<PAGE>
 
               UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                  FORM 10-QSB
                                        
   (Mark One)
   [X]  QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
        ACT OF 1934
                 For the quarterly period ended March 31, 1999

                                       OR

   [_]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
        EXCHANGE ACT OF 1934

                        Commission File Number:  0-27234

                                        
                             PHOTON DYNAMICS, INC.
             (Exact name of registrant as specified in its charter)


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


    6325 SAN IGNACIO AVENUE, SAN JOSE, CA                          95119
   (Address of principal executive offices)                     (Zip Code)

                                 (408) 226-9900
              (Registrant's telephone number, including area code)

                                      N/A
       (Former name, former address, and former fiscal year, if changed 
                              since last report.)

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

As of May 10, 1999, 7,553,515 shares of the Issuer's Common Stock, no par value,
were outstanding.

                                       1
<PAGE>
 
                               TABLE OF CONTENTS


<TABLE>
<CAPTION>
                                            Part I:  Financial Information                                 Page
                                                                                                          ------
<S>            <C>                                                                                        <C> 
Item 1.        Financial Statements (unaudited)
               Condensed Consolidated Balance Sheets - March 31, 1999 and September 30, 1998...........       3
               Condensed Consolidated Statements of Operations - three and six months ended March 31,     
                1999 and 1998..........................................................................       4
                                                                                                          
               Condensed Consolidated Statements of Cash Flows - six months ended March 31, 1999 and      
                1998...................................................................................       5
                                                                                                          
               Notes to Condensed Consolidated Financial Statements....................................       6
                                                                                                          
Item 2.        Management's Discussion and Analysis of Financial Condition and Results of Operations...       8
                                                                                                          
                                             Part II:  Other Information                                  
                                                                                                          
Item 1.        Legal Proceedings.......................................................................      12
Item 2.        Changes in Securities...................................................................      12
Item 3.        Defaults Upon Senior Securities.........................................................      12
Item 4.        Submission of Matters to a Vote of Security Holders.....................................      12
Item 5.        Other Information.......................................................................      13
Item 6.        Exhibits and Reports on Form 8-K........................................................      13
                                                                                                          
               Signatures..............................................................................      14
</TABLE>
                                        

                                       2
<PAGE>
 
                             Photon Dynamics, Inc.

                     Condensed Consolidated Balance Sheets
                                 (In thousands)
                                  (Unaudited)

<TABLE>
<CAPTION>
                                                         March 31, 1999       September 30, 1998
                                                         ---------------     -------------------
 <S>                                                     <C>                 <C> 
                               Assets                  
Current assets:                                        
 Cash and cash equivalents                                    $  5,686                $  5,562
 Accounts receivable, net                                        9,261                   6,027
 Inventories, net                                                4,876                   6,767
 Prepaid expenses and other current assets                         168                     276
                                                              --------                --------
 Total current assets                                           19,991                  18,632
                                                                                    
Property, equipment and leasehold improvements, net              1,436                   1,798
                                                                                    
Other assets                                                       715                     603
                                                              --------                --------
Total assets                                                  $ 22,142                $ 21,033
                                                              ========                ========
                                                                                    
            Liabilities and Shareholders' Equity  
Current liabilities:                                                                
 Accounts payable                                             $  1,952                $  1,486
 Accrued expenses and other liabilities                          2,939                   2,936
 Customer deposits and deferred revenue                            211                     116
 Current obligations under lines of credit                       1,500                       -
 Current portion of long-term debt                                   4                       4
                                                              --------                --------
Total current liabilities                                        6,606                   4,542
                                                                                    
Noncurrent portion of long-term debt                                 -                       2
                                                                                    
Shareholders' equity:                                                               
 Common stock                                                   39,274                  38,918
 Accumulated deficit                                           (23,619)                (22,147)
 Foreign currency translation adjustment and other                 (39)                   (197)
 Notes receivable from shareholders                                (80)                    (85)
                                                              --------                --------
 Total shareholders' equity                                     15,536                  16,489
                                                              --------                --------
 Total liabilities and shareholders' equity                   $ 22,142                $ 21,033
                                                              ========                ========
</TABLE>

See accompanying notes to condensed consolidated financial statements.

