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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q (Mark One)  þ
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934 For the quarterly period ended December 31, 2004 OR  o
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934 For the transition period from______ to______ Commission file number: 0-27234 PHOTON DYNAMICS, INC. (Exact name of registrant as specified in its charter)
 California
(State or other jurisdiction of
incorporation or organization)
    
    94-3007502
(I.R.S. Employer Identification No.)
 5970 Optical Court
San Jose, California 95138-1400
(Address of principal executive offices including zip code) (408) 226-9900
(Registrants telephone number, including area code) 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 þ No o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act). Yes þ No o As of January 31, 2005, there were 16,914,002 shares outstanding of the Registrants Common
Stock, no par value.




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INDEX  
 PagePART
I FINANCIAL INFORMATIONItem 1. Financial Statements (unaudited)Condensed Consolidated Balance Sheets as of December 31, 2004 and September 30, 2004
    
    
    1Condensed Consolidated Statements of Operations for the Three Months Ended December 31, 2004 and 2003
    
    
    2Condensed Consolidated Statements of Cash Flows for the Three Months Ended December 31, 2004 and 2003
    
    
    3Notes to Condensed Consolidated Financial Statements
    
    
    4Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    17Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    34Item 4. Controls and Procedures
    
    
    34PART
II OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    36Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    36Item 3. Defaults Upon Senior Securities
    
    
    36Item 4. Submission of Matters to a Vote of Security Holders
    
    
    36Item 5. Other Information
    
    
    36Item 6. Exhibits
    
    
    37Signatures
    
    
    38EXHIBIT 10.41EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1




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PART I. FINANCIAL INFORMATION 
 ITEM 1.Financial Statements PHOTON DYNAMICS, INC. 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
 December 31,
    
    
    September 30,2004
    
    
    2004(in thousands)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    34,487
    
    
    $
    25,483Short-term investments
    
    
    64,932
    
    
    
    58,672Accounts receivable, net
    
    
    35,826
    
    
    
    58,341Inventories
    
    
    33,708
    
    
    
    31,716Other current assets
    
    
    4,337
    
    
    
    4,536Total current assets
    
    
    173,290
    
    
    
    178,748Land, property and equipment, net
    
    
    20,235
    
    
    
    20,337Other assets
    
    
    4,510
    
    
    
    3,909Intangible assets, net
    
    
    4,356
    
    
    
    4,753Goodwill
    
    
    153
    
    
    
    153Total assets
    
    $
    202,544
    
    
    $
    207,900LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    11,959
    
    
    $
    18,485Warranty
    
    
    6,231
    
    
    
    6,194Other current liabilities
    
    
    10,895
    
    
    
    10,260Deferred gross margin
    
    
    9,878
    
    
    
    10,104Total current liabilities
    
    
    38,963
    
    
    
    45,043Other liabilities
    
    
    1,512
    
    
    
    1,528Commitments and contingenciesShareholders equity:Common stock, no par value
    
    
    286,324
    
    
    
    285,790Accumulated deficit
    
    
    (124,574
    )
    
    
    (124,808
    )Accumulated other comprehensive income
    
    
    319
    
    
    
    347Total shareholders equity
    
    
    162,069
    
    
    
    161,329Total liabilities and shareholders equity
    
    $
    202,544
    
    
    $
    207,900
 See accompanying notes to condensed consolidated financial statements. 1




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PHOTON DYNAMICS, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
 Three Months EndedDecember 31,2004
    
    
    2003(in thousands, exceptper share data)Net revenue
    
    $
    36,356
    
    
    $
    24,499Cost of revenue
    
    
    22,781
    
    
    
    13,412Gross margin
    
    
    13,575
    
    
    
    11,087Operating expenses:Research and development
    
    
    9,470
    
    
    
    5,810Selling, general and administrative
    
    
    4,684
    
    
    
    4,598Amortization of intangible assets
    
    
    397
    
    
    
    201Goodwill impairment charge
    
    
    
    
    
    
    665Impairment of purchased intangibles
    
    
    
    
    
    
    2,089Impairment of fixed assets
    
    
    
    
    
    
    234Total operating expenses
    
    
    14,551
    
    
    
    13,597Loss from operations
    
    
    (976
    )
    
    
    (2,510
    )Interest income and other, net
    
    
    1,255
    
    
    
    3,781Income from continuing operations before income taxes and discontinued operations
    
    
    279
    
    
    
    1,271Provision for income taxes
    
    
    39
    
    
    
    362Income from continuing operations before discontinued operations
    
    
    240
    
    
    
    909Income (loss) from discontinued operations
    
    
    (6
    )
    
    
    47Net income
    
    $
    234
    
    
    $
    956Income per share from continuing operations:Basic
    
    $
    0.01
    
    
    $
    0.06Diluted
    
    $
    0.01
    
    
    $
    0.05Income (loss) per share from discontinued operations:Basic
    
    $
    0.00
    
    
    $
    0.00Diluted
    
    $
    0.00
    
    
    $
    0.00Net income per share:Basic
    
    $
    0.01
    
    
    $
    0.06Diluted
    
    $
    0.01
    
    
    $
    0.06Weighted average number of shares:Basic
    
    
    16,872
    
    
    
    16,461Diluted
    
    
    17,009
    
    
    
    17,174
 See accompanying notes to condensed consolidated financial statements. 2




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PHOTON DYNAMICS, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 Three Months EndedDecember 31,2004
    
    
    2003(in thousands)Cash flows from operating activities:Net income from continuing operations
    
    $
    240
    
    
    $
    909Adjustments to reconcile net income from continuing operations to net cash
provided by (used in) operating activities from continuing operations:Depreciation
    
    
    1,024
    
    
    
    1,020Amortization of intangible assets
    
    
    397
    
    
    
    201Impairment of goodwill
    
    
    
    
    
    
    665Impairment of purchased intangibles and fixed assets
    
    
    
    
    
    
    2,323Stock ownership expense
    
    
    35
    
    
    
    Accretion of non-interest bearing notes payable
    
    
    19
    
    
    
    Changes in assets and liabilities:Accounts receivable
    
    
    22,515
    
    
    
    (5,009
    )Inventories
    
    
    (1,990
    )
    
    
    (709
    )Other current assets
    
    
    268
    
    
    
    2,417Other assets
    
    
    (601
    )
    
    
    (407
    )Accounts payable
    
    
    (6,526
    )
    
    
    413Other current liabilities
    
    
    526
    
    
    
    (852
    )Deferred gross margin
    
    
    (226
    )
    
    
    (1,088
    )Other liabilities
    
    
    (16
    )
    
    
    (53
    )Net cash provided by (used in) operating activities from continuing operations
    
    
    15,665
    
    
    
    (170
    )Net cash provided by operating activities from discontinued operations
    
    
    50
    
    
    
    653Net cash provided by operating activities
    
    
    15,715
    
    
    
    483Cash flows from investing activities:Purchase of property and equipment
    
    
    (922
    )
    
    
    (5,402
    )Purchase of short-term investments
    
    
    (17,244
    )
    
    
    (143,149
    )Redemption of short-term investments
    
    
    10,828
    
    
    
    143,963Net cash used in investing activities from continuing operations
    
    
    (7,338
    )
    
    
    (4,588
    )Cash flows from financing activities:Issuance of common stock
    
    
    499
    
    
    
    1,360Net cash provided by financing activities from continuing operations
    
    
    499
    
    
    
    1,360Effect of exchange rate changes on cash and cash equivalents
    
    
    128
    
    
    
    (147
    )Net increase (decrease) in cash and cash equivalents from continuing operations
    
    
    8,954
    
    
    
    (3,545
    )Net increase in cash and cash equivalents from discontinued operations
    
    
    50
    
    
    
    653Net increase (decrease) in cash and cash equivalents
    
    
    9,004
    
    
    
    (2,892
    )Cash and cash equivalents at beginning of period
    
    
    25,483
    
    
    
    18,305Cash and cash equivalents at end of period
    
    $
    34,487
    
    
    $
    15,413
 See accompanying notes to condensed consolidated financial statements. 3




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PHOTON DYNAMICS, INC. 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 NOTE 1Basis of Presentation and Summary of Significant Accounting Policies Basis of Presentation.The accompanying unaudited condensed consolidated financial statements
of Photon Dynamics, Inc. (Photon Dynamics or the Company) have been prepared in accordance with
U.S. generally accepted accounting principles for interim financial information and with the
instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of
the information and footnotes required by accounting principles generally accepted in the United
States for complete financial statements. In the opinion of management, the unaudited interim
financial statements reflect all adjustments (consisting only of normal recurring adjustments)
considered necessary for a fair presentation of the financial position, results of operations and
cash flows for the periods indicated. These financial statements and notes should be read in conjunction with Item 8, Financial
Statements and Supplementary Data included in the Companys Annual Report on Form 10-K for the
fiscal year ended September 30, 2004, filed with the Securities and Exchange Commission on December
14, 2004. Operating results for the three months ended December 31, 2004, are not necessarily
indicative of the results that may be expected for any other interim period or for the full fiscal
year ending September 30, 2005. The condensed consolidated balance sheet as of September 30, 2004 is derived from the
Companys audited consolidated financial statements as of September 30, 2004, included in the
Companys Annual Report on Form 10-K for the fiscal year ended September 30, 2004 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. Certain
prior year amounts in these condensed consolidated financial statements and notes thereto have been
reclassified to conform to the current periods presentation. Description of Operations and Principles of Consolidation.Photon Dynamics is a supplier of
integrated yield management solutions for the flat panel display industry. The condensed
consolidated financial statements include the accounts of the Company and its wholly owned
subsidiaries. Intercompany accounts and transactions have been eliminated. Through January 14, 2003, the Company conducted business in three operating segments: flat
panel display products, cathode ray tube display and high quality glass inspection products and
printed circuit board assembly inspection products. In January 2003, the Company implemented a plan
to exit the printed circuit board assembly inspection business. In June 2003, the Company
implemented a plan to exit the cathode ray tube display and high quality glass inspection
businesses. Accordingly, the operating results of these former business segments have been
presented as discontinued operations in accordance with the provisions of Statement of Financial
Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-lived Assets,
(FAS 144). Accordingly, in the condensed consolidated statements of operations, the net operating
results of these former businesses have been classified as Income (loss) from discontinued
operations, for all periods presented. The cash flows from these businesses have been presented as
Net cash flows from discontinued operations in the operating, investing and financing sections of
the condensed consolidated statements of cash flows. Management Estimates.The preparation of financial statements in conformity with U.S.
generally accepted accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting periods. Actual results could
differ from those estimates. Significant estimates made by management include the allowance for
doubtful accounts, inventory write-downs, warranty accruals, impairment of goodwill, other acquired
intangible assets and long-lived assets, acquired in-process research and development and
litigation and contingency assessments. Fair Value of Financial Instruments.The Company evaluates the estimated fair value of
financial instruments using available market information and certain valuation methodologies. The
use of different market information and/or estimation techniques could have a negative effect on
the estimated fair value amounts. The fair value of the Companys cash, cash equivalents, accounts
receivable, accounts payable and other current liabilities approximates the carrying amounts due to
the relatively short maturity of these items. Inventories.Inventories, consisting of raw materials, work in process and finished goods, are
stated at the lower of cost (first-in, first-out) or market. Inventory which is obsolete (defined
as inventory that will no longer be used in the manufacturing process) or in excess of the
forecasted usage is written down to its estimated market value based on projected demand,
historical usage and other known factors. Photon Dynamics reviews the appropriate valuation of its
inventories on a quarterly basis. If actual demand were to decline below the Companys forecasts,
the Company may or would need to record additional inventory write-downs. 4




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PHOTON DYNAMICS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) Concentration of Credit and Other Risk.Financial instruments which potentially subject the
Company to concentrations of credit risk consist principally of available for sale securities,
trade accounts receivable and, for the quarter ended December 31, 2003, derivative financial
instruments used to mitigate the effect of exchange rate changes. The Company invests excess cash in securities that the Company believes bear minimal risk.
These investments are of a short-term nature and include investments in auction rate preferred
securities, commercial paper and government and corporate debt securities. The Company has not
experienced any losses due to institutional failure or bankruptcy. The Companys customers are located in Korea, Taiwan, Japan and China. Therefore, the
Companys sales to these customers may be adversely affected by the overall health of these
economies, including the effects of currency exchange rate fluctuations. The Company generally does
not require collateral for its trade accounts receivable. The Company maintains a provision for
potential credit losses based upon expected collectibility of all accounts receivable. For sales to
some of its customers in certain geographic regions, the Company requires letters of credit. The
majority of the Companys revenue is invoiced in U.S. dollars although approximately $11.5 million
of revenue that was recognized in the first quarter of fiscal 2005 was invoiced in Japanese Yen.
The Company believes its credit evaluation prior to shipment and subsequent monitoring of customer
status mitigates its credit risk. The Company is exposed to credit loss in the event of non-performance by counterparties on the
foreign exchange contracts used to mitigate the effect of exchange rate changes. These
counterparties are large international financial institutions, and to date, no such counterparty
has failed to meet its financial obligations to the Company. Photon Dynamics does not anticipate
nonperformance by these counterparties. The Company had no outstanding foreign exchange forward
contracts at December 31, 2004 or September 30, 2004. The Companys products include certain components that are currently purchased from a single
vendor. The Company believes that other vendors would be able to provide similar components;
however, the qualification of such vendors may require start-up time. In order to mitigate any
adverse impacts from a disruption of supply, the Company attempts to maintain an adequate inventory
of critical single-sourced components. Revenue Recognition.Photon Dynamics derives revenue primarily from the sale and installation
of equipment and spare part sales. The Company recognizes revenue when persuasive evidence of an
arrangement exists, delivery has occurred or services have been rendered, the selling price is
fixed or determinable and collectibility is reasonably assured. The Company accounts for certain of its product sales, including sales to a value-added
reseller, as arrangements with multiple deliverables in accordance with Emerging Issues Task Force
Issue 00-21 Revenue Arrangements with Multiple Deliverables. For arrangements with multiple
deliverables, the Company recognizes revenue for the delivered items if the delivered items have
value to the customer on a standalone basis, the amount of revenue for delivered elements is not
subject to refund, the Company has met defined customer acceptance experience levels for the
delivered items, and the fair value of undelivered items, such as installation and system upgrade
rights, can be reliably determined. The Company allocates revenue to the delivered items based on
the lesser of the amount due and billable upon shipment and the allocated fair value, with the
remaining amount recognized after installation and acceptance when the final amount becomes due.
The Company recognizes all other product sales upon customer acceptance. The Company recognizes
revenue from the sale of spare parts upon shipment. Terms and conditions of the Companys sale of products to its value-added reseller are
generally consistent with terms and conditions offered to other customers and title typically
transfers to the value-added reseller upon shipment. The Company does not grant any rights of
return, stock rotation or price protection for its product sales to its value-added reseller.
Accordingly, sales transactions with the value-added reseller, consisting of $0 and $6.0 million in
the three month period ending December 31, 2004 and 2003, respectively, are recorded in accordance
with the policy stated above. The Company records a provision based on historical rates for estimated sales returns in the
same period as the related revenue is recorded, which is netted against revenue. The Companys products are subject to warranty and such estimated costs are provided
for in costs of sales when product revenue is recognized. Installation is not essential to the
functionality of the products as this service does not alter the product capabilities, does not
require specialized skills or tools and can be performed by other vendors. Shipping Costs. The Companys shipping and handling costs are included under cost of sales for
all periods presented. In those instances where the Company charges its customers for shipping and
handling, the amounts billed are classified as revenue. Research and Development Cost.Costs to develop the Companys products, which include both
hardware and software components are expensed as incurred. Software incorporated in the Companys
products is an integral part of the overall product 5




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PHOTON DYNAMICS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) design process and costs to develop software, which is deemed to be incidental, are not
tracked separately. The Company does not sell or market any software product on a standalone basis. Interest Income. Interest income was approximately $378,000 and $474,000 for the three months
ended December 31, 2004 and 2003, respectively. Stock-Based Compensation Plans.The Company accounts for its stock-based employee compensation
plans using the intrinsic value method in accordance with the provisions of Accounting Principles
Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and related
interpretations. Pro forma information regarding net income and earnings per share is required by Statement of
Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (FAS 123) as
amended by SFAS No. 148, Accounting for Stock-based Compensation  Transition and disclosure and
has been determined as if the Company had accounted for its employee stock purchase plan and
employee stock options granted under the fair value method. The fair value of each option grant is
estimated on the date of grant using the Black-Scholes option pricing model for the multiple option
approach with the following weighted-average assumptions: Three Months EndedDecember 31,2004
    
    
    2003Stock option plan:Expected stock price volatility
    
    
    0.72
    
    
    
    0.92Risk free interest rate
    
    
    2.89
    %
    
    
    2.46
    %Expected life of options (years)
    
    
    5.5
    
    
    
    5.3Stock purchase plan:Expected stock price volatility
    
    
    0.80
    
    
    
    0.96Risk free interest rate
    
    
    1.70
    %
    
    
    2.13
    %Expected life of plan (years)
    
    
    1.6
    
    
    
    2.0
 FAS 123 requires the use of option pricing models that were not developed for use in valuing
employee stock options. The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly subjective
assumptions, including the expected stock price volatility. Because the Companys employee stock
option and employee stock purchase plans have characteristics significantly different from those of
traded options, and because changes in the subjective input assumptions can materially affect the
fair value estimate, in managements opinion, the existing models may not necessarily provide a
reliable single measure of the fair value of such Company options. For purposes of pro forma disclosures required by FAS 123, the estimated fair value of the
options is amortized to expense over the options vesting periods using the straight-line method.
The Companys pro forma information for the three months ended December 31, 2004 and 2003 is as
follows: Three Months EndedDecember 31,2004
    
    
    2003(in thousands, exceptper share data)Net income  as reported
    
    $
    234
    
    
    $
    956Less: total stock-based employee
compensation expense determined under
fair value based method for all
awards, net of tax
    
    
    (1,935
    )
    
    
    (1,936
    )Net loss
 pro forma
    
    $
    (1,701
    )
    
    $
    (980
    )Basic net income per share  as reported
    
    $
    0.01
    
    
    $
    0.06Diluted net income per share  as reported
    
    $
    0.01
    
    
    $
    0.06Basic net loss per share  pro forma
    
    $
    (0.10
    )
    
    $
    (0.06
    )Diluted net loss per share  pro forma
    
    $
    (0.10
    )
    
    $
    (0.06
    )
 Recent Accounting Pronouncements.In December 2004, the FASB issued SFAS 123 (revised 2004), Share-Based Payment. SFAS 123R
requires measurement of all employee stock-based compensation awards using a fair value method and
the recording of such expense in the consolidated financial statements. In addition, the adoption
of SFAS 123R will require additional accounting related to the income tax effects and additional
disclosure regarding the cash flow effects resulting from share-based payment arrangements. SFAS
123R is effective beginning in the fourth quarter of fiscal 2005. The Company is evaluating the
requirements of SFAS 123R and expects that the adoption of SFAS 123R will have a material impact on
the Companys results of operations and financial condition. The Company has not yet determined
whether the adoption of SFAS 123R will result in stock-based compensation charges that are similar
to the current pro forma disclosures under SFAS 123. 6




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PHOTON DYNAMICS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43,
Chapter 4. SFAS No. 151 clarifies that abnormal inventory costs such as costs of idle facilities,
excess freight and handling costs, and wasted materials (spoilage) are required to be recognized as
current period charges. The provisions of SFAS No. 151 are effective for fiscal periods beginning
after June 15, 2005. The adoption of SFAS No. 151 is not expected to have material impact on the
Companys consolidated results of operations, financial position or cash flows. In March 2004, the Emerging Issues Task Force (EITF) reached a consensus on recognition and
measurement guidance previously discussed under EITF Issue No. 03-01, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments. (EITF 03-01). The
consensus clarifies the meaning of other-than temporary impairment and its application to
investments in debt and equity securities, in particular investments within the scope of FASB
Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, and
investments accounted for under the cost method. In September 2004, the Financial Accounting
Standards Board approved the issuance of a FASB staff position to delay the requirement to record
impairment losses under EITF 03-1. The approved delay applies to all securities within the scope of
EITF 03-01 and is expected to end when new guidance is issued and comes into effect. Adoption of
this consensus is not expected to have a material impact on the Companys consolidated results of
operations, financial position or cash flows. 7




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PHOTON DYNAMICS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) NOTE 2Financial Statement Components December 31,
    
    
    September 30,2004
    
    
    2004(in thousands)Accounts receivable:Accounts receivable, gross
    
    $
    36,322
    
    
    $
    58,838Allowance for doubtful accounts
    
    
    (496
    )
    
    
    (497
    )Total
    
    $
    35,826
    
    
    $
    58,341Inventories:Raw materials
    
    $
    18,650
    
    
    $
    15,529Work-in-process
    
    
    14,354
    
    
    
    15,046Finished goods
    
    
    704
    
    
    
    1,141Total
    
    $
    33,708
    
    
    $
    31,716Other current liabilities:Compensation
    
    $
    3,958
    
    
    $
    3,984Obligation to a manufacturing subcontractor in connection
with inventory purchases
    
    
    623
    
    
    
    623Accrued closing costs associated with discontinued operations
    
    
    443
    
    
    
    449Notes Payable
    
    
    1,508
    
    
    
    1,534Other accrued expenses
    
    
    4,363
    
    
    
    3,670Total
    
    $
    10,895
    
    
    $
    10,260Accumulated other comprehensive income:Foreign currency translation adjustments
    
    $
    661
    
    
    $
    533Unrealized gains on available for sale securities
    
    
    (342
    )
    
    
    (186
    )Total
    
    $
    319
    
    
    $
    347
 NOTE 3Discontinued Operations Printed Circuit Board Assembly Inspection Business The Company formerly had a business which sold printed circuit board assembly inspection
products. In January 2003, the Company implemented a plan to exit this business. Accordingly, the
operating results of this former business segment have been reclassified as a discontinued
operation for all periods presented. As of December 31, 2004, the Company is attempting to sublease
the facilities associated with the discontinued operations, but there can be no assurances that the
Company will be successful in recovering any additional costs associated with this discontinued
operation. The following table summarizes the results of discontinuing the printed circuit board assembly
inspection products reporting segment for the three months ended December 31, 2004 and 2003: Three Months EndedDecember 31,2004
    
    
    2003(in thousands)Revenue
    
    $
    
    
    
    $
    83Cost of revenue
    
    
    
    
    
    
    9Gross margin
    
    
    
    
    
    
    74Operating expenses:Selling, general and administrative
    
    
    4
    
    
    
    62Total operating expenses
    
    
    4
    
    
    
    62Income (loss) from discontinued operations
    
    $
    (4
    )
    
    $
    12
 The following summarizes the assets and liabilities of the printed circuit board assembly
inspection products discontinued operations: 8




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PHOTON DYNAMICS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) December 31,
    
    
    September 30,2004
    
    
    2004(in thousands)ASSETSCurrent assets:Other current assets
    
    $
    977
    
    
    $
    908Total assets
    
    $
    977
    
    
    $
    908LIABILITIESCurrent liabilities:Accounts payable
    
    $
    5
    
    
    $
    5Other current liabilities
    
    
    707
    
    
    
    707Total current liabilities
    
    
    712
    
    
    
    712Other liabilities
    
    
    96
    
    
    
    113Total liabilities
    
    $
    808
    
    
    $
    825
 Other current assets at December 31, 2004, include a receivable of approximately $801,000
against shares that are being held in escrow related to the Companys acquisition of Intelligent
Reasoning Systems, Inc., and $175,000 in security deposits on various leases. Other current liabilities at December 31, 2004, include approximately $79,000 related to
current operating lease obligations, approximately $90,000 related to accrued legal costs and
approximately $537,000 related to potential vendor obligations. Other liabilities of approximately
$96,000 relate entirely to non-current operating lease obligations. These lease obligations are to
be paid out through December of 2006. In the second quarter of fiscal 2003, in accordance with Statement of Financial Accounting
Standards No. 146, Accounting for Costs Associated with Exit or Disposal Activities (FAS 146),
the Company recorded a liability of approximately $2.0 million for costs associated with the
discontinuation of the business, including termination benefits of approximately $700,000 and
approximately $1.3 million of purchase obligations to suppliers. The following summarizes the
liability since inception: One-timeTerminationBenefits
    
    
    Other Costs
    
    
    Total(in thousands)Inception of liability
    
    $
    696
    
    
    $
    1,326
    
    
    $
    2,022Cash expenditures
    
    
    (614
    )
    
    
    (447
    )
    
    
    (1,061
    )Adjustments to the liability
    
    
    (82
    )
    
    
    (342
    )
    
    
    (424
    )Balance at September 30, 2004
    
    
    
    
    
    
    537
    
    
    
    537Cash expenditures
    
    
    
    
    
    
    
    
    
    
    Adjustments to the liability
    
    
    
    
    
    
    
    
    
    
    Balance at December 31, 2004
    
    $
    
    
    
    $
    537
    
    
    $
    537
 The balance of $537,000 remaining at December 31, 2004, consists primarily of potential vendor
obligations that the Company is currently negotiating. Cathode Ray Tube Display and High Quality Glass Inspection Business The Company formerly had a business which sold cathode ray tube display and high quality glass
inspection products. In June 2003, the Company implemented a plan to exit this business.
Accordingly, the operating results of this former business segment have been reclassified as a
discontinued operation for all periods presented and the Company now conducts business in one
segment, the manufacture and servicing of flat panel display products. The following table summarizes the results of discontinuing the cathode ray tube display and
high quality glass inspection products reporting segment for the three months ended December 31,
2004 and 2003: 9




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PHOTON DYNAMICS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) Three MonthsEndedDecember 31,2004
    
    
    2003(in thousands)Selling, general and administrative
    
    $
    2
    
    
    $
    35Impairment of purchased intangibles and fixed assets
    
    
    
    
    
    
    (70
    )Total operating expenses
    
    
    2
    
    
    
    (35
    )Income (loss) from discontinued operations
    
    $
    (2
    )
    
    $
    35
 The following summarizes the assets and liabilities of the cathode ray tube display and high
quality glass inspection discontinued operations: December 31,
    
    
    September 30,2004
    
    
    2004(in thousands)LIABILITIESCurrent liabilities:
    
    $
    782
    
    
    $
    797Other current liabilities
    
    $
    782
    
    
    $
    797
 Other current liabilities at December 31, 2004, include approximately $201,000 related to
warranty obligations, approximately $242,000 related to operating lease obligations and
approximately $339,000 related to a loan payable. Lease obligations are to be paid out through
March of 2008. In the third quarter of fiscal 2003, in accordance with FAS 146, the Company recorded a
liability of approximately $1.9 million for costs associated with the discontinuation of the
business. The following summarizes the liability since inception: One-time
    
    
    ContractTermination
    
    
    TerminationBenefits
    
    
    Costs
    
    
    Other Costs
    
    
    Total(in thousands)Inception of liability
    
    $
    1,116
    
    
    $
    771
    
    
    $
    11
    
    
    $
    1,898Cash expenditures
    
    
    (1,116
    )
    
    
    (322
    )
    
    
    (61
    )
    
    
    (1,499
    )Adjustments to the liability
    
    
    
    
    
    
    
    
    
    
    50
    
    
    
    50Balance at September 30, 2004
    
    
    
    
    
    
    449
    
    
    
    
    
    
    
    449Cash expenditures
    
    
    
    
    
    
    (6
    )
    
    
    
    
    
    
    (6
    )Balance at December 31, 2004
    
    $
    
    
    
    $
    443
    
    
    $
    
    
    
    $
    443
 Future minimum lease payments, due by fiscal year are approximately: $77,000 in fiscal 2005,
$83,000 in fiscal 2006, $76,000 in fiscal 2007 and $6,000 in fiscal 2008. 10




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##### Table of Contents



PHOTON DYNAMICS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) NOTE 4Goodwill and Other Purchased Intangible Assets Goodwill The carrying value of goodwill was approximately $153,000 at both December 31, 2004 and
September 30, 2004. There were no additions or adjustments to goodwill during the three months
ended December 31, 2004. In accordance with Statement of Financial Accounting Standards No. 142,
Goodwill and Other Intangible Assets (FAS 142), the Company performed its annual impairment
test during the three months ended September 30, 2004 and concluded there was no impairment of
goodwill. There have been no significant events or circumstances affecting the valuation of
goodwill subsequent to the Companys impairment test performed during the fourth quarter of fiscal
2004. During the three months ended December 31, 2003, the Company recorded approximately $665,000
in goodwill impairment charges. This impairment charge included charges associated with the
Companys RTP and Akcron reporting units of $300,000 and $365,000, respectively. The RTP reporting
unit consists of rapid thermal processing technology. The Akcron reporting unit consists of thin
film transistor liquid crystal display (TFT-LCD) backlight inverter technology. In November 2002, as part of the acquisition of the RTP Assets, $2.0 million was placed into
escrow to be released either to the Company or to Intevac depending on the occurrence of certain
future events during the escrow period. In September 2003, the Company filed a claim against the
escrow for the full $2.0 million. In October 2003, the Company received $1.7 million on its claim
against the $2.0 million escrow related to the RTP Asset purchase from Intevac. The claim for the
remaining $300,000 was resolved in favor of Intevac. Because the Company has written off all
goodwill resulting from the acquisition of the RTP Assets, the $300,000 resolved in favor of
Intevac resulted in an adjustment to record additional goodwill, which was deemed to be impaired
due to continuing deterioration in business conditions during the three month period ended December
31, 2003. During the three months ended December 31, 2003, the Company recorded a goodwill impairment
charge of approximately $365,000 under the provisions of FAS 142, representing the remaining
goodwill associated with its Akcron reporting unit. This impairment charge was a result of the
continuing softness in the inverter market during the three month period ended December 31, 2003.
Accordingly the Company performed an impairment analysis for the remaining acquired intangible
assets as required by FAS 144. Goodwill of $153,000 as of December 31, 2004 relates entirely to the Companys purchase of
assets from Summit Imaging in May 2003. Intangible Assets Information regarding the Companys intangible assets is as follows: NonDeveloped
    
    
    
    
    
    
    License
    
    
    CompeteTechnology
    
    
    Core Technology
    
    
    Agreement
    
    
    Contract
    
    
    Total(in thousands)Balance as of September 30, 2004
    
    $
    932
    
    
    $
    2,109
    
    
    $
    949
    
    
    $
    763
    
    
    $
    4,753Amortization during the period
    
    
    (63
    )
    
    
    (150
    )
    
    
    (95
    )
    
    
    (89
    )
    
    
    (397
    )Balance as of December 31, 2004
    
    $
    869
    
    
    $
    1,959
    
    
    $
    854
    
    
    $
    674
    
    
    $
    4,356
 During the three months ended December 31, 2003, the Company recorded impairment charges of
approximately $2.1 million related to the remaining portion of the acquired developed technology
and core technology related to the Akcron and RTP reporting units. These charges have been
reflected in the results of operations in the quarter ended December 31, 2003. Based on intangible assets recorded at December 31, 2004, and assuming no subsequent additions
to, or impairment of the underlying assets, the remaining estimated amortization expense relating
to intangible assets at December 31, 2004 is approximately $1.1 million, $1.5 million, $1.2 million
and $558,000 in fiscal 2005 through 2008, respectively. In assessing the recoverability of its intangible assets, the Company must make assumptions
regarding estimated future cash flows and other factors to determine the fair value of the
respective assets. It is reasonably possible that these estimates, or their related assumptions,
may change in the future, in which case the Company may be required to record additional impairment
charges for these assets. 11




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PHOTON DYNAMICS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) NOTE 5Derivative Financial Instruments Under its foreign currency risk management strategy, the Company may utilize derivative
instruments to protect its interests from unanticipated fluctuations in earnings and cash flows
caused by volatility in currency exchange rates. This financial exposure is monitored and managed
by the Company as an integral part of its overall risk management program which focuses on the
unpredictability of financial markets and seeks to reduce the potentially adverse effects that the
volatility of these markets may have on its operating results. The Company accounts for its derivatives instruments according to Statement of Financial
Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS
133), which requires that all derivatives be recorded on the balance sheet at fair value. Changes
in the fair value of derivatives which do not qualify or are not effective as hedges must be
recognized currently in earnings. The Company does not use derivative financial instruments for
speculative or trading purposes, nor does it hold or issue leveraged derivative financial
instruments. The Companys international sales are primarily denominated in U.S. dollars although
approximately $11.5 million of revenue that was recognized in the first quarter of fiscal 2005 was
invoiced in Japanese Yen. For foreign currency denominated sales; however, the volatility of the
foreign currency markets could impact the Companys margin. The Company defines its exposure as the
risk of changes in the functional-currency-equivalent cash flows (generally U.S. dollars)
attributable to changes in the related foreign currency exchange rates. The Company records the
mark-to-market change in fair value of its derivative instruments within Other current
liabilities in the Companys Condensed Consolidated Balance Sheets. The Company did not have any
forward sales contracts at December 31, 2004. At December 31, 2003, the Company had foreign
exchange forward contracts maturing throughout fiscal 2004 to sell approximately $2.8 million in
foreign currencies, primarily Japanese Yen. The Company did not qualify these forward sales
contract as hedging instruments, as defined by FAS 133, and, as such, recorded the changes in the
fair value of these derivatives immediately in Interest income and other, net in the Condensed
Consolidated Statements of Operations. The Company recorded a net gain of approximately $0 and
$208,000, respectively, in the first quarter of fiscal year 2005 and 2004. These gains are included
in Interest income and other, net in the Condensed Consolidated Statements of Operations. The
fair value of these open contracts at December 31, 2004 and 2003 were approximately $0 and
$329,000, respectively, and were included in Other current liabilities in the Condensed
Consolidated Balance Sheets. NOTE 6Comprehensive Income The components of comprehensive income (loss) were as follows: Three MonthsEndedDecember 31,2004
    
    
    2003(in thousands)Net income
    
    $
    234
    
    
    $
    956Other comprehensive loss:Net change in unrealized gain on investments
    
    
    (156
    )
    
    
    (130
    )Change in foreign currency translation
    
    
    128
    
    
    
    (147
    )Other comprehensive loss
    
    
    (28
    )
    
    
    (277
    )Total comprehensive income
    
    $
    206
    
    
    $
    679
 12




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##### Table of Contents



PHOTON DYNAMICS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) NOTE 7Net Income Per Share Basic earnings per share is computed by dividing income available to common shareholders by
the weighted-average number of shares of common stock outstanding during the period. Diluted
earnings per share is computed by dividing income available to common shareholders by the
weighted-average number of shares of common stock outstanding during the period increased to give
effect to all dilutive potential common 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 per share: Three Months EndedDecember 31,2004
    
    
    2003(in thousands, exceptper share data)Numerator:Net income from continuing operations before discontinued operations
    
    $
    240
    
    
    $
    909Net income (loss) from discontinued operations
    
    
    (6
    )
    
    
    47Net income
    
    $
    234
    
    
    $
    956Denominator:Weighted average shares for basic net income per share
    
    
    16,872
    
    
    
    16,461Effect of dilutive securities: Employee stock options
    
    
    137
    
    
    
    713Weighted average shares for diluted net income per share
    
    
    17,009
    
    
    
    17,174Earnings per share:Basic net income per share:Net income from continuing operations
    
    $
    0.01
    
    
    $
    0.06Net income (loss) from discontinued operations
    
    
    0.00
    
    
    
    0.00Net income per share
    
    $
    0.01
    
    
    $
    0.06Diluted net income per share:Net income from continuing operations
    
    $
    0.01
    
    
    $
    0.05Net income (loss) from discontinued operations
    
    
    0.00
    
    
    
    0.00Net income per share
    
    $
    0.01
    
    
    $
    0.06
 During the three month periods ended December 31, 2004 and 2003, options to purchase 1,236,827
and 175,815 shares, respectively, were not included in the computation of diluted earnings per
share because the exercise price was greater than the average market price of common shares for the
respective periods and hence, their effect would have been anti-dilutive. NOTE 8Commitments and Contingencies Purchase Agreements The Company maintains certain open inventory purchase commitments with suppliers to ensure a
smooth and continuous supply chain for key components. The Companys liability in these purchase
commitments is generally restricted to a forecasted time horizon as mutually agreed upon between
the parties. The Companys open inventory purchase commitments were approximately $25.6 million as
of December 31, 2004 and $27.3 million as of September 30, 2004. 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 three month periods ended December 31,
2004 and 2003, were as follows: 13




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##### Table of Contents



PHOTON DYNAMICS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) Three Months EndedDecember 31,2004
    
    
    2003(in thousands)Beginning balance
    
    $
    6,194
    
    
    $
    2,363Estimated warranty cost of new shipments during the period
    
    
    1,500

    
    
    
    960Warranty costs during the period
    
    
    (1,538
    )
    
    
    (906
    )Changes in liability for pre-existing warranties, including expirations
    
    
    75
    
    
    
    423Ending balance
    
    $
    6,231
    
    
    $
    2,840
 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. Defendants have filed a motion for summary judgment, which is set for hearing on April 5,
2005, and a trial, if necessary, is scheduled to begin on May 2, 2005. Discovery is ongoing. The
Company believes the plaintiffs case is without merit and it intends to defend this action
vigorously. The Company cannot predict the outcome of this litigation and no provision or liability
has been recorded in the accompanying condensed consolidated financial statement should the outcome
of this matter be adverse to the Company. The Company believes that an adverse judgment in this
litigation could be material and could have an adverse effect on the Companys financial condition,
results of operations or cash flows. The Company has been named as a defendant in a lawsuit captioned Sanmina SCI Corporation v.
Photon Dynamics, Inc., No. CV 013715, filed on February 3, 2004 in the Superior Court of the State
of California, County of Santa Clara. The plaintiff in this action, who previously was a
third-party manufacturer of the Company, has asserted several causes of action arising out of the
alleged nonperformance by the Company of the manufacturing outsourcing agreement between the
Company and the plaintiff, and is seeking approximately $3.1 million in compensatory damages and
punitive damages in a unknown amount. The Company responded to the complaint on March 19, 2004, by
filing an answer and cross complaint seeking damages of at least $135,000. The Company amended its
cross complaint on June 26, 2004. The parties attempted to mediate this dispute, which attempt was
not successful. The parties are currently engaged in discovery. Although the Company cannot predict
the outcome of this litigation, the Company believes that any adverse judgment in this litigation
would not have a material adverse effect on the Companys financial condition, results of
operations or cash flows. The Company filed a lawsuit captioned Photon Dynamics, Inc. vs. PanelVision Technology and
Guillermo Toro-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 was alleging infringement of a
U.S. Patent owned by it and was seeking full compensatory damages and an injunction against the
defendants. On July 17, 2002, the defendants answered the Companys complaint and asserted a
counterclaim alleging damages of at least $6.0 million in compensatory damages for loss of
business. On January 23, 2003, the Company added Shimadzu Corporation as an additional defendant.
On April 23, 2003, the defendants added additional counterclaims against the Company alleging
violations of the antitrust laws and requesting the damages sought to be trebled. Subsequently, the
court bifurcated the antitrust claims of Toro-Lira and Shimadzu Corporation against the Company,
thus deferring any consideration of these claims until the conclusion of the patent infringement
issues. On October 16, 2003, the parties to the litigation settled all litigation between them
regarding US Patent 5,081,687, US Reissue Patent No.37,847, and Japanese Patent 3292990. Pursuant
to the settlement agreement between the parties, Shimadzu Corporation, companies affiliated with
Shimadzu, and customers of Shimadzu are irrevocably licensed world-wide under US Patent 5,081,687,
US Reissue Patent No. 37,847, Japanese Patent 3292990 and any corresponding patents to manufacture,
use, and sell e-beam based panel test equipment designed by or for Shimadzu. All other terms of the
settlement agreement are confidential. The proceeds of this settlement are included in Interest
income and other, net, in the Condensed Consolidated Statement of Operations for the three months
ended December 31, 2003. 14




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##### Table of Contents



PHOTON DYNAMICS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) Photon Dynamics is subject to certain other legal proceedings and claims that have arisen in
the ordinary course of business and have not been fully adjudicated. Other than with respect to
the Amtower matter as described above, in the opinion of management, the Company does not have a
potential liability related to any current legal proceedings and claims that would individually, or
in the aggregate, have a material adverse effect on its financial condition, liquidity or results
of operations. However, litigation in general, and intellectual property and securities litigation
in particular, can be expensive and disruptive to normal business operations. Moreover, the results
of complex legal proceedings are difficult to predict. The Company believes that it has defenses in
each of the aforementioned matters and it is vigorously contesting each of these matters. NOTE 9Geographic Information The Company sells its products for the flat panel display industry directly to customers in
Korea, Taiwan, China and Japan. For geographical reporting, revenue is attributed to the
geographic location to which the product was shipped. Long-lived assets consist primarily of
property, plant and equipment, goodwill and intangibles and are attributed to the geographic
location in which they are located. The following is a summary of revenue by geographic area based on location where the product
was shipped: Three Months EndedDecember 31,2004
    
    
    2003(in thousands)Revenue:Korea
    
    $
    6,321
    
    
    $
    11,295Taiwan
    
    
    8,115
    
    
    
    7,199Japan
    
    
    11,533
    
    
    
    6,005China
    
    
    10,387
    
    
    
    Total
    
    $
    36,356
    
    
    $
    24,499
 The following is a summary of revenue by product line (as a percentage of total revenue): Three Months EndedDecember 31,2004
    
    
    2003Revenue:ArrayChecker
    
    
    64
    %
    
    
    79
    %ArraySaver
    
    
    29
    %
    
    
    14
    %Spares and other
    
    
    7
    %
    
    
    7
    %Total
    
    
    100
    %
    
    
    100
    %
 Sales to individual unaffiliated customers in excess of 10% of total revenue were as follows: Three Months EndedDecember 31,2004
    
    
    2003Customer A
    
    
    17
    %
    
    
    16
    %Customer B
    
    
    *
    
    
    
    24
    %Customer C
    
    
    29
    %
    
    
    *Customer D
    
    
    *
    
    
    
    24
    %Customer E
    
    
    *
    
    
    
    16
    %Customer F
    
    
    32
    %
    
    
    *Customer G
    
    
    18
    %
    
    
    13
    %
   *
    
    Customer accounted for less than 10% of total revenue for the period Accounts receivable from individual unaffiliated customers in excess of 10% of total gross
accounts receivable were as follows: 15




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##### Table of Contents



PHOTON DYNAMICS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) December 31,
    
    
    September 30,2004
    
    
    2004Customer A
    
    
    17
    %
    
    
    29
    %Customer B
    
    
    23
    %
    
    
    *Customer E
    
    
    *
    
    
    
    16
    %Customer F
    
    
    26
    %
    
    
    13
    %Customer G
    
    
    10
    %
    
    
    *Customer H
    
    
    *
    
    
    
    12
    %
   *
    
    Customer accounted for less than 10% of total gross accounts receivable for the period Long-lived assets by geographical area are as follows: December 31
    
    
    September 302004
    
    
    2004(in thousands)United States
    
    $
    22,400
    
    
    $
    22,889Canada
    
    
    1,897
    
    
    
    1,947Other
    
    
    447
    
    
    
    407Total
    
    $
    24,744
    
    
    $
    25,243
 NOTE 10Related Party Transactions During the three months ended December 31, 2004 and 2003, the Company paid $36,000 and $2,000,
respectively, to one member of the Companys board of directors for consulting services rendered to
the Company. During the three months ended December 31, 2004 and 2003, the Company recorded
approximately $35,000 and $0, respectively, in stock ownership expense related to options granted
to this consultant. NOTE 11Provision for Income Taxes For
the three months ended December 31, 2004 and 2003, the Company recorded a provision for income
taxes of $39,000 and $362,000, respectively. The provision for income taxes for the three months
ended December 31, 2003 included a foreign withholding tax related to the resolution of the
technology license fee litigation settlement. The effective tax rate in both periods is lower than
the statutory rate due to tax benefits arising from net operating losses. The effective tax rate
is a combination of foreign income taxes and domestic alternative minimum taxes. 16




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##### Table of Contents



ITEM 2.Managements Discussion and Analysis of Financial Condition and Results of
Operations This Quarterly Report onForm 10-Qcontains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.
Actual results could differ materially from those projected in the forward-looking statements as a
result of a number of factors, risks and uncertainties, including the risk factors set forth in
this discussion, especially under the caption Factors Affecting Operating Results in this Form
10-Q. Generally, the words anticipate, expect, intend, believe and similar expressions
identify forward-looking statements. The forward-looking statements made in thisForm 10-Qare made
as of the filing date with the Securities and Exchange Commission and future events or
circumstances could cause results that differ significantly from the forward-looking statements
included here. Accordingly, we caution readers not to place undue reliance on these statements. We
expressly disclaim any obligation to update or alter our forward-looking statements, whether, as a
result of new information, future events or otherwise. The following discussion and analysis should be read in conjunction with the condensed
consolidated financial statements and notes thereto in Item 1 above and with our financial
statements and notes thereto for the year ended September 30, 2004, contained in our Annual Report
onForm 10-K. Overview Our Company We are a leading provider of yield management solutions to the flat panel display industry.
Our customers use our systems to increase manufacturing yields of high performance flat panel
displays used in a number of products, including notebook and desktop computers, televisions and
advanced mobile electronic devices such as cellular phones, personal digital assistants and
portable video games. Our test and repair systems are used by manufacturers to collect data,
analyze product quality and identify and repair product defects at critical steps in the
manufacturing process. We sell our products to manufacturers in the flat panel display industries. Our flat panel
display customers are located in Korea, Taiwan and Japan, where flat panel display
production is concentrated, and China. We derive most of our revenue from a small number of customers, and we
expect this to continue for the foreseeable future. Our products are primarily manufactured in San Jose, California. Our manufacturing activities
consist primarily of final assembly and test of components and subassemblies, which are purchased
from third party vendors. We schedule production based upon customer purchase orders and
anticipated orders during the planning cycle. We generally expect to be able to accept a customer
order, build the required machinery and ship to the customer within 26 to 39 weeks. The success of our business depends upon numerous factors, including, but not limited to:  
    The level of capital expenditures of flat panel display manufacturers, which in
turn depends on the current and anticipated market demand for products utilizing flat
panel displays, and
    The relative competitiveness of our products and services. We do not consider our business to be seasonal in nature, but it is cyclical with respect to
the capital equipment procurement practices of flat panel display manufacturers and is impacted by
the investment patterns of these manufacturers in different global markets. A substantial
percentage of our revenue is derived from the sale of a small number of yield management systems
ranging in price from approximately $400,000 to $3.4 million. Therefore, the timing of the sale of
a single system could have a significant impact on our quarterly results. Focus on Flat Panel Display Industry We have not always focused solely on the flat panel display industry. Previously, we also
produced printed circuit board assembly inspection products and cathode ray tube display and high
quality glass inspection products. However, we determined to exit these markets as we believed that
they did not have the potential to be profitable for us. Consequently, in January 2003, we
implemented a plan to exit the printed circuit board assembly inspection business, and in June
2003, we implemented a plan to exit the cathode ray tube display and high quality glass inspection
business. Accordingly, the operating results of these former businesses are reclassified as
discontinued operations for all periods presented. In view of continued deterioration in market opportunities that began in the fourth quarter of
fiscal 2003, we suspended operations in the low temperature poly-silicon (LTPS) technology and
inverter markets in the first quarter of fiscal 2004. Although we continue to support LTPS systems
in the field with parts and service, we currently are not actively pursuing new business for
systems, upgrades or enhancements for the foreseeable future. In our third quarter of fiscal 2004,
we sold all assets related to the inverter business. 17




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##### Table of Contents



Our transition to the singular focus on our core business of developing yield management
solutions for the flat panel display industry has given us a clear strategy and direction. As a
result of this strategic shift in fiscal 2004, we returned to profitability, successfully acquired
two key suppliers, moved into a new facility that doubled our manufacturing capacity and introduced
our new automated cell and module inspection systems. In fiscal 2005 our emphasis is to strengthen our market position, our product focus, our
operations and our fiscal performance. Our management team is focused on several imperatives to
support these objectives:  
    Product Focus: We continue to improve our product performance in defect detection,
repair success, cost of ownership, ease of use and throughput for each of our product
generations. We seek to couple this improved system performance with our expert
applications engineering services to provide the best possible business solutions to our
customers.
    Quality Focus: We are continuing to implement processes to drive product quality
improvement and ease of use for our customers.
    Technology Leadership: We are continuing to emphasize our research and development
to maintain our technology leadership in our products. We have formed an advance
technology organization to focus on our ArrayTest product, our camera development for all
of our products, and our repair and defect classification algorithms for the ArraySaver
and PanelMaster products.
    Financial Improvement: We are continuing to improve financial performance. To
achieve these goals, we will continue to look for vertical integration opportunities,
source certain raw materials and certain system integration in Asia, and expand sales and
marketing of our service product offerings. Acquisitions and Dispositions We continue to refine our strategic direction. For example, in the first quarter of fiscal
2004, we suspended operations in the LTPS technology and inverter markets. In the fourth quarter of
fiscal 2003, as a result of limited opportunities in the inverter market and uncertainty with
regard to flat panel manufacturers commitment to LTPS technology, we performed an impairment
analysis of the goodwill and the purchased intangible assets and certain other long-lived assets
associated with the Akcron and RTP reporting units. In fiscal 2003, we exited the printed circuit
board assembly inspection and cathode ray tube and high quality glass inspection businesses. As a
result, some or all of the technologies acquired in connection with some of our prior acquisitions,
have been sold or abandoned. We recorded impairment charges of approximately $365,000 of goodwill and $2.1 million of
acquired core technology and acquired developed technology associated with these reporting units in
the three months ended December 31, 2003. Industry Continuous innovations in microelectronics and materials science have enabled manufacturers,
including our customers, to produce flat panel displays with sharper resolution, brighter pixels
and faster imaging in varying sizes for differing applications. Each progressive increase in panel
size is referred to by its generation. Growth in the mobile electronic devices market, the
desktop computer market and the television market have driven the demand for flat panel displays,
which offer reduced footprint, weight, