       |   |                |       

The acquired core technology and acquired developed technology are being
amortized over five years. Backlog is being amortized to cost of sales at the
time revenue is recognized for the related customer order.

NOTE 7Impairment of Goodwill and Other Long-Lived Assets

In accordance with FAS 142, the Company is required to review goodwill for
impairment of value, at least annually, and in certain circumstances between
annual tests if there are indicators of impairment. The goodwill impairment
test involves a two-step process. Step one consists of a comparison of the fair
value of a reporting unit with its carrying amount, including the goodwill
allocated to the reporting unit. If the carrying amount is in excess of the
fair value, step two requires the comparison of the implied fair value of the
reporting unit goodwill with the carrying amount of the reporting unit
goodwill. Any excess of the carrying value of the reporting unit goodwill over
the implied fair value of the reporting unit goodwill will be recorded as an
impairment loss. In the first quarter of fiscal 2003, based on further
deterioration of business conditions from the fourth quarter of fiscal 2002
when the Company recorded impairment of goodwill, the Company performed an
interim analysis of the fair value of the printed circuit board assembly
reporting unit. As a result of this analysis, the Company determined that the
remaining goodwill was impaired and recorded an impairment charge of $15.1
million in the quarter ended December 31, 2002. The valuation was done as of
December 31, 2002, using established valuation techniques, specifically, the
income and market approaches.

Changes in the carrying amount of goodwill for the six months ended March
31, 2003, are as follows:

|                                    |  |            |        |              |  |                |         |   |  |   |         |  
|----------------------------------- |  | ---------- | ------ | ------------ |  | -------------- | ------- | - |  | - | ------- | -
|                                    |  | Flat Panel |        | Discontinued |  |                |         |  
|                                    |  | Display    |        | Operations   |  | Total         
|                                    |  |            |        |              |  |               
|                                    |  |            |        |              |  | (in thousands) |         |   |  |  
|Balance as of September 30, 2002    |  | $          | 3,454  |              |  | $              | 15,083  |   |  | $ | 18,537  |  
|Goodwill acquired during the
period |  |            | 7,386  |              |  |                |        |   |  |   | 7,386   |  
|Adjustment to goodwill              |  |            | (320   | )            |  |                |        |   |  |   | (320    | )
|Goodwill impairment charge          |  |            |       |              |  |                | (15,083 | ) |  |   | (15,083 | )
|                                    |  |            |        |              |  |                |         |   |  |   |         |  
|Balance as of March 31, 2003        |  | $          | 10,520 |              |  | $              |        |   |  | $ | 10,520  |  
|                                    |  |            |        |              |  |                |         |   |  |   |         |  

In conjunction with the Companys acquisition of Akcron Corporation Ltd.
(Akcron) in September 2002, the Company established a $1.6 million liability
for a portion of the purchase price to be held by the Company as security for
indemnification should Akcron breach any of its representations and warranties.
In the six month period ended March 2003, net adjustments of $320,000 were
made to goodwill, of which $350,000 reflects the reduced purchase price
resulting from one such breach of warranty.

In accordance with FAS 144, the Company performs tests for impairment of
its long-lived assets, including intangible assets whenever events or
circumstances suggest that such assets may be impaired. FAS 144 requires the
Company to assess whether the carrying value is recoverable from undiscounted
future cash flows. If the assets are not recoverable, the impairment is
calculated by the difference between the carrying value of the assets and their
fair value which is generally determined based on discounted future cash flows.
Accordingly, in the first quarter of fiscal

11



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2003, based on certain indicators of impairment in the printed circuit
board assembly inspection division, the Company performed an impairment
analysis of purchased intangible assets and certain other long-lived assets
associated with the printed circuit board assembly inspection reporting unit.
As a result, the Company recorded impairment charges of approximately $2.9
million related to the unamortized portion of the acquired developed and core
technology intangible assets and approximately $2.9 million related to certain
other long-lived assets to reduce the carrying values of purchased intangible
assets and other long-lived assets to their respective estimated values.

Information regarding the Companys other acquisition related intangible
assets is as follows:

|                                                             |                |            |       |            |  |         |        |         |  |       |     |   |  |   |      |   |  |   |        |  
|------------------------------------------------------------ | -------------- | ---------- | ----- | ---------- |  | ------- | ------ | ------- |  | ----- | --- | - |  | - | ---- | - |  | - | ------ | -
|                                                             |                | Developed  |       | Core       |  |         |        |         |  |       |     |   |  |   |      |  
|                                                             |                | Technology |       | Technology |  | Patents |        | Backlog |  | Total
|                                                             |                |            |       |            |  |         |        |         |  |      
|                                                             | (in thousands)
|Balance as of September 30, 2002                             |                | $          | 557   |            |  | $       | 2,878  |         |  | $     | 119 |   |  | $ |     |   |  | $ | 3,554  |  
|Originating from acquisition of
business during the period   |                |            | 2,673 |            |  |         | 3,764  |         |  |       |    |   |  |   | 557  |   |  |   | 6,994  |  
|Amortization during the period                               |                |            | (301  | )          |  |         | (325   | )       |  |       | (1  | ) |  |   |     |   |  |   | (627   | )
|Amortization during the period in discontinued
operations    |                |            | (16   | )          |  |         | (173   | )       |  |       | (6  | ) |  |   |      |   |  |   | (195   | )
|Amortization of backlog to cost of revenue during
the period |                |            |      |            |  |         |       |         |  |       |    |   |  |   | (557 | ) |  |   | (557   | )
|Impairment charge related to discontinued operations         |                |            | (470  | )          |  |         | (2,332 | )       |  |       | (80 | ) |  |   |     |   |  |   | (2,882 | )
|                                                             |                |            |       |            |  |         |        |         |  |       |     |   |  |   |      |   |  |   |        |  
|Balance as of March 31, 2003                                 |                | $          | 2,443 |            |  | $       | 3,812  |         |  | $     | 32  |   |  | $ |     |   |  | $ | 6,287  |  
|                                                             |                |            |       |            |  |         |        |         |  |       |     |   |  |   |      |   |  |   |        |  

NOTE 8Earnings Per Share

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

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

|                                                         |  |                                       |         |                  |  |      |        |      |  |   |         |     |  |   |        |  
|-------------------------------------------------------- |  | ------------------------------------- | ------- | ---------------- |  | ---- | ------ | ---- |  | - | ------- | --- |  | - | ------ | -
|                                                         |  | Three months ended                    |         | Six months ended
|                                                         |  | March 31,                             |         | March 31,       
|                                                         |  |                                       |         |                 
|                                                         |  | 2003                                  |         | 2002             |  | 2003 |        | 2002
|                                                         |  |                                       |         |                  |  |      |        |     
|                                                         |  | (in thousands, except per share data)
|Net income (loss) from continuing operations             |  | $                                     | (7,916  | )                |  | $    | 791    |      |  | $ | (9,854  | )   |  | $ | 37     |  
|Net loss from discontinued operations                    |  |                                       | (15,099 | )                |  |      | (2,403 | )    |  |   | (38,177 | )   |  |   | (5,013 | )
|                                                         |  |                                       |         |                  |  |      |        |      |  |   |         |     |  |   |        |  
|Net loss                                                 |  | $                                     | (23,015 | )                |  | $    | (1,612 | )    |  | $ | (48,031 | )   |  | $ | (4,976 | )
|                                                        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                        
|Net income (loss) from continuing operations             |  | $                                     | (0.50   | )                |  | $    | 0.05   |      |  | $ | (0.61   | )   |  | $ | 0.00   |  
|Net loss from discontinued operations                    |  |                                       | (0.94   | )                |  |      | (0.15  | )    |  |   | (2.38   | )   |  |   | (0.34  | )
|                                                         |  |                                       |         |                  |  |      |        |      |  |   |         |     |  |   |        |  
|Basic net income (loss) per share                        |  | $                                     | (1.44   | )                |  | $    | (0.10  | )    |  | $ | (2.99   | )   |  | $ | (0.34  | )
|                                                        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                        
|Net income (loss) from continuing operations             |  | $                                     | (0.50   | )                |  | $    | 0.05   |      |  | $ | (0.61   | )   |  | $ | 0.00   |  
|Net loss from discontinued operations                    |  |                                       | (0.94   | )                |  |      | (0.15  | )    |  |   | (2.38   | )   |  |   | (0.34  | )
|                                                         |  |                                       |         |                  |  |      |        |      |  |   |         |     |  |   |        |  
|Diluted loss per share                                   |  | $                                     | (1.44   | )                |  | $    | (0.10  | )    |  | $ | (2.99   | )   |  | $ | (0.34  | )
|                                                        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                        
|                                                        
|Weighted average shares for net income
(loss) per share: |  |                                       | 15,944  |                  |  |      | 15,746 |      |  |   | 16,052  |     |  |   | 14,831 |  
|Effect of dilutive securities:                           |  |                                       |         |                  |  |      |        |      |  |   |         |     |  |   |        |  
|Employee stock options                                   |  |                                       |        |                  |  |      | 1,042  |      |  |   |        |     |  |   | 975    |  
|Warrants                                                 |  |                                       |        |                  |  |      |       |      |  |   |        |     |  |   |       |  
|                                                         |  |                                       |         |                  |  |      |        |      |  |   |         |     |  |   |        |  
|Weighted average shares for diluted net
income per share |  |                                       | 15,944  | (1)              |  |      | 16,788 |      |  |   | 16,052  | (1) |  |   | 15,806 |  
|                                                         |  |                                       |         |                  |  |      |        |      |  |   |         |     |  |   |        |  

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(1)  The effect of dilutive securities from employee stock options and warrants
to purchase 316,092 and 425,919 shares of common stock for the three and six
months ended March 31, 2003, respectively, was not included in the computation
of diluted earnings per share as the effect is anti-dilutive due to net losses.

NOTE 9Operations by Industry Segment

Through January 14, 2003, the Company conducted business in three
operating segments: flat panel display products, cathode ray tube display and
high quality glass inspection products and printed circuit board assembly
inspection products. In January 2003, the Company implemented a plan to exit
the printed circuit board assembly inspection business. Accordingly, the
operating results of this business segment have been reclassified as a
discontinued operation and the Company now conducts business in two segments.
The Companys flat panel display products include test, repair, inspection and
rapid thermal process equipment. The Companys flat panel display test and
inspection equipment identifies and characterizes defects at early stages of
the manufacturing process so that the panels may be repaired before the next
stage, or, if necessary, discarded, minimizing the loss of time and materials.
The Companys flat panel display test and inspection products gather
comprehensive data that enable flat panel display manufacturers to control and
refine their manufacturing processes. The Companys rapid thermal process
equipment enables manufacturers of flat panel displays to thermally activate
low temperature poly-silicon films at temperatures that would otherwise distort
or destroy underlying glass substrates. The Companys cathode ray tube display
and high quality glass inspection products allow cathode ray tube display
manufacturers to locate and characterize defects and glass manufacturers to
detect and identify defects such as scratches, pits, bubbles, stones,
inclusions and distortions, thereby increasing yields and quality and reducing
costs.

The Companys management has determined the operating segments based upon
the manner in which the business is managed and operated. There are no
significant inter-segment sales or transfers, and the majority of the Companys
long-lived assets are located in the U.S. The Companys principal customers are
primarily Asian-based flat panel display and cathode ray tube display
manufacturers.

The Company sells its products for the flat panel display industry
directly to customers in Korea and Taiwan and through a value-added reseller,
Ishikawajima-Harima Heavy Industries Co., Ltd. (IHI), in Japan. The Company
sells its products for the cathode ray tube display and glass industries
directly except in Japan where a sales representative is used.

A significant portion of the segments expenses currently arise from
shared services and infrastructure provided to the segments in order to realize
economies of scale and to efficiently use resources. These expenses include
sales and marketing, field service, finance, human resource, information
technology services and other corporate infrastructure costs. These expenses
are allocated to the segments and the allocations have been determined on a
basis that the Company considers to be a reasonable reflection of the
utilization of services provided to or benefits received by the segments. The
Company does not allocate interest and other income, interest and other
expenses or taxes to operating segments. Accounting policies for segment
reporting are the same as for the Company as a whole.

The Companys operating segments consisted of the following:

|                                                   |                                                        |   |                    |        |                  |   |                |        |      |   |         |         |                |   |        |        |  
|-------------------------------------------------- | ------------------------------------------------------ | - | ------------------ | ------ | ---------------- | - | -------------- | ------ | ---- | - | ------- | ------- | -------------- | - | ------ | ------ | -
|                                                   |                                                        |   | Three months ended |        | Six months ended
|                                                   |                                                        |   | March 31,          |        | March 31,       
|                                                   |                                                        |   |                    |        |                 
|                                                   |                                                        |   | 2003               |        | 2002             |   | 2003           |        | 2002
|                                                   |                                                        |   |                    |        |                  |   |                |        |     
|                                                   |                                                        |   |                    |        |                  |   | (reclassified) |        |      |   |         |         | (reclassified)
|                                                   |                                                        |   | (in thousands)     |        | (in thousands)  
|Net sales to external customers:                   |                                                        |   |                    |        |                  |   |                |        |      |   |         |         |                |   |        |       
|                                                   | Flat panel display products                            |   | $                  | 9,058  |                  |   | $              | 12,250 |      |   | $       | 28,220  |                |   | $      | 21,423 |  
|                                                   | Cathode ray tube display and glass inspection products |   |                    | 1,075  |                  |   |                | 1,682  |      |   |         | 1,785   |                |   |        | 3,878  |  
|                                                   |                                                        |   |                    |        |                  |   |                |        |      |   |         |         |                |   |        |        |  
|Net sales to external customers                    |                                                        | $ | 10,133             |        |                  | $ | 13,932         |        |      | $ | 30,005  |         |                | $ | 25,301 |       
|                                                   |                                                        |   |                    |        |                  |   |                |        |      |   |         |         |                |   |        |        |  
|Operating income (loss):                           |                                                        |   |                    |        |                  |   |                |        |      |   |         |         |                |   |        |       
|                                                   | Flat panel display products                            |   | $                  | (8,416 | )                |   | $              | 755    |      |   | $       | (10,485 | ) (1)          |   | $      | (102   | )
|                                                   | Cathode ray tube display and glass inspection products |   |                    | (180   | )                |   |                | (603   | )    |   |         | (863    | ) (2)          |   |        | (1,022 | )
|                                                   |                                                        |   |                    |        |                  |   |                |        |      |   |         |         |                |   |        |        |  
|Operating
income (loss) from continuing operations |                                                        | $ | (8,596             | )      |                  | $ | 152            |        |      | $ | (11,348 | )       |                | $ | (1,124 | )     
|                                                   |                                                        |   |                    |        |                  |   |                |        |      |   |         |         |                |   |        |        |  

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|(1) |  | Includes non-recurring charges of $1,849,000 for acquired in-process
research and development in connection with the acquisition of the RTP
Assets.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(2) |  | Includes non-recurring charges of $303,000 for impairment of long-lived
assets.                                                                    

Identifiable assets and long-lived assets by operating segments are as
follows:

|                    |                     |  |                |         |               |  |              |       |       |  |   |        |  |  |   |         | 
|------------------- | ------------------- |  | -------------- | ------- | ------------- |  | ------------ | ----- | ----- |  | - | ------ |  |  | - | ------- | 
|                    |                     |  |                |         |               |  | CRT Display  |       |       |  |   |        |  |  |  
|                    |                     |  | Flat Panel     |         | and High      |  |              |       |       |  |   |        | 
|                    |                     |  | Display        |         | Quality Glass |  | Discontinued |       |       |  |  
|                    |                     |  | Products       |         | Products      |  | Operations   |       | Total
|                    |                     |  |                |         |               |  |              |       |      
|                    |                     |  | (in thousands)
|March 31, 2003:     |                     |  |                |         |               |  |              |       |       |  |   |        |  |  |   |        
|                    | Identifiable assets |  | $              | 178,752 |               |  | $            | 5,667 |       |  | $ | 1,485  |  |  | $ | 185,904 | 
|                    | Long-lived assets   |  |                | 30,687  |               |  |              | 1,317 |       |  |   |       |  |  |   | 32,004  | 
|September 30, 2002: |                     |  |                |         |               |  |              |       |       |  |   |        |  |  |   |        
|                    | Identifiable assets |  | $              | 211,119 |               |  | $            | 7,430 |       |  | $ | 30,610 |  |  | $ | 249,159 | 
|                    | Long-lived assets   |  |                | 15,891  |               |  |              | 1,475 |       |  |   | 20,054 |  |  |   | 37,420  | 

Sales to individual unaffiliated customers in excess of 10% of total
revenue were as follows:

|           |  |                    |    |                  |  |                |    |      |  |  |    |                |  |  |    |  
|---------- |  | ------------------ | -- | ---------------- |  | -------------- | -- | ---- |  |  | -- | -------------- |  |  | -- | -
|           |  | Three months ended |    | Six months ended
|           |  | March 31,          |    | March 31,       
|           |  |                    |    |                 
|           |  | 2003               |    | 2002             |  | 2003           |    | 2002
|           |  |                    |    |                  |  |                |    |     
|           |  |                    |    |                  |  | (reclassified) |    |      |  |  |    | (reclassified)
|           |  | (in thousands)     |    | (in thousands)  
|Customer A |  |                    | 29 | %                |  |                | 26 | %    |  |  | 47 | %              |  |  | 45 | %
|Customer B |  |                    | 15 | %                |  |                | *  |      |  |  | 10 | %              |  |  | *  |  
|Customer C |  |                    | 36 | %                |  |                | *  |      |  |  | 30 | %              |  |  | *  |  
|Customer D |  |                    | *  |                  |  |                | 26 | %    |  |  | *  |                |  |  | 15 | %
|Customer E |  |                    | *  |                  |  |                | 13 | %    |  |  | *  |                |  |  | *  |  

* Customer accounted for less than 10% for the period.

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

|         |               |       |   |                    |        |                  |   |                |        |      |   |        |        |                |   |        |        | 
|-------- | ------------- | ----- | - | ------------------ | ------ | ---------------- | - | -------------- | ------ | ---- | - | ------ | ------ | -------------- | - | ------ | ------ | 
|         |               |       |   | Three months ended |        | Six months ended
|         |               |       |   | March 31,          |        | March 31,       
|         |               |       |   |                    |        |                 
|         |               |       |   | 2003               |        | 2002             |   | 2003           |        | 2002
|         |               |       |   |                    |        |                  |   |                |        |     
|         |               |       |   |                    |        |                  |   | (reclassified) |        |      |   |        |        | (reclassified)
|         |               |       |   | (in thousands)     |        | (in thousands)  
|Revenue: |               |       |   |                    |        |                  |   |                |        |      |   |        |        |                |   |       
|         | Taiwan        |       | $ | 2,405              |        |                  | $ | 4,381          |        |      | $ | 4,506  |        |                | $ | 5,210  |       
|         | United States |       |   | 413                |        |                  |   | 123            |        |      |   | 648    |        |                |   | 343    |       
|         | Korea         |       |   | 6,466              |        |                  |   | 4,308          |        |      |   | 23,190 |        |                |   | 12,643 |       
|         | Japan         |       |   | 191                |        |                  |   | 3,604          |        |      |   | 566    |        |                |   | 3,800  |       
|         | China         |       |   | 328                |        |                  |   | 605            |        |      |   | 385    |        |                |   | 1,204  |       
|         | Europe        |       |   | 237                |        |                  |   | 92             |        |      |   | 584    |        |                |   | 1,115  |       
|         | Canada        |       |   | 17                 |        |                  |   | 17             |        |      |   | 17     |        |                |   | 28     |       
|         | Other         |       |   | 76                 |        |                  |   | 802            |        |      |   | 109    |        |                |   | 958    |       
|         |               |       |   |                    |        |                  |   |                |        |      |   |        |        |                |   |        |       
|         |               | Total |   | $                  | 10,133 |                  |   | $              | 13,932 |      |   | $      | 30,005 |                |   | $      | 25,301 | 
|         |               |       |   |                    |        |                  |   |                |        |      |   |        |        |                |   |        |       

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

|           |  |           |    |               |  |  |    |  
|---------- |  | --------- | -- | ------------- |  |  | -- | -
|           |  | March 31, |    | September 30,
|           |  | 2003      |    | 2002         
|           |  |           |    |              
|Customer A |  |           | 25 | %             |  |  | 32 | %
|Customer B |  |           | 15 | %             |  |  | *  |  
|Customer C |  |           | 23 | %             |  |  | *  |  

* Customer accounted for less than 10% for the period.

NOTE 10Comprehensive Income

The components of comprehensive income were as follows:

|                                   |                                          |                                   |                          |     |                    |         |                  |      |                |        |         |    |     |         |                |      |      |        |  
|---------------------------------- | ---------------------------------------- | --------------------------------- | ------------------------ | --- | ------------------ | ------- | ---------------- | ---- | -------------- | ------ | ------- | -- | --- | ------- | -------------- | ---- | ---- | ------ | -
|                                   |                                          |                                   |                          |     | Three months ended |         | Six months ended
|                                   |                                          |                                   |                          |     | March 31,          |         | March 31,       
|                                   |                                          |                                   |                          |     |                    |         |                 
|                                   |                                          |                                   |                          |     | 2003               |         | 2002             |      | 2003           |        | 2002   
|                                   |                                          |                                   |                          |     |                    |         |                  |      |                |        |        
|                                   |                                          |                                   |                          |     |                    |         |                  |      | (reclassified) |        |         |    |     |         | (reclassified)
|                                   |                                          |                                   |                          |     | (in thousands)     |         | (in thousands)  
|Net loss                           |                                          | $                                 | (23,015                  | )   |                    | $       | (1,612           | )    |                | $      | (48,031 | )  |     | $       | (4,976         | )   
|Other comprehensive income (loss): |                                          |                                   |                          |     |                    |         |                  |      |                |        |         |    |     |         |                |     
|                                   | Change in unrealized gain on investments |                                   |                          | 26  |                    |         |                  | (52  | )              |        |         | 74 |     |         |                | (113 | )   
|                                   | Currency translation adjustments         |                                   |                          | (14 | )                  |         |                  | (189 | )              |        |         | 73 |     |         |                | (39  | )   
|                                   |                                          |                                   |                          |     |                    |         |                  |      |                |        |         |    |     |         |                |      |      |        |  
|                                   |                                          | Other comprehensive income (loss) |                          |     | 12                 |         |                  |      | (241           | )      |         |    | 147 |         |                |      | (152 | )     
|                                   |                                          |                                   |                          |     |                    |         |                  |      |                |        |         |    |     |         |                |      |      |        |  
|                                   |                                          |                                   | Total comprehensive loss |     | $                  | (23,003 | )                |      | $              | (1,853 | )       |    | $   | (47,884 | )              |      | $    | (5,128 | )
|                                   |                                          |                                   |                          |     |                    |         |                  |      |                |        |         |    |     |         |                |      |      |        |  

NOTE 11Restructuring Charges

During the fourth quarter of fiscal 2002, the Company implemented a
restructuring plan to reduce its workforce, consolidate and close certain
facilities and write-off related fixed assets in accordance with a management
approved plan. The Company recorded a restructuring charge of $2.6 million,
which was comprised of approximately $550,000 for employee severance and
related benefits, $1.3 million related to excess facilities and $700,000 of
abandoned assets with no future economic benefit. The charge for excess
facilities relates to rent obligations under long term operating lease
agreements which are to be paid in cash through December 2006. In the three
month period ended March 31, 2003, the Company renegotiated the terms of the
lease obligation related to one of the excess facilities, resulting in a
reduction to the liability of approximately $237,000. This benefit was taken
as part of the discontinued operations. As of March 31, 2003, the remaining
liability associated with the restructuring plan is approximately $840,000,
which consists of operating lease obligations associated with excess
facilities. Management settled all employee severance and related benefits in
the second quarter of fiscal 2003.

During the fourth quarter of fiscal 2001, the Company implemented a
restructuring plan as a result of several initiatives, including the
integration of IRSI into the printed circuit board assembly inspection
division, the combining of sales and service into one organization and the
Companys continuing strategy to outsource manufacturing. As of March 31, 2003,
the remaining liability associated with this restructuring plan is
approximately $350,000 which represents contractual payments to be paid to a
former executive officer of the Company through March 2004. There have been no
adjustments to the liability.

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NOTE 12Warranty Obligations

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

Changes in the Companys product liability during the six month period
ended March 31, 2003, are as follows:

|                                                                        |  |                |       |  
|----------------------------------------------------------------------- |  | -------------- | ----- | -
|                                                                        |  | March 31,     
|                                                                        |  | 2003          
|                                                                        |  |               
|                                                                        |  | (in thousands)
|Balance at September 30, 2002                                           |  | $              | 2,383 |  
|Estimated warranty cost of new shipments during the period              |  |                | 1,018 |  
|Warranty charges during the period                                      |  |                | (847  | )
|Changes in liability for pre-existing warranties, including expirations |  |                | (369  | )
|Liability assumed as a result of the acquisition of the RTP Assets      |  |                | 150   |  
|                                                                        |  |                |       |  
|Balance at March 31, 2003                                               |  | $              | 2,335 |  
|                                                                        |  |                |       |  

NOTE 13Stock Repurchase Program

In August 2002, the Companys Board of Directors approved a stock
repurchase program authorizing the Company to repurchase up to an aggregate of
$25.0 million of the Companys common stock. The repurchase program was
terminated on January 15, 2003. The repurchases were made from time to time on
the open market at prevailing prices, in negotiated transactions off the market
or pursuant to a 10b5-1 plan adopted by the Company. The 10b5-1 plan allowed
the Company to repurchase its shares during a period in which the Company was
in possession of material non-public information, provided that the Company
communicated share repurchase instructions to the broker at a time when it was
not in possession of such material non-public information. During the
six month
period ended March 31, 2003, the Company repurchased 903,032 shares for an
aggregate repurchase price of approximately $17.7 million. As of March 31,
2003, the Company had purchased a total of 1,253,932 shares for an aggregate
repurchase price of approximately $24.6 million.

NOTE 14Shareholders Equity

On February 4, 2003, at the Companys Annual Meeting of Shareholders, the
Companys shareholders approved an increase of 400,000 shares reserved for
grant under the Companys 1995 Stock Option Plan from a total of 2,590,943
shares to 2,990,943 shares and an increase of 250,000 shares authorized for
issuance under the Companys 1995 Employee Stock Purchase Plan from a total of
1,000,000 shares to 1,250,000 shares

NOTE 15Legal Proceedings

The Company and certain of its directors and officers have been named as
defendants in a lawsuit captioned Amtower v. Photon Dynamics, Inc., No.
CV797876, filed on April 30, 2001 in the Superior Court of the State of
California, County of Santa Clara. The plaintiff, who previously served as one
of the Companys officers, has asserted several causes of action arising out of
alleged misrepresentations made to plaintiff regarding the existence and
enforcement of the Companys insider trading policy. The plaintiff is seeking
damages of approximately $17.7 million for defendants alleged refusal to allow
plaintiff to sell shares of the Companys stock in May of 2000, plus
unspecified emotional distress and punitive damages. On December 6, 2001, the
court granted defendants motion to dismiss the complaint for failure to allege
facts sufficient to state a cause of action, with leave to file an amended
complaint. On January 17, 2002, plaintiff filed his amended complaint and
defendants again moved to dismiss the action. On June 27, 2002, the court
issued an order granting in part and denying in part the motion, and further
granted plaintiff an opportunity to restate certain claims. On October 1,
2002, plaintiff filed his Second Amended Complaint, which was heard on April 8,
2003, and defendants again moved to dismiss the action. On April 21, 2003,
the Court granted in part and denied in part the Companys motion. The
pleadings have been finalized and certain claims against the Company and the
individual defendants will proceed. The Company believes the plaintiffs case
is without merit and intends to defend this action vigorously. Although the
Company cannot predict

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##### Table of Contents



the outcome of this litigation, the Company believes that any adverse
judgment in this litigation would not have a material adverse effect on the
Companys financial condition or results of operations.

The Company filed a lawsuit captioned Photon Dynamics, Inc. vs.
PanelVision Technology and Guillermo Tora-Lira, No. CO202563PJH filed on May
28, 2002, in the U.S. District Court for the Northern District of California,
County of Santa Clara. The Company is alleging infringement of a U.S. Patent
owned by it and seeking full compensatory damages and an injunction against the
defendants. On July 17, 2002, the defendants answered the Companys complaint
and asserted a counterclaim alleging damages of at least $6.0 million in
compensatory damages for loss of business. The Company believes that the
counterclaims are without merit and intends to vigorously contest the
counterclaims. On January 23, 2003, the Company added Shimadzu Corporation as
an additional defendant. On April 23, 2003, the defendants added additional
counterclaims against Photon Dynamics alleging violations of the antitrust laws
and requesting the damages sought to be trebled. Although the Company cannot
predict the outcome of this litigation, the Company believes that any adverse
determination in this litigation would not have a material adverse effect on
its financial condition or results of operations.

NOTE 16Subsequent Events

In April 2003, the Company extended its bank line of credit until June
2003. The line of credit is secured by substantially all of the Companys
assets and contains financial and other covenants.

On
May 9, 2003, the Company acquired substantially all of the
assets of Summit Imaging, Inc., for approximately $1.5 million
in cash. Summit Imaging, Inc. designs and manufactures cooled
cameras for the capital equipment industry. The funds used to
purchase the assets came directly out of the Companys working
capital.




Item 2.Managements Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933 and Section 21E
of the Securities Exchange Act of 1934. Actual results could differ materially
from those projected in the forward-looking statements as a result of a number
of factors, risks and uncertainties, including the risk factors set forth in
this discussion, especially under the caption Factors Affecting Operating
Results and elsewhere in this Form 10-Q. Generally, the words anticipate,
expect, intend, believe and similar expressions identify forward-looking
statements. The information included in this Form 10-Q is as of the filing date
with the Securities and Exchange Commission and future events or circumstances
could differ significantly from the forward-looking statements included here.
Accordingly, we caution readers not to place undue reliance on such statements.

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, 2002, contained in our Annual Report on Form 10-K.

Overview

We are a leading provider of yield management solutions to the flat panel
display industry. Our test, repair and inspection systems are used by
manufacturers to collect data, analyze product quality and identify and repair
product defects at critical steps in the manufacturing process. We recently
acquired rapid thermal processing technology, which enables manufacturers of
flat panel displays to thermally activate low temperature poly-silicon films at
temperatures that would otherwise distort or destroy underlying glass
substrates. We also offer yield management solutions for cathode ray tube
display, cathode ray tube glass and automotive glass industries, collectively
referred to as our cathode ray tube display and high quality glass products.
Through January 14, 2003, we offered yield management solutions for the printed
circuit board assembly industry, however, we implemented a plan to exit the
printed circuit board assembly inspection business in January 2003.
Accordingly, the operating results of this business segment have been presented
as discontinued operations and our results of operations for the prior periods
have been reclassified to conform to the current periods presentation.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have
been prepared in accordance with accounting principles generally accepted in
the
17Table of Contents

United States for interim financial information. The preparation of these
financial statements requires us to make estimates and judgments that affect
the reported amounts of assets, liabilities, revenue and expenses, and related
disclosure of contingent assets and liabilities. On an ongoing basis, we
evaluate our estimates, including those related to accounts receivable,
inventories, purchase order commitments, warranty obligations, intangible
assets and contingencies and litigation. We base our estimates on historical
experience and on various other assumptions that are believed to be reasonable
under the circumstances, the results of which form the basis for making
judgments about the carrying values of assets and liabilities that are not
readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions.

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

Revenue Recognition

We recognize revenue when persuasive evidence of an arrangement exists,
delivery has occurred or services have been rendered, the selling price is
fixed or determinable and collectibility is reasonably assured.

We account for certain of our product sales, including sales to a value
added reseller, in our flat panel display and cathode ray tube display and high
quality glass inspection product segments as arrangements with multiple
deliverables. For arrangements with multiple deliverables, we recognize revenue
for the delivered items if the delivered items have value to the customer on a
standalone basis, and the amount of revenue for delivered elements is not
subject to refund, we have met defined customer acceptance experience levels
for the delivered items, and the fair value of undelivered items, such as
installation and system upgrade rights, can be reliably determined. We allocate
revenue to the delivered items based on the amount due and billable upon
shipment, with the remaining amount recognized after installation and
acceptance when the final amount becomes due. We recognize all other product
sales upon customer acceptance. We recognize revenue from the sale of spare
parts upon shipment.

We record a provision for estimated sales returns in the same period as
the related revenue is recorded, which is netted against revenue. These
estimates are based on historical sales returns and other known factors. If the
historical data we use to calculate these estimates does not properly reflect
future returns, additional provisions may be required.

Accounts Receivable

We maintain an allowance for the inability of our customers to make
required payments. These estimates are based on historical data, the length of
time the receivables are past due and other known factors. If a single customer
returned a product or was unable or unwilling to make payments, additional
allowances may be required as certain of our products have selling prices in
excess of $1.5 million per unit. Accordingly, a single customer could have a
material adverse effect on our results of operations.

Inventories

We make purchase commitments for inventory based upon existing backlog and
sales forecasts. To mitigate supply constraints and to fulfill orders for
non-standard configurations, we maintain certain inventory levels especially
for parts with long lead times.

Inventories consist of raw materials, work-in-process and finished goods and
are stated at the lower of cost or market. Cost is computed using currently
adjusted standards which approximate actual costs on a first-in, first-out
basis. We assess the recoverability of all inventory and purchase commitments
to determine whether write-downs are required. Inventory which is obsolete
(defined as inventory that will no longer be used in the manufacturing process)
or in excess of the forecasted usage is written down to its estimated fair
value based on projected demand, historical usage and other known factors. If
actual demand is lower than our forecast, additional inventory write-downs may
be required.

18



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##### Table of Contents



Warranty Obligations

Our warranty policy generally states that we will provide warranty
coverage for a period of one year from final acceptance. We record the
estimated cost of warranty coverage, primarily material and labor to repair and
service the equipment, upon product shipment. Our warranty obligation is
affected by the number of installed units under warranty, product failure
rates, material usage rates and the efficiency by which the product failure is
corrected. Should actual product failure rates, material usage and labor
efficiencies differ from our estimates, revisions to the estimated warranty
liability would be required.

Goodwill

We account for goodwill and other intangible assets resulting from our
acquisitions in accordance with Statement of Financial Accounting Standards FAS
142 Goodwill and Other Intangible Assets (FAS 142). FAS 142 prohibits the
amortization of goodwill and intangible assets with indefinite useful lives.
FAS 142 requires that these assets be reviewed for impairment at least annually
and more frequently if indicators of impairment exist. The process for
evaluating the potential impairment of goodwill is highly subjective and
requires significant judgment at many points during the analysis. In estimating
the fair value of the reporting unit with recognized goodwill, we make
estimates and judgments about the future cash flows of the reporting unit. Our
cashflow forecasts are based on assumptions that are consistent with the plans
and estimates we are using to manage the underlying business. We also consider
our market capitalization (adjusted for unallocated monetary assets such as
cash, marketable debt securities and debt) in determining the fair value of the
respective businesses. Should actual results differ from our estimates,
revisions to the recorded amount of goodwill could be reported.

Long-Lived Assets and Intangible Assets

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

Restructuring Costs

We have accounted for restructuring costs incurred prior to December 31,
2002, in accordance with the provisions of Emerging Issues Task Force (EITF)
Issue No. 94-3, Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred
in a Restructuring). These accruals include estimates pertaining to employee
separation costs and related abandonment of excess equipment and facilities.
Actual costs may differ from these estimates. Future restructuring costs will
be accounted for under the Statement of Financial Accounting Standards No. 146
Accounting for Costs Associated with Exit or Disposal Activities.

Contingencies and Litigation

We make an assessment of the probability of an adverse judgment resulting
from current and threatened litigation. We accrue the cost of an adverse
judgment if, in our estimation, the adverse settlement is probable and we can
reasonably estimate the ultimate cost of such litigation. We have made no such
accruals at March 31, 2003.

Results of Operations

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

19



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##### Table of Contents



|                                         |                                              |                          |        |                    |      |                  |       |                |      |      |        |      |      |                |       |      |      | 
|---------------------------------------- | -------------------------------------------- | ------------------------ | ------ | ------------------ | ---- | ---------------- | ----- | -------------- | ---- | ---- | ------ | ---- | ---- | -------------- | ----- | ---- | ---- | 
|                                         |                                              |                          |        | Three months ended |      | Six months ended
|                                         |                                              |                          |        | March 31,          |      | March 31,       
|                                         |                                              |                          |        |                    |      |                 
|                                         |                                              |                          |        | 2003               |      | 2002             |       | 2003           |      | 2002
|                                         |                                              |                          |        |                    |      |                  |       |                |      |     
|                                         |                                              |                          |        |                    |      |                  |       | (reclassified) |      |      |        |      |      | (reclassified)
|Revenue                                  |                                              |                          | 100.0  | %                  |      |                  | 100.0 | %              |      |      | 100.0  | %    |      |                | 100.0 | %   
|Cost of revenue                          |                                              |                          | 85.4   |                    |      |                  | 53.1  |                |      |      | 69.1   |      |      |                | 56.8  |     
|                                         |                                              |                          |        |                    |      |                  |       |                |      |      |        |      |      |                |       |     
|Gross margin                             |                                              |                          | 14.6   |                    |      |                  | 46.9  |                |      |      | 30.9   |      |      |                | 43.2  |     
|Operating expenses:                      |                                              |                          |        |                    |      |                  |       |                |      |      |        |      |      |                |       |     
|                                         | Research and development                     |                          |        | 55.2               |      |                  |       | 23.6           |      |      |        | 34.1 |      |                |       | 24.6 |     
|                                         | Selling, general and administrative          |                          |        | 40.6               |      |                  |       | 22.2           |      |      |        | 25.3 |      |                |       | 23.0 |     
|                                         | Long-lived asset impairment charge           |                          |        |                   |      |                  |       |               |      |      |        | 1.0  |      |                |       |     |     
|                                         | Acquired in-process research and
development |                          |        |                   |      |                  |       |               |      |      |        | 6.2  |      |                |       |     |     
|                                         | Amortization of intangible assets            |                          |        | 3.6                |      |                  |       |               |      |      |        | 2.1  |      |                |       |     |     
|                                         |                                              |                          |        |                    |      |                  |       |                |      |      |        |      |      |                |       |     
|                                         |                                              | Total operating expenses |        |                    | 99.4 |                  |       |                | 45.8 |      |        |      | 68.7 |                |       |      | 47.6 | 
|Income (loss) from operations            |                                              |                          | (84.8  | )                  |      |                  | 1.1   |                |      |      | (37.8  | )    |      |                | (4.4  | )   
|Interest income and other, net           |                                              |                          | 6.7    |                    |      |                  | 4.6   |                |      |      | 5.0    |      |      |                | 4.5   |     
|                                         |                                              |                          |        |                    |      |                  |       |                |      |      |        |      |      |                |       |     
|Income (loss) from continuing operations |                                              |                          | (78.1  | )                  |      |                  | 5.7   |                |      |      | (32.8  | )    |      |                | 0.1   |     
|Loss from discontinued operations        |                                              |                          | (149.0 | )                  |      |                  | (17.3 | )              |      |      | (127.2 | )    |      |                | (19.8 | )   
|                                         |                                              |                          |        |                    |      |                  |       |                |      |      |        |      |      |                |       |     
|Net loss                                 |                                              |                          | (227.1 | %)                 |      |                  | (11.6 | %)             |      |      | (160.0 | %)   |      |                | (19.7 | %)  

Revenue

Revenue for the second quarter of fiscal 2003 was $10.1 million compared
to $13.9 million in the same period of the prior fiscal year, representing a
decrease of $3.8 million, or 27%. This decrease is primarily due to a $3.2
million decrease in flat panel display revenue. Revenue decreased by
approximately 50% from prior quarter primarily as a result of technical delays
with respect to the introduction of our new Array Checker 3500 products.
During the second quarter of fiscal 2003, five Array Checker 3500 systems were
shipped to customers; however, these systems were recorded as deferred revenue
during the quarter, per our revenue recognition policy. Revenue for the six
months ended March 31, 2003, was $30.0 million compared with $25.3 million for
the six months ended March 31, 2002, representing an increase of $4.7 million,
or 19%. This increase was due to an increase of $6.8 million in flat panel
display revenue for the six months ended March 31, 2003, despite the Array
Checker 3500 delay, attributable to substantially greater Array Checker unit
volumes in the first quarter of fiscal 2003 compared to the prior year
comparable period, offset in part by a reduction of approximately $2.1 million
in cathode ray tube and high quality glass revenue.

Sales of flat panel display products represented $9.1 million and $12.3
million, or 89% and 88%, of revenue in the three month periods ended March 31,
2003 and 2002, respectively. The $3.2 million decrease is largely attributed
to the reduction in the number of Array Checker units for which revenue was
recognized, offset in part by approximately $2.1 million of revenue from our
new rapid thermal processing products, which we acquired in November 2002 from
Intevac, Inc. Sales of cathode ray tube display and high quality glass
products represented $1.1 million and $1.7 million, or 11% and 12%, of revenue
in the three month periods ended March 31, 2003 and 2002, respectively. This
decrease was primarily the result of flat panel displays continuing to replace
cathode ray tubes displays, which resulted in a reduction in unit volume of
cathode ray tubes display inspection systems sold. For the six month periods
ended March 31, 2003 and 2002, sales of flat panel display products represented
$28.2 million and $21.4 million, or 94% and 85%, of revenue, respectively.
Included in the $6.8 million increase in flat panel display revenue for the six
months ended March 31, 2003, is $3.6 million of revenue contributed by the
rapid thermal processing products. Sales of cathode ray tube display and high
quality glass products represented $1.8 million and $3.9 million, or 6% and
15%, of revenue in the six month periods ended March 31, 2003 and 2002,
respectively. This decrease was primarily the result of flat panel displays
continuing to replace cathode ray tube
20Table of Contentsdisplays, resulting in a decrease in capital spending by cathode ray tube
manufactures and a slow down in general economic conditions.International revenue is derived primarily from customers in Korea, Taiwan
and Japan. International revenue represented $9.7 million and $13.8 million,
or 96% and 99%, of revenue in the three month periods ended March 31, 2003 and
2002, respectively. Revenue from Taiwan and Japan, collectively, decreased
$5.4 million while revenue from Korea increased
$2.2 million. For the six month
period ended March 31, 2003 and 2002, international revenue represented $29.4
million and $25.0 million, or 98% and 99%, of net revenue, respectively. For
the six months ended March 31, 2003, revenue from Korea increased approximately
$10.5 million over the same period of the prior year while revenue from Taiwan
and Japan, collectively, decreased by approximately $4.0 million.Gross MarginGross
margin decreased to approximately 15% in the three month period
ended March 31, 2003, from approximately 47% in the three month period ended
March 31, 2002. For the six month period ended March 31, 2003, the gross
margin was 31% as compared to 43% for the same period of the prior fiscal year.
The overall decrease in gross margin for the six months ended March 31, 2003
is attributed to the most recent quarters results, as gross margin was
relatively constant during the first quarter of fiscal 2003. In the third
quarter of fiscal 2003, we expect our gross margins to increase due to the
acceptance of the Array Checker 3500 systems shipped during the second quarter
of fiscal 2003, resulting in fixed costs spread over a greater revenue base, as
well as anticipated improvement in system and modulator manufacturing
efficiencies for flat panel display products.Gross margin from flat panel display products was approximately 14% and
48% in the three month periods ended March 31, 2003 and 2002, and approximately
32% and 43% in the six months ended March 31, 2003 and 2002, respectively. The
overall decrease in gross margin is primarily due to manufacturing
inefficiencies resulting from the introduction of our new Array
Checker 3500
product and lower modulator yields. A modulator is a consumable electro-optic
input device which is required to maintain the reliability of our
Array Checker
systems. In addition, non-recurring charges related to the acquisition of
rapid thermal processing backlog from Intevac, Inc. had a negative impact on
gross margin of 3% for the six months ended March 31, 2003. Gross margin for
the three and six months ended March 31, 2002, benefited by the final
acceptance of more systems as compared to the number of systems accepted for
the three months and six months ended March 31, 2003. The gross margin
related to revenue recognized upon final acceptance (typically the final
payment of 10% to 20% of the system selling price) is higher than the gross
margin recognized upon shipment of the systems. Gross margin from cathode ray
tube display and high quality glass products was approximately 24% and 40% in
the three months ended March 31, 2003 and 2002, and approximately 29% and 44%
for the six months ended March 31, 2002 and 2001, respectively. The decrease
in gross margins for the three and six months ended March 31, 2003 was
primarily due to manufacturing inefficiencies resulting from decreased revenue
and lower manufacturing volumes.Research and DevelopmentOur research and development expenses consisted primarily of salaries,
related personnel costs, depreciation, prototype materials, patent filing
costs and fees paid to consultants and outside service providers, all of which
relate to the design, development, testing, pre-manufacturing and improvement
of our products. Research and development expenses were $5.6 million and $3.3
million, or approximately 55% and 24%, of net revenue in the three months ended
March 31, 2003 and 2002, respectively. This increase of $2.3 million was
primarily attributed to a higher level of spending resulting from the
acquisitions of Akcron and assets relating to the rapid thermal processing
technology from Intevac, Inc., combined with an increase in engineering
headcount and legal expenses for patent defense. For the six months ended
March 31, 2003 and 2002, research and development expenses were $10.2 million
and $6.2 million, or approximately 34% and 25%, of net revenue, respectively.
This increase of $4.0 million is primarily attributable to higher spending on
prototype materials, a higher level of spending associated with the
acquisitions of Akcron and assets relating to the rapid thermal processing
technology from Intevac, Inc., an increase in engineering headcount and legal
expenses for patent defense. We expect research and development21Table of Contentsexpenses to remain a high percentage of revenue as we are developing generation
6 and 7 systems in our flat panel display segment concurrently.Selling, General and Administrative.Our selling, general and administrative expenses consisted primarily of
salaries and related expenses for marketing, sales, finance, administration,
and human resources personnel, legal and accounting, commissions, insurance and
other corporate expenses. Selling, general and administrative expenses were
$4.1 million and $3.1 million, or approximately 41% and 22% of net revenue, in
the three months ended March 31, 2003 and 2002, respectively. For the six
months ended March 31, 2003 and 2002, selling, general and administrative
expenses were $7.6 million and $5.8 million, or approximately 25% and 23% of
revenue, respectively. The increase in selling, general and administrative
expenses of $1.0 million and $1.8 million from the three and six
month periods ending March 31, 2002, respectively was primarily attributed to increases in
legal, accounting and directors and officers insurance, related to the
corporate governance requirements, and severance expenses. We have embarked on
several selling, general and administrative expense reduction initiatives with
a goal to reduce our selling, general and administrative expenses to
approximately $3.6 million next quarter.Impairment of Long-lived AssetsIn the first quarter of fiscal 2003, based on indicators of impairment, we
performed an impairment analysis of certain long-lived assets associated with
the cathode ray tube display and high quality glass products reporting unit. As
a result, we recorded impairment charges of approximately $303,000 to reduce
the carrying values of long-lived assets to their respective estimated values.Acquired InProcess Research and DevelopmentIn November 2002, we completed our acquisition of certain assets from
Intevac, Inc. related to Intevacs rapid thermal processing technology used for
activating low temperature poly-silicon during the manufacturing process for
flat panel displays. The purchase price has been allocated in accordance with
FAS 141, including inprocess research and development charges of approximately
$1.8 million. This was expensed on the acquisition date as it represents
ongoing research and development projects that had not yet reached
technological feasibility and had no alternative future uses.Acquired in-process research and development was identified and valued
through interviews with acquired company executives, analysis of data
concerning developmental products and their stage of development, the time and
resources needed to complete the projects, their expected income generating
ability, target markets and associated risks. The income approach, which
includes an analysis of the markets, cash flows and risks associated with
achieving such cash flows, was the primary technique utilized in valuing
in-process research and development. We discounted back to their present value
projected incremental cash flows using a discount rate of 25%, which was
determined after consideration of our weighted average cost of capital and the
weighted average return on assets. Associated risks include the inherent
difficulties and uncertainties in completing each project and thereby achieving
technological feasibility, anticipated levels of market acceptance and
penetration, market growth rates and risks related to the impact of potential
changes in future target markets. The nature of the efforts required to develop
the acquired in-process research and development into commercially viable
products principally relate to the completion of all planning, designing,
prototyping, verification and testing activities that are necessary to
establish that the products can be produced to meet their design
specifications, including functions, features and technical performance
requirements. As such, the timing of completion and ultimate commercial
application are affected by the successful completion of these activities and
ultimately, market acceptance. In-process research and development projects
included a new transport system for more efficient handling of larger glass,
redesign of the lamphouse for selective heating of the film and enhancement of
low oxygen technology. The current percentage of completion on these projects
is approximately 85%, with approximately $100,000 of additional expenditures
anticipated to be necessary to complete this development.Amortization of IntangiblesThe identified intangible assets (other than goodwill) are being amortized
over a two to five year period,22Table of Contentscommencing on the date of the acquisitions. We have recorded related
amortization expense of $367,000 and $627,000 for the three and six months
ended March 31, 2003, respectively.Interest Income and Other, NetInterest income and other, net consisted primarily of interest income,
foreign currency exchange gains and losses and other miscellaneous income and
expense. Interest income and other, net was $680,000 and $639,000 for the three
months ended March 31, 2003 and 2002, respectively and $1.5 million and $1.2
million for the six months ended March 31, 2003 and 2002, respectively. The
increase in interest income was primarily attributable to higher average cash
balances.Discontinued OperationsIn January 2003, we implemented a plan to exit the printed circuit board
assembly inspection business. The loss from discontinued operations for the
three months ended March 31, 2003, included a write-off of inventory of
approximately $7.8 million, a write-off of accounts receivable of approximately
$1.7 million, and a write-off of licensed technology of approximately $1.9
million. The loss from discontinued operations for the six months ended March
31, 2003, also included impairment charges of approximately $15.1 million of
goodwill, $2.9 million of purchased intangibles and $2.5 million of long-lived
assets.

|                                  |  |                    |         |                  |  |                |        |      |  |   |         |                |  |   |        |  
|--------------------------------- |  | ------------------ | ------- | ---------------- |  | -------------- | ------ | ---- |  | - | ------- | -------------- |  | - | ------ | -
|                                  |  | Three months ended |         | Six months ended
|                                  |  | March 31,          |         | March 31,       
|                                  |  |                    |         |                 
|                                  |  | 2003               |         | 2002             |  | 2003           |        | 2002
|                                  |  |                    |         |                  |  |                |        |     
|                                  |  |                    |         |                  |  | (reclassified) |        |      |  |   |         | (reclassified)
|Loss
from discontinued operations |  | $                  | (15,099 | )                |  | $              | (2,403 | )    |  | $ | (38,177 | )              |  | $ | (5,013 | )

Liquidity and Capital Resources

We have financed our operations primarily by a combination of cash flows
from operations and public stock offerings. At March 31, 2003, we had
approximately $117.9 million in cash, cash equivalents and short-term
investments. This is a decrease of approximately $52.2 million from $170.1
million at September 30, 2002. In January 2003, we implemented a plan to exit
the printed circuit board assembly inspection business. Accordingly, the
operating results of this business segment have been reclassified as a
discontinued operation. During the first six months of fiscal 2003, net cash
used by discontinued operations was $8.3 million, compared to $3.0 million for
the first six months of fiscal 2002.

Operating Activities. During the first six months of fiscal 2003, net cash
used in operating activities from continuing operations was $6.8 million.
Significant components of this use of cash from continuing operations were a
net loss of $9.8 million, offset in part by $4.6 million of non-cash charges
such as acquired in-process research and development, amortization of
intangibles and depreciation. Other components include a reduction in accounts
payable of $2.4 million, an increase in accounts receivable of $3.2 million and
a reduction in other current liabilities of $2.2 million, partially offset by
an increase in deferred revenue of $5.4 million.

During the first six months of fiscal 2002, net cash used in operating
activities from continuing operations was $801,000. The primary components of
this use of cash from continuing operations were an increases in accounts
receivable of $3.9 million and other current assets of $2.5 million, a
decrease in deferred revenue of $2.0 million, offset in part by an increase in
accounts payable of $1.8 million, an increase in other current liabilities of
$1.1 million and a decrease in inventory of $3.1 million.

Investing Activities. During the first six months of fiscal 2003,
investing activities provided cash of $18.9 million. Cash provided by investing
activities was primarily the result of the redemption of short-term investments
of $319.7 million, offset in part by the purchase of short-term investments of
$279.5 million, acquisition of certain assets from Intevac, Inc. for $20.0
million and $1.2 million in purchases of capital equipment.

23



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##### Table of Contents



During the first six months of fiscal 2002, investing activities provided
cash of $30.9 million. Cash provided by investing activities was primarily the
result of the redemption of short-term investments of $265.3 million, offset in
part by the purchase of short-term investments of $234.1 million and $312,000
in purchases of capital equipment.

Financing Activities. Cash used by financing activities was $16.1 million
in the first six months of fiscal 2003. This was the result of repurchases of
common stock of $17.7 million, offset in part by employee exercises of stock
options of $1.6 million.

During the first six months of fiscal 2002, financing activities provided
cash of $110.7 million. This was primarily the result $107.0 million from the
public sale of common stock, $3.3 million of employee exercises of stock
options, and an exercise of warrants to purchase 21,285 shares, providing cash
proceeds of $360,000.

In August 2002, our Board of Directors approved a stock repurchase program
authorizing us to repurchase up to an aggregate of $25.0 million of our common
stock. As of March 31, 2003, we have repurchased 1,253,932 shares for an
aggregate of approximately $24.6 million.

The following table summarizes the approximate contractual obligations
that we have at March 31, 2003. Such obligations include both non-cancelable
obligations and other obligations that are generally non-cancelable except
under certain limited conditions.

|                            |       |       |                |        |  |       |                 |         |     |   |       |       |  |   |     |     | 
|--------------------------- | ----- | ----- | -------------- | ------ |  | ----- | --------------- | ------- | --- | - | ----- | ----- |  | - | --- | --- | 
|                            |       |       |                |        |  |       | Payments Due by |         |     |   |      
|                            |       |       |                |        |  |       | Period          |         |     |   |      
|                            |       |       |                |        |  |       |                 |         |     |   |      
|                            |       |       |                |        |  |       | Less than       |         | 1-4 |   | After
|Contract Obligations        |       | Total |                | 1 Year |  | Years |                 | 4 Years
|                            |       |       |                |        |  |       |                 |        
|                            |       |       | (in thousands)
|Operating lease
obligations |       | $     | 9,832          |        |  | $     | 2,481           |         |     | $ | 7,140 |       |  | $ | 211 |    
|Capital lease obligations   |       |       | 49             |        |  |       | 45              |         |     |   | 4     |       |  |   |    |    
|Purchase obligations        |       |       | 17,158         |        |  |       | 17,158          |         |     |   |      |       |  |   |    |    
|                            |       |       |                |        |  |       |                 |         |     |   |       |       |  |   |     |    
|                            | Total |       | $              | 27,039 |  |       | $               | 19,684  |     |   | $     | 7,144 |  |   | $   | 211 | 
|                            |       |       |                |        |  |       |                 |         |     |   |       |       |  |   |     |    

The
table above includes purchase orders that we have recently placed with
Sanmina-SCI Corporation under the terms of our manufacturing outsourcing
agreement with Sanmina-SCI, the terms of which requires us to place orders
covering a minimum period of 90 days.

We believe that existing liquid capital resources and funds generated from
operations combined with the ability, if necessary, to borrow up to $4.0
million under our line of credit, which was recently extended until
June 2003, will be
sufficient to meet our operating and capital requirements and obligations for
at least the next twelve months. However, this forward-looking statement is
based upon our current plans and assumptions, which may change, and our capital
requirements may increase in future periods. In addition, we believe that
success in our industry requires substantial capital in order to maintain the
flexibility to take advantage of opportunities as they may arise. We may, from
time to time, invest in or acquire complementary businesses, products or
technologies and may seek additional equity or debt financing to fund such
activities. There can be no assurance that such funding will be available to us
on commercially reasonable terms, if at all, and if we were to proceed with
acquisitions without this funding or with limited funding it would decrease our
capital resources. The sale of additional equity or convertible debt securities
could result in dilution to our shareholders.

Factors Affecting Operating Results

We have recently sustained losses and we may not be able to return to
profitability.

We reported net losses and a decrease in revenue for each of the fiscal
years ended September 30, 2002 and 2001, as well as a net loss for the six
months ended March 31, 2003. In the future, our revenue may decline, remain
flat or grow at a rate slower than expected, especially in light of the
continuing economic slowdown. Our ability to regain profitability on an annual
basis is dependent in part on our customers recovery from this slowdown and
the success of our efforts to reduce operating expenses as a percentage of
revenue through our ongoing cost-cutting measures, including our recent
restructuring and the discontinuance of our printed circuit board operations.
In

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addition, if we determine that the goodwill, intangible assets and other
long-lived assets of one of the businesses we acquired have been impaired, then
we would need to decrease the carrying value of these assets, which would
decrease our net income, or increase our net loss, during the period in which
we determined that the assets were impaired. Our operating results are
difficult to predict, and there is no assurance that we will be successful in
achieving increased revenue, positive cash flows or profitability.

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

We have experienced and expect to continue to experience significant
fluctuations in our quarterly results. Consequently, past financial results may
not be indicative of future financial results. A substantial percentage of our
revenue is derived from the sale of a small number of yield management systems
ranging in price from $250,000 to $1.85 million. Therefore, the timing of the
sale of a single system could have a significant impact on our quarterly
results. Moreover, customers may cancel or reschedule shipments, and production
difficulties could delay shipments. For example, as we announced in December
2002, we experienced technical delays with respect to the introduction of our
next generation Array Checker 3500 system. This delay has had a significant
impact on the timing of both our revenue and net income for the second quarter
of fiscal 2003. As a result, our backlog at the beginning of each quarter does
not necessarily determine actual sales for the quarter or any succeeding
period.

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



| |  |  | 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;



| |  |  | continued or worsened financial markets or economic instability in
Asia or the world in general;                                                      
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the relative proportions of domestic and international sales;                                                                                         
|
| |  |  | any write down in the value of acquired goodwill in the event that
we determine that the goodwill has been impaired;                                  
|
| |  |  | 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 we experience difficulties in any of these areas, our operating results
could be significantly and adversely affected and our stock price could
decline. In addition, it is possible that in some future quarter our operating
results may be below the expectations of public market analysts and investors,
which could cause our stock price to fall.

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

Our business depends in large part on capital expenditures by
manufacturers of flat panel display products, which in turn depends on the
current and anticipated market demand for the end products in that industry.
The market for flat panel display products is highly cyclical and has
experienced periods of oversupply resulting in significantly reduced demand for
capital equipment. For example, the flat panel display industry experienced a
downturn in 1998, which led many flat panel display manufacturers to delay or
cancel capital expenditures. Additionally, in 2001, due to the general
deteriorating economic environment, flat panel display and electronics
manufacturers reduced capital expenditures resulting in a decrease in revenue
for all segments of our business. If the flat panel display and other markets
in which we sell our products do not recover sufficiently or experience further
slowdowns in the future, it could cause our revenue to decrease significantly.
In addition, the need to invest in the engineering, research and development,
and marketing required to penetrate targeted foreign markets and maintain
extensive service and support capabilities limits our ability to reduce
expenses during these downturns.

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

The flat panel display industry is extremely concentrated with a small
number of manufacturers producing the majority of the worlds flat panel
displays. If one or more of our major customers ceased or significantly
curtailed their purchases, our revenue could drop significantly. We may be
unable to replace sales to these customers. Sales of flat panel display
products represented 89% and 94% of our revenue for the three and six months
ended March 31, 2003. Sales of flat panel display products to our largest
customer represented 47% of our revenue for the six months ended March 31,
2003. Our three largest customers., all customers of our flat panel display
products, collectively accounted for 87% of our total revenue, and each in
excess of 10% of our total revenue, in the six months ended March 31, 2003.

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

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

Similarly, as the technologies for products in the cathode ray tube display and
high quality glass industries continue to become more complex, we will be
forced to continually refine our product offerings. As a result, we expect to
continue to incur significant research and development costs. There can be no
assurance that we will be successful in the introduction, marketing and cost
effective manufacture of any of our new products, that we will be able to
timely develop and introduce new products and enhance our existing products and
processes to satisfy customer needs or achieve market acceptance, or that the
new markets for which we are developing new products or expect to sell current
products will develop sufficiently. For example, we recently experienced
technical delays relating to the introduction of our next generation Array
Checker 3500 system causing us to reschedule several shipments from the first
quarter to the second quarter of fiscal 2003. We depend on close relationships
with our customers and the willingness of those customers to share information
with us, and the failure to do so could harm our development efforts.

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

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

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

Sales to countries other than the United States accounted for 98% of
revenue for the six months ended March 31, 2003. We expect sales to foreign
countries to continue to represent a significant percentage of our revenue. A
number of factors may adversely affect our international sales and operations,
including:



| |  |  | political instability and the possibility of hostilities or war;                                                            
| | - |  | ----------------------------------------------------------------------------------------------------------------------------
|
| |  |  | imposition of governmental controls;                                                                                        
|
| |  |  | fluctuations in the United States dollar, which could increase the
foreign sales prices of our products in local currencies;
|
| |  |  | export license requirements;                                                                                                
|
| |  |  | restrictions on the export of technology;                                                                                   
|
| |  |  | limited foreign protection of intellectual property rights;                                                                 
|
| |  |  | trade restrictions;                                                                                                         
|
| |  |  | changes in tariffs; and                                                                                                     
|
| |  |  | difficulties in staffing and managing international operations.                                                             

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

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.

A substantial percentage of our revenue has come from a limited range of
products for the flat panel display industry. We expect that these products
will continue to account for a substantial percentage of our revenue. Any
decline in demand for, or failure to achieve continued market acceptance of,
our primary products or any new version of these products could harm our
business. We currently market two primary products for the flat panel display
industry, our array test and array repair equipment. Revenue from these two
products represented 74% of our total revenue in the six months ended March 31,
2003, and 66% of our total revenue in fiscal 2002. Moreover, we expect that
these products will account for an even greater percentage of our revenue in
the future in light of our planned exit from the printed circuit board assembly
inspection business. Continued market acceptance of these primary products is
critical to our success.

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

We have recently consummated several acquisitions, including acquisitions
of Intelligent Reasoning Systems, Inc. in July 2001, Akcron Corporation, LTD in
September 2002, and certain assets from ART Advanced Research Technologies Inc.
in July 2002 and Intevac, Inc. in November 2002. We may acquire other assets or
companies in the future. Integrating businesses can be a complex,
time-consuming and expensive process. If we are not able to do so effectively,
we will not be able to realize the benefits that we expect to receive from
acquisitions. For each acquisition, we must integrate separate technologies,
product lines, business cultures and practices, employees and systems.
Acquisitions are subject to numerous risks, including:



| |  |  | difficulties 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;              

27



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| |  |  | 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 of these difficulties could increase our operating costs and harm our
financial performance. In addition, we may also elect to change our strategic
direction and may no longer have need for certain acquired businesses or
technologies. For example, we recently exited the printed circuit board
assembly inspection business. As a result, some or all of the technologies
acquired in connection with certain of our acquisitions, including ART Advanced
Research Technologies Inc. and Intelligent Reasoning Systems, Inc. have been
abandoned. Future acquisitions may also result in potentially dilutive
issuances of equity securities, incurrence of debt and contingent liabilities
and amortization expenses related to acquired intangible assets, which could
harm our profitability.

Any failure of, or other problems at or with, Sanmina-SCI Corporation or other
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 Sanmina-SCI Corporation or any other third party that we use to
manufacture our products is unable to satisfy our quality requirements or
provide us with the products and services in a timely manner, our shipments of
these products may be delayed, our customer relationships may be harmed and our
results of operations may be adversely impacted. There can be no assurance that
our relationship with Sanmina-SCI or any other third party that we use to
manufacture our products will result in a reduction of our expenses or enable
us to satisfy our customers quality requirements or to deliver our products to
our customers in a timely manner.

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

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

IHI has determined to exit the market as a value-added reseller of flat panel
display products in Japan. We have previously relied on our relationship with
IHI to sell our flat panel display products in Japan, and if we are not able to
continue to access this important market, our business will be harmed.

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

Historically,
IHI has been a significant value-added reseller with respect
to sales of our flat panel display products in Japan. In the six months ended
March 31, 2003, fiscal 2002 and fiscal 2001, 2%, 8% and 13% of our

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total revenue came from sales to IHI, respectively. We are currently in
discussions with IHI regarding our on-going relationship with IHI and expect
that IHI will cease to sell and support our flat panel display products in
Japan in the future. If we are unable to negotiate a favorable termination of
this relationship with IHI, and to support existing customers or develop new
customers in Japan without IHI, our business will be harmed.

IHIs rights to serve as our exclusive value-added reseller in Japan are
currently unresolved. IHI may have the right to market some or all of our
products in Japan on an exclusive basis, even exclusive as to us. Consequently,
if we are unable to negotiate a favorable termination of this relationship with
IHI, we may not be able to compete effectively in Japan. Although IHI must
purchase certain critical components from us, IHI may manufacture competing
array test systems based on our technology. If this occurs, our business could
be harmed. We also have granted IHI the non-exclusive right to manufacture and
sell array test systems based on our technology, excluding technology
incorporated into some critical components, in Korea, Taiwan and several other
countries. Although IHI has neither manufactured these products, nor sold these
products in countries other than Japan, our business could be harmed if IHI
manufactures and sells array test systems in competition with our own in these
countries.

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

We believe that future orders of our products will depend in part on our
ability to satisfy the performance, reliability and quality standards required
by our customers. Particularly as customers seek increased yields, greater
throughput and higher quality end products, we must continually redesign our
products to meet the needs of our customers. If our products have performance,
reliability or quality problems, then we may experience:



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

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

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

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

While our technology is applicable to other flat panel display
technologies, our experience has been focused on applications for active matrix
liquid crystal displays, the most prevalent and one of the highest performance
flat panel displays available today. In the six months ended March 31, 2003, we
derived approximately 94% of our revenue from sales of flat panel display
products, substantially all of which were based on the active matrix liquid
crystal display technology. An industry shift away from active matrix liquid
crystal display technology to existing or new competing technologies could
reduce the demand for our existing products and require significant
expenditures to develop new products, each of which could harm our business.

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

Our success depends largely on our ability to protect our intellectual
property. While we attempt to protect our intellectual property through
patents, copyrights and trade secrets in the United States and other countries,
there can be no assurance that we will successfully protect our technology or
that competitors will not be able to develop similar technology independently.
We cannot assure you that the claims allowed on any patents held by us will be
sufficiently broad to protect our technology against competition from third
parties with similar technologies or
29Table of Contents

products. In addition, we cannot assure you that any patents issued to us
will not be challenged, invalidated or circumvented or that the rights granted
thereunder will provide competitive advantages to us. Moreover, the laws of
some foreign countries do not protect intellectual property rights to the same
extent as the laws of the United States and we could experience various
obstacles and high costs in protecting our intellectual property rights in
foreign countries. If we are unable to obtain or maintain these protections, we
may not be able to prevent third parties from using our intellectual property.

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

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

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

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

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

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

In addition, our management team recently has experienced significant
personnel changes. Elwood H. Spedden recently became our President and Chief
Executive Officer when Vincent Sollitto resigned. Jeffrey A. Hawthorne,
previously Vice President of Development, recently became Senior Vice President
responsible for the flat panel display business replacing Bernard T. Clark who
resigned. In addition, Jon Hopper, Senior Vice President of our sales and
support organization recently resigned. If our management team experiences high
attrition or does not work effectively together, it could seriously harm our
business.

Earthquakes may damage our facilities.

Our corporate and manufacturing facilities in California are located near
major earthquake faults which have experienced earthquakes in the past. In
addition, some of our customers in Asia are located near fault lines. In the
event of a major earthquake or other disaster in or near the San Francisco Bay
Area, our facilities may sustain significant damage and our operations could be
harmed. Similarly, a major earthquake in Asia, like the one that occurred in
Taiwan in September 1999, could disrupt our operations or the operations of our
customers, which could reduce demand for our products.

Our stock price may fluctuate significantly.

The market price of our common stock could fluctuate significantly in
response to variations in quarterly
30Table of Contents

operating results and other factors, such as:



| |  |  | 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.                                  

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

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

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

We do not anticipate paying cash dividends.

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




Item 3.Quantitative and Qualitative Disclosures About Market Risk

Our market and currency risk disclosures set forth in Item 7A of our
Annual Report on Form 10-K for the year ended September 30, 2002, have not
changed significantly.




Item 4. Controls and Procedures



|(a) |  | Our chief executive officer and chief financial officer have concluded,
subject to the limitations on the effectiveness of the controls described
below, that our disclosure controls and procedures (as defined in the
Securities Exchange Act Rules 13a-14(c) and 15d-14(c)) are sufficiently
effective to ensure that the information required to be disclosed by us in
the reports we file under the Exchange Act is gathered, analyzed and
disclosed with adequate timeliness, accuracy and completeness, based on an
evaluation of such controls and procedures conducted within 90 days prior
to the date hereof.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(b) |  | There have been no significant changes in our internal controls or in
other factors that could significantly affect these controls subsequent to
the date of the evaluation referred to above, nor were there any
significant deficiencies or material weaknesses in our internal controls.
Accordingly, no corrective actions were required or undertaken.                                                                                                                                                                                                                                                             

Limitations on the Effectiveness of Controls. Our management, including
our chief executive officer and chief financial officer, does not expect that
our disclosure controls and procedures or our internal controls will prevent
all error and all fraud. A control system, no matter how well conceived and
operated, is based in part upon certain assumptions about the likelihood of
future events and can provide only reasonable, not absolute, assurance that the
objectives of the control system are met. Further, the design of a control
system must reflect the fact that there are
31Table of Contents

resource constraints, and the benefits of controls must be considered
relative to their costs. Because of the inherent limitations in all control
systems, no evaluation of controls can provide absolute assurance that all
control issues and instances of fraud, if any, within our company have been or
will be detected.

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##### Table of Contents






PART II. OTHER INFORMATION




Item 1. Legal Proceedings

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

We filed a lawsuit captioned Photon Dynamics, Inc. vs. PanelVision
Technology and Guillermo Tora-Lira, No. CO202563PJH filed on May 28, 2002, in
the U.S. District Court for the Northern District of California, County of
Santa Clara. We are alleging infringement of a U.S. Patent owned by us and
seeking full compensatory damages and an injunction against the defendants. On
July 17, 2002, the defendants answered our complaint and asserted a
counterclaim alleging damages of at least $6.0 million in compensatory damages
for loss of business. We believe that the counterclaims are without merit and
intend to vigorously contest the counterclaims. On January 23, 2003, we added
Shimadzu Corporation to the complaint. On April 23, 2003, the defendants added
additional counterclaims against us alleging violations of the antitrust laws
and requesting the damages sought to be trebled. Although we cannot predict
the outcome of this litigation, we believe that any adverse determination in
this litigation would not have a material adverse effect on our financial
condition or results of operations.




Item 2.Changes in Securities and Use of Proceeds

None.




Item3. Defaults Upon Senior Securities

None.




Item4. Submission of Matters to a Vote of Security Holders

At our Annual Meeting of Shareholders this year, which was held on
January 21, 2003, and adjourned to and continued on February 4, 2003, our
shareholders voted on the following three proposals:

Proposal to elect directors to serve for the ensuing year and until their
successors are elected. Prior to the vote, Vincent F. Sollitto, Jr. resigned
as director and declined to stand for reelection. The results of the votes for
the directors standing for election were as follows:

|                       |  |     |            |          |  |  |         | 
|---------------------- |  | --- | ---------- | -------- |  |  | ------- | 
|Director               |  | FOR |            | WITHHELD
|                       |  |     |            |         
|E. Floyd Kvamme        |  |     | 13,557,798 |          |  |  | 639,907 | 
|Nicholas E. Brathwaite |  |     | 13,939,681 |          |  |  | 258,024 | 
|Elwood H. Spedden      |  |     | 13,930,989 |          |  |  | 266,716 | 
|Michael J. Kim         |  |     | 13,930,868 |          |  |  | 266,837 | 
|Malcolm J. Thompson    |  |     | 13,858,746 |          |  |  | 338,989 | 
|Richard P. Beck        |  |     | 13,557,844 |          |  |  | 639,861 | 

33



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##### Table of Contents



Proposal to approve our 1995 Stock Option Plan, as amended, to increase
the aggregate number of shares of Common Stock authorized for issuance under
such plan by 400,000 shares from 2,590,943 shares to 2,990,943 shares.

|         |  |  |           | 
|-------- |  |  | --------- | 
|FOR      |  |  | 8,496,261 | 
|AGAINST  |  |  | 5,688,926 | 
|ABSTAIN  |  |  | 12,518    | 
|NON-VOTE |  |  | 0         | 

Proposal to approve our 1995 Employee Stock Purchase Plan, as amended, to
increase the aggregate number of shares of Common Stock authorized for issuance
under such plan by 250,000 shares from 1,000,000 shares to 1,250,000 shares.

|         |  |  |            | 
|-------- |  |  | ---------- | 
|FOR      |  |  | 12,167,934 | 
|AGAINST  |  |  | 2,023,462  | 
|ABSTAIN  |  |  | 6,309      | 
|NON-VOTE |  |  | 0          | 




Item5. Other Information

In January 2003, Elwood (Woody) H. Spedden, a member of our Board of
Directors, became our President and Chief Executive Officer, replacing Vincent
S. Sollitto in this capacity. Mr. Sollitto also resigned as a member of our
Board of Directors. Jon Hopper, our Senior Vice President of sales and support
since July 2001, also resigned accepting a Chief Executive Officer position at
another company. In addition, Bernard Clark, our Vice President and President
of the Flat Panel Display Division since February 2001 resigned. Jeffrey A.
Hawthorne was named as our new Senior Vice President to manage the Flat Panel
Display business in February 2003. Mr. Hawthorne has held various management
positions with us since 1991.




Item6. Exhibits and Reports on Form 8-K

(a)  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                                                                
|          |  |                                                                                                                
|3.4(3)    |  | Certificate of Determination of Series A1 Preferred Stock of the Registrant                                    
|          |  |                                                                                                                
|4.1       |  | Reference is made to Exhibits 3.1, 3.2 and 3.3                                                                 
|          |  |                                                                                                                
|10.20 (4) |  | 1995 Employee Stock Purchase Plan, as amended                                                                  
|          |  |                                                                                                                
|10.21 (4) |  | Amended and Restated 1995 Stock Option Plan                                                                    
|          |  |                                                                                                                
|10.22     |  | 2001 Equity Incentive Plan, as amended                                                                         
|          |  |                                                                                                                
|10.26     |  | Separation and Consulting Agreement, dated January 28, 2003, between
Vincent Sollitto and Photon Dynamics, Inc.
|          |  |                                                                                                                
|10.27     |  | Separation Agreement, dated February 4, 2003, between Bernard Clark and
Photon Dynamics, Inc.                  
|          |  |                                                                                                                
|10.28     |  | Offer Letter, dated February 4, 2003, between Elwood Spedden and Photon
Dynamics, Inc.                         

34



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##### Table of Contents



|       |  |                                                                      |  |  |  | 
|------ |  | -------------------------------------------------------------------- |  |  |  | 
|Number |  | Exhibit                                                              |  |  |  | 
|       |  |                                                                      |  |  |  | 
|99.1   |  | Certification of Chief Executive Officer and Chief Financial Officer

Key to Exhibits:



| | (1) |  | Previously filed as an exhibit to the Registrants Registration
Statement on Form S-1 (Commission File No. 333-76650) as filed with the
SEC on January 14, 2002, as amended, and incorporated herein by
reference.
| | --- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | (2) |  | Previously filed as an exhibit to the Registrants Annual Report on
Form 10-KSB for the fiscal year ended September 30, 1998 as filed with
the SEC on December 18, 1998, and incorporated herein by reference.    
|
| | (3) |  | Previously filed as an exhibit to the Registrants Current Report on
Form 8-K as filed with the SEC on December 29, 2000, and incorporated
herein by reference.                                                   
|
| | (4) |  | Previously filed as an exhibit to the Registrants Registration
Statement on Form S-8 (Reg. No. 333-104809) as filed with the SEC on
April 29, 2003, and incorporated herein by reference.                        
|
| | (b) |  | Reports on Form 8-K                                                                                                                                                                                               
|
| |     |  | None.                                                                                                                                                                                                             

35



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##### Table of Contents






SIGNATURES

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

| |  |                       |                                                                                                                        | 
| |  | --------------------- | ---------------------------------------------------------------------------------------------------------------------- | 
| |  | PHOTON DYNAMICS, INC.
| |  |                       |                                                                                                                        | 
| |  | By:
By:
Chief
(Duly   | /s/ RICHARD L. DISSLY

Richard L. Dissly
 Financial Officer and Secretary
 authorized and principal financial officer)

Dated: May 9, 2003

36



---



##### Table of Contents






CERTIFICATIONS



|   |  | I, Elwood H. Spedden, certify that:                                                                                                                                                                                                                                                                                           
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  
|1. |  | I have reviewed this quarterly report on Form 10-Q of Photon Dynamics,
Inc.;                                                                                                                                                                                                                                                  
|  
|2. |  | Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
|  
|3. |  | Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;                   
|  
|4. |  | The registrants other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we
have:                                                                                                      



| | a) |  | designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) |  | evaluated the effectiveness of the registrants disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the Evaluation Date); and                                                                                                  
|
| | c) |  | presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;                                                                                                                        



|5. |  | The registrants other certifying officer and I have disclosed, based on
our most recent evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons performing the
equivalent function):
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrants ability to
record, process, summarize and report financial data and have identified
for the registrants auditors any material weaknesses in internal
controls; and
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) |  | any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrants internal
controls; and                                                                                                                                        



|6. |  | The registrants other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |                                                        
| | -------------------------------------------------------
| | /S/ ELWOOD H. SPEDDEN                                  
| |                                                        
| | Elwood H. Spedden
President and Chief Executive Officer

Date: May 9, 2003

37



---



##### Table of Contents





|   |  | I, Richard L. Dissly, certify that:                                                                                                                                                                                                                                                                                           
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  
|1. |  | I have reviewed this quarterly report on Form 10-Q of Photon Dynamics,
Inc.;                                                                                                                                                                                                                                                  
|  
|2. |  | Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
|  
|3. |  | Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;                   
|  
|4. |  | The registrants other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we
have:                                                                                                      



| | a) |  | designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) |  | evaluated the effectiveness of the registrants disclosure controls
and procedures as of a date within 90 days prior to the filing date of
this quarterly report (the Evaluation Date); and                                                                                                  
|
| | c) |  | presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;                                                                                                                        



|5. |  | The registrants other certifying officer and I have disclosed, based on
our most recent evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons performing the
equivalent function):
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrants ability to
record, process, summarize and report financial data and have identified
for the registrants auditors any material weaknesses in internal
controls; and
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) |  | any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrants internal
controls; and                                                                                                                                        



|6. |  | The registrants other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |                                                        
| | -------------------------------------------------------
| | /s/ RICHARD L. DISSLY                                  
| |                                                        
| | Richard L. Dissly
Secretary and Chief Financial Officer

Date: May 9, 2003

38



---



##### Table of Contents



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                                                                
|         |  |                                                                                                                
|3.4 (3)  |  | Certificate of Determination of Series A1 Preferred Stock of the Registrant                                    
|         |  |                                                                                                                
|4.1      |  | Reference is made to Exhibits 3.1, 3.2 and 3.3                                                                 
|         |  |                                                                                                                
|10.20(4) |  | Amended and Restated 1995 Stock Option Plan.                                                                   
|         |  |                                                                                                                
|10.21(4) |  | 1995 Employee Stock Purchase Plan, as amended                                                                  
|         |  |                                                                                                                
|10.22    |  | 2001 Equity Incentive Plan, as amended                                                                         
|         |  |                                                                                                                
|10.26    |  | Separation and Consulting Agreement, dated January 28, 2003, between
Vincent Sollitto and Photon Dynamics, Inc.
|         |  |                                                                                                                
|10.27    |  | Separation Agreement, dated February 4, 2003, between Bernard Clark and
Photon Dynamics, Inc.                  
|         |  |                                                                                                                
|10.28    |  | Offer Letter, dated February 4, 2003, between Elwood Spedden and Photon
Dynamics, Inc.                         
|         |  |                                                                                                                
|99.1     |  | Certification of Chief Executive Officer and Chief Financial Officer                                           

Key to Exhibits:

(1)  Previously filed as an exhibit to the Registrants Registration Statement
on Form S-1 (Commission File No. 33-76650) as filed with the SEC on January 14,
2002, as amended, and incorporated herein by reference.

(2)  Previously filed as an exhibit to the Registrants Annual Report on Form
10-KSB for the fiscal year ended September 30, 1998 as filed with the SEC on
December 18, 1998, and incorporated herein by reference.

(3)  Previously filed as an exhibit to the Registrants Current Report on Form
8-K as filed with the SEC on December 29, 2000, and incorporated herein by
reference.

(4)  Previously filed as an exhibit to the Registrants Registration Statement
on Form S-8 (Reg. No. 333-104809) as filed with the SEC on April 29, 2003, and
incorporated herein by reference

39