Note: The balance sheet at September 30, 1998 has been derived from the audited
consolidated financial statements at that date but does not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements.

                                       3
<PAGE>
 
                             Photon Dynamics, Inc.

                Condensed Consolidated Statements of Operations
                    (In thousands, except per share amounts)
                                  (Unaudited)

<TABLE>
<CAPTION>
                                                Three Months Ended                       Six Months Ended 
                                                     March 31,                               March 31,
                                            ---------------------------            --------------------------
                                               1999             1998                 1999             1998
                                            ----------        ---------            ---------       ---------- 
<S>                                         <C>               <C>                 <C>              <C>
Revenue:
 Product revenue                               $ 6,727        $  7,362            $ 10,808          $ 12,737
 Non-product revenue                               500               -                 500                 -
                                               -------        --------            --------          --------
                                                 7,227           7,362              11,308            12,737
                                                                                                   
Cost of revenue:                                                                                   
 Product revenue                                 4,244           4,313               7,064             7,042
 Non-product revenue                                 -               -                   -                 -
                                               -------        --------            --------          --------
                                                 4,244           4,313               7,064             7,042
                                               -------        --------            --------          --------
Gross margin                                     2,983           3,049               4,244             5,695
                                                                                                   
Operating expenses:                                                                                
 Research and development                        1,192           1,479               2,317             3,352
 Selling, general and administrative             1,747           1,372               3,417             2,493
 Asset recovery related to product line       
  disposal                                           -               -                   -              (350)
                                               -------        --------            --------          --------
Total operating expenses                         2,939           2,851               5,734             5,495
                                               -------        --------            --------          --------
Operating income (loss)                             44             198              (1,490)              200
                                                                                                   
Interest income                                     51              69                 123               138
Interest expense and other                         (12)            (25)               (103)              (49)
                                               -------        --------            --------          --------
Income (loss) before provision for income taxes     83             242              (1,470)              289
                                                                                                   
Provision for income taxes                           -              21                   2                21
                                               -------        --------            --------          --------
                                                                                                   
Net income (loss)                              $    83        $    221            $ (1,472)         $    268
                                               =======        ========            ========          ========
                                                                                                   
Basic net income (loss) per share              $  0.01        $   0.03            $  (0.20)         $   0.04
                                               =======        ========            ========          ========
Diluted net income (loss) per share            $  0.01        $   0.03            $  (0.20)         $   0.04
                                               =======        ========            ========          ========
Shares used in computing basic                                                                     
net income (loss) per share                      7,488           7,220               7,425             7,186
                                               =======        ========            ========          ========
Shares used in computing diluted                                                                  
net income (loss) per share                      7,856           7,461               7,425             7,477
                                               =======        ========            ========          ========
</TABLE>


See accompanying notes to condensed consolidated financial statements.

                                       4
<PAGE>
 
                             Photon Dynamics, Inc.

                Condensed Consolidated Statements of Cash Flows
                                 (In thousands)
                                  (Unaudited)

<TABLE>
<CAPTION>
                                                                            Six Months Ended March 31,
                                                                           1999                   1998
                                                                        ----------            -----------
 
<S>                                                                     <C>                   <C> 
OPERATING ACTIVITIES:
Net income (loss)                                                        $(1,472)             $   268
Adjustments to reconcile net income (loss) to net cash provided by                            
 (used in) operating activities:                                                              
 Depreciation and amortization                                               509                  567
 Changes in operating assets and liabilities:                                                 
   Accounts receivable                                                    (3,234)                 750
   Inventories                                                             1,891                 (565)
   Prepaid expenses and other current assets                                 108                  309
   Other assets                                                             (112)                 267
   Accounts payable                                                          466               (1,075)
   Accrued expenses and other liabilities                                      3                 (241)
   Customer deposits and deferred revenue                                     94                  144
                                                                         -------              -------
Net cash provided by (used in) operating activities                       (1,747)                 424
                                                                                              
INVESTING ACTIVITIES:                                                                         
Acquisition of property and equipment                                       (147)                (236)
                                                                        --------              -------
Net cash used in investing activities                                       (147)                (236)
                                                                                              
FINANCING ACTIVITIES:                                                                         
Proceeds from borrowings under lines of credit                             1,500                  350
Principal payments under capital leases                                       (2)                  (2)
Proceeds from issuance of common stock                                       356                  140
Issuance of notes receivable to employees                                     (7)                   -
Repayment of notes receivable from shareholders                               13                   11
                                                                        --------              -------
Net cash provided by financing activities                                  1,860                  499
                                                                        --------              -------
Effect of exchange rate changes                                              158                 (200)
                                                                        --------              -------
Net increase in cash and cash equivalents                                    124                  487
Cash and cash equivalents at beginning of period                           5,562                4,831
                                                                        --------              -------
Cash and cash equivalents at end of period                              $  5,686              $ 5,318
                                                                        ========              =======
</TABLE>

See accompanying notes to condensed consolidated financial statements.

                                       5
<PAGE>
 
                              PHOTON DYNAMICS, INC
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (Unaudited)

1.   SIGNIFICANT ACCOUNTING POLICIES

     Interim Financial Statements

     The accompanying unaudited financial statements have been prepared in
accordance with generally accepted accounting principles for interim financial
information and with the instructions to Form 10-QSB.  Accordingly, they do not
include all of the information and footnotes required by generally accepted
accounting principles for complete financial statements.  In the opinion of
management, all adjustments (consisting of normal recurring accruals) considered
necessary for a fair presentation have been included.  Operating results for the
six months ended March 31, 1999 are not necessarily indicative of the results
that may be expected for the fiscal year ending September 30, 1999.  For further
information, refer to the audited consolidated financial statements and
footnotes thereto included in the Company's Annual Report on Form 10-KSB for the
fiscal year ended September 30, 1998.

2.   INVENTORIES

     Inventories are stated at the lower of cost or market, with cost being
determined on a first-in, first-out basis.
<TABLE> 
<CAPTION> 
     Inventories comprise (in thousands):        March 31,       September 30,
                                                    1999             1998
                                                ------------     -------------
<S>                                             <C>              <C> 
     Raw materials                                   $1,324            $1,888
     Work-in-process                                  3,250             2,144
     Finished goods                                     302             2,735
                                                     ------            ------
                                                     $4,876            $6,767
                                                     ======            ======
</TABLE>

3.   NET INCOME (LOSS) PER SHARE

     For the three and six months ended March 31, 1999, basic and diluted net
income (loss) per share is computed using the weighted average number of shares
of common stock outstanding.  Shares issuable from stock options and warrants
are excluded from the diluted net income (loss) per share computation for the
six months ended March 31, 1999 as their effect is antidilutive.  As the Company
incurred a loss for the six month period ended March 31, 1999, the effect of
dilutive securities totaling approximately 296,131 has been excluded from the
computation as they are antidilutive.  The following table sets forth the
computation of basic and diluted net income (loss) per share:

<TABLE>
<CAPTION>
(In thousands, except per share amounts)                  THREE MONTHS ENDED MARCH 31,      SIX MONTHS ENDED MARCH 31,
                                                       --------------------------------   -----------------------------
                                                             1999             1998              1999            1998
                                                       ----------------------------------------------------------------
<S>                                                       <C>              <C>              <C>               <C>
Numerator for basic and diluted
net income (loss) per share                                    $   83           $  221          $(1,472)         $  268
 
Denominator for basic net income (loss) per share               7,488            7,220            7,425           7,186
Effect of dilutive securities:
 Employee stock options                                           276              138                -             183
 Warrants                                                          92              103                -             108
                                                               ------          -------         --------         -------
Denominator for diluted net income (loss) per share             7,856            7,461            7,425           7,477
 
Basic net income (loss) per share                              $ 0.01           $ 0.03          $(0.20)          $ 0.04
Diluted net income (loss) per share                            $ 0.01           $ 0.03          $(0.20)          $ 0.04
</TABLE>

                                       6
<PAGE>
 
4.   COMPREHENSIVE INCOME

     Effective October 1, 1998, the Company adopted Statement of Financial
Accounting Standard No. 130, Reporting Comprehensive Income ("SFAS 130").  SFAS
130 establishes new rules for the reporting and display of comprehensive income
and its components.  Comprehensive income generally represents all changes in
shareholders' equity except those resulting from investments or contributions by
shareholders.  The Company has reclassified earlier financial statements for
comparative purposes.  The Company's total comprehensive income was as follows:


<TABLE>
<CAPTION>
                                                          THREE MONTHS ENDED MARCH 31,      SIX MONTHS ENDED MARCH 31,
                                                         -----------------------------      --------------------------
(In thousands)                                              1999               1998            1999            1998
                                                         ------------       ----------      ----------      ---------
<S>                                                       <C>               <C>              <C>                <C>
Net income (loss)                                           $  83             $ 221           $(1,472)         $ 268
                                                         
Foreign currency translation income (loss)                    (18)               26               158           (200)
                                                            -----             -----           -------          -----
Total comprehensive income (loss)                           $  65             $ 247           $(1,314)         $  68
                                                            =====             =====           =======          =====
</TABLE>

5.   NEW ACCOUNTING PRONOUNCEMENT

     In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard No. 133, Accounting for Derivative Instruments and
Hedging Activities ("SFAS 133").  SFAS 133 requires all derivatives to be
recorded on the balance sheet at fair value and establishes special accounting
rules for different types of hedges.  Adoption of this statement is required in
the year ending September 30, 2001 and is not expected to have a material impact
on the Company's results of operations or financial condition.

                                       7
<PAGE>
 
                             PHOTON DYNAMICS, INC

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS

    The statements contained in this report on Form 10-QSB that are not purely
historical are 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, including statements regarding the Company's expectations, hopes,
intentions or strategies regarding the future.  All forward looking statements
included in this document are based on information available to the Company on
the date hereof, and the Company assumes no obligation to update any such
forward looking statements.  It is important to note that the Company's actual
results could differ materially from those in such forward looking statements.
You should consult the risk factors listed from time to time in the Company's
reports on Form 10-KSB and annual reports to shareholders.  Among the factors
that could cause actual results to differ materially are those discussed under
"Other Factors Affecting Company Results" and elsewhere in this Form 10-QSB.

    The following discussion should be read in conjunction with the attached
condensed consolidated financial statements and notes thereto and with the
Company's audited financial statements and notes thereto for the year ended
September 30, 1998.

RESULTS OF OPERATIONS

    Revenue.  Revenue for the second quarter of fiscal 1999 decreased 2% to $7.2
million from $7.4 million in the second quarter of fiscal 1998. Revenue for the
first six months of fiscal 1999 decreased 11% to $11.3 million from $12.7
million in the comparable period of fiscal 1998. Revenue for the second quarter
of fiscal 1999 increased 77% to $7.2 million from $4.1 million in the first
quarter of fiscal 1999. This increase in revenue from the first quarter of
fiscal 1999 was due to a significant increase in customer orders from Korea and
Taiwan. As of March 31, 1999, backlog was approximately $16.2 million compared
to $8.4 million at March 31, 1998.

    Non-product revenue in the current quarter consisted of a non-recurring
$500,000 fee paid by a Japanese company for development work transferred to it
by the Company.

    Gross Margin.  Gross margin as a percent of revenue was 41% and 38% for the
three and six month periods ended March 31, 1999, respectively, compared to 41%
and 45% for the three and six month periods ended March 31, 1998, respectively.
For the second quarter of fiscal 1999, the non-product development agreement
with a Japanese company increased gross margin from 37% to 41%.  The decrease in
gross margin for the first six months of fiscal 1999 from the comparable period
of fiscal 1998 was due to the Company's efforts to expand its customer base
through the shipment of several system upgrade orders in the second quarter of
fiscal 1999.  Such system upgrade orders have gross margins lower than typical
system shipments.  Overall gross margins will fluctuate on a quarterly basis due
to the Company's production volume and product mix, among other factors.

    Research and Development.  Research and development spending decreased to
$1.2 million in the second quarter of fiscal 1999, or 16% of revenue, from $1.5
million in the second quarter of fiscal 1998, or 20% of revenue. Research and
development expenses for the first six months of fiscal 1999 were $2.3 million,
or 20% of revenue, compared to $3.4 million, or 26% of revenue, in the
comparable period in 1998. The decrease in research and development spending was
primarily in the areas of outside consultants and prototype materials. In the
first six months of fiscal 1998, the Company was working on a number of product
enhancements that it believed would improve its ability to sell to volume
production environments. Because this work is now complete, the Company has
reduced its spending on outside consultants and prototype materials during the
first six months of fiscal 1999. The Company does not expect to materially
increase the level of research and development spending from its current level
through the remainder of fiscal 1999.

    Selling, General and Administrative.  Selling, general and administrative
expenses in the second quarter of fiscal 1999 increased to $1.7 million, or 24%
of revenue, from $1.4 million, or 19% of revenue, in the second quarter of
fiscal 1998.  Selling, general and administrative expenses for the first six
months of fiscal 1999 were $3.4 million, or 30% of revenue, an increase from
$2.5 million, or 20% of revenue, in the comparable period of fiscal 1998.  In
the first six months of fiscal 1998, the Company collected some older extended
receivables that had previously been reserved.  Without this cash 

                                       8
<PAGE>
 
collection, total selling, general and administrative costs for the first six
months of fiscal 1998 would have been $2.7 million. The increase in these
expenses for the three and six month periods ended March 31, 1999 is due to
higher commission expense related to large order volume and expenses related to
financing activities. Selling, general and administrative expenses may increase
in absolute dollar amounts in fiscal 1999 and in future periods depending on
factors such as the level of the Company's revenue and other operations. Selling
expenses may also fluctuate based on the Company's product and territory sales
mix, which have different sales channels and associated cost structures.

    Asset Recovery Related to Product Line Disposal.  During the quarter ended
December 31, 1997, the Company received a payment of $350,000 in settlement of a
dispute related to the cancellation of its Defect Monitoring Tool (DMT) product
line.  In September 1996, the Company ceased operations of its DMT product line.
The DMT product group worked exclusively on a single customer project not in the
Flat Panel Display (FPD) market.  As a result of the cancellation of this
project, the Company expensed the associated inventory and assets of this
product line which were not transferred to other products.

    Interest Income.  Interest income for the three and six month periods ended
March 31, 1999 were $51,000 and $123,000, respectively, as compared to $69,000
and $138,000, respectively, for the three and six month periods ended March 31,
1998.  The decreases were the result of a slight decrease in interest rates over
fiscal 1999 as compared to the respective periods of fiscal 1998.

    Interest Expense and Other.  Interest expense and other consists of interest
expense, foreign exchange gains and losses, and other miscellaneous income and
expense.

    Provision for Income Tax.  The provision for income taxes for the six months
ended March 31, 1999 was related to taxes by the Company's foreign subsidiary in
Korea.  There were no U.S. taxes as a result of the Company's net operating loss
for the six months ended March 31, 1999.

LIQUIDITY AND CAPITAL RESOURCES

    The Company has financed its growth primarily from a combination of amounts
raised in equity financings, loans, lines of credit, and cash flows from
operations.  As of March 31, 1999, the Company had working capital of $13.4
million of which $5.7 million was cash or cash equivalents.

    Cash used in operating activities was $1.7 million for the six months ended
March 31, 1999.  Working capital items that significantly impacted cash balances
in the period were accounts receivable, inventories and accounts payable.  The
Company's accounts receivable balance increased $3.3 million to $9.3 million in
the second quarter of fiscal 1999 from $6.0 million in the fourth quarter of
fiscal 1998 due to higher shipments.  This higher level of shipments resulted in
a $1.9 million decrease in inventories from $6.8 million in the fourth quarter
of fiscal 1998 to $4.9 million in the second quarter of fiscal 1999.  Accounts
payable increased $0.5 million from $1.5 million in the fourth quarter of fiscal
1998 to $2.0 million in the second quarter of fiscal 1999 due to the additional
incoming material required to meet the increased production requirements.

    Capital expenditures during the first six months of fiscal 1999 were
$147,000 compared to $236,000 in the first six months of fiscal 1998.

    The Company has also entered into a $3.5 million line of credit with a bank
which expires in March 2000.  The line of credit is secured by substantially all
of the Company's assets and contains certain financial and other covenants.  The
Company is eligible to borrow against accounts receivable and a portion of
inventories.  Borrowings under this line of credit bear interest at the prime
rate plus 1.00% to 1.25% (8.75% to 9.00% as of March 31, 1999).  At March 31,
1999, $1.5 million was outstanding under this bank line of credit, and the
Company was in compliance with all bank covenants.

    The Company believes that cash and cash equivalents, borrowings from the
line of credit, and cash flow from operations will be sufficient to satisfy
working capital requirements and capital equipment needs for the next twelve
months. As of March 31, 1999, the Company had no material outstanding
commitments to purchase or lease capital equipment.

                                       9
<PAGE>
 
    The Company believes that success in its industry requires substantial
capital in order to maintain the flexibility to take advantage of opportunities
as they may arise. The Company 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 the Company on commercially reasonable terms.
The sale of additional equity or convertible debt could result in additional
dilution to the Company's shareholders.

YEAR 2000 COMPUTER SYSTEM COMPLIANCE

    The Year 2000 Issue is the result of computer programs being written using
two digits rather than four to define the applicable year. Any of the Company's
computer programs that have date-sensitive software may recognize a date using
"00" as the year 1900 rather than the year 2000. This could result in a system
failure or miscalculations causing the disruption of operations, including among
other things, a temporary inability to process transactions, send invoices or
engage in similar normal business activities. In addition to the Company's own
systems, the Company relies, directly and indirectly, on external systems of its
customers, creditors, financial organizations, utility providers, and government
entities, both domestic and international (collectively, "Third Parties").
Consequently, the Company could be affected by disruptions in the operations of
Third Parties with which the Company interacts.

    The Company is in the process of addressing internal and external Year 2000
issues and has established a task force with this responsibility.  To date, the
Company has made several modifications to its product software, its enterprise
software and its network software to ensure Year 2000 compliance.  Although the
Company believes that its products and internal systems are currently Year 2000
compliant, there can be no assurance that the Third Parties with which the
Company interacts are or will be Year 2000 compliant.  Failure of Third Party
enterprises to achieve Year 2000 compliance could have a material adverse effect
on the Company's business, financial condition and results of operations.  The
Company continues to evaluate the estimated costs associated with the efforts to
prepare for the year 2000 based on actual experience.  While the efforts will
involve additional costs, the Company believes, based on available information,
that it will be able to manage its total Year 2000 transition without any
material adverse effect on its business operations, products or financial
prospects.  The actual outcome and result could be affected by future factors
including, but not limited to, the continued availability of skilled personnel,
cost control, the ability to locate and correct software code problems, critical
suppliers and subcontractors meeting their commitments to be Year 2000
compliant, and timely actions by customers.  The Company anticipates that it
will remediate all Year 2000 risks and be able to conduct normal operations
without having to establish a Year 2000 contingency plan; accordingly, the
Company does not have a contingency plan and does not intend to establish one.
There is no guarantee, however, that all problems will be foreseen and corrected
or that no material disruption of business will occur.

OTHER FACTORS AFFECTING COMPANY RESULTS

    The Company has experienced and expects to continue to experience
significant fluctuations in its quarterly results of operations. The Company
derives substantially all of its revenue from the sale of a relatively small
number of systems, which typically range in price from $0.4 million to $1.5
million. As a result, the timing of the sale of a single system could have a
significant impact on the Company's quarterly revenue and results of operations.
The failure to receive anticipated orders or delays in shipments in a particular
quarter due, for example, to unanticipated shipment reschedulings, cancellations
by customers or unexpected manufacturing difficulties may cause revenue for that
quarter to fall significantly below the Company's expectations. This would have
a material adverse effect on the Company's results of operations for such a
quarter. The Company's backlog at the beginning of each quarter is not
necessarily indicative of actual sales for any succeeding period. All orders are
subject to delay or cancellation with limited or no penalty. The Company's sales
will often reflect orders shipped in the same quarter that they are received.
Other factors which may have an influence on the Company's results of operations
in a particular quarter include the volume, mix and timing of the receipt of
orders from major customers; competitive pricing pressures; costs of components
and subsystems; the Company's ability to design, manufacture and introduce new
products on a cost effective and timely basis; the delay between incurrence of
expenses to further develop marketing and service capabilities and realization
of benefits from such improved capabilities; fluctuations in foreign exchange
rates; the timing of recognition of revenue under development contracts; the
introduction and announcement of new products by the Company's competitors; and
changing conditions in the FPD market. In particular, due to substantial
differences in gross margin for the Company's products, changes in the mix of
products sold could result in substantial fluctuations in the Company's gross
margin. Accordingly, the Company's 

                                       10
<PAGE>
 
results of operations are subject to significant variability from quarter to
quarter. For a further discussion of the Company's business and certain risk
factors pertaining to its business, please refer to the Company's 1998 Annual
Report on Form 10-KSB.

                                       11
<PAGE>
 
                          PART II: OTHER INFORMATION
                                        

ITEM 1.  LEGAL PROCEEDINGS
--------------------------

         None.

ITEM 2.  CHANGES IN SECURITIES
------------------------------

         None.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES
----------------------------------------

         None.

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
------------------------------------------------------------

The Company held its Annual Meeting of Shareholders on January 26, 1999.
Matters voted upon at the meeting included:

         1) Election of Directors (listed below)

         The following directors were elected to hold office until the next
         Annual Meeting of Shareholders of the Company:

         Director                        For              Withheld
         --------                     ---------           --------
                                                        
         Floyd Kvamme............     4,567,701            541,792
         Vincent Sollitto........     4,568,201            541,292
         Francois Henley.........     4,567,701            541,792
         Barry Cox...............     4,567,701            541,792
         Michael Kim.............     4,547,653            561,840
         Malcolm Thompson........     4,568,201            541,292


         2) Approval of an increase in shares reserved for issuance under the
            1995 Stock Option Plan by 230,000 from 1,110,943 shares to
            1,340,943.

         For.....................     3,221,935
         Against.................       682,057
         Abstained...............        29,800
         No Vote.................     1,175,701
          

                                       12
<PAGE>
 
         3) Approval of an increase in shares reserved for issuance under the
            1995 Employee Stock Purchase Plan by 150,000 from 200,000 shares to
            350,000.

         For.....................     3,518,418
         Against.................       108,020
         Abstained...............       307,354
         No Vote.................     1,175,701
          
          
         4) Ratification of the selection of Ernst & Young LLP as the
            independent auditors for the Company for the fiscal year ending
            September 30, 1999.

         For.....................     5,059,103
         Against.................        29,140
         Abstained...............        21,250
         No Vote.................             0
          
          
          
ITEM 5.  OTHER INFORMATION
--------------------------

         None.

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K
-----------------------------------------

    (a)  EXHIBITS
 
         27  Financial Data Schedule

    (b)  REPORTS ON FORM 8-K

         None.

                                       13
<PAGE>
 
                                  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.
                                        (Registrant)
 
 


Date: May 12, 1999                  /s/ VINCENT SOLLITTO
                                    ----------------------------------- 
                                    Vincent Sollitto
                                    Chief Executive Officer and Director
                                    (Principal Executive Officer)
 

 
  
Date: May 12, 1999                  /s/ RICHARD DISSLY
                                    -----------------------------------
                                    Richard Dissly
                                    Chief Financial Officer and Secretary
                                    (Principal Financial and Accounting Officer)

                                       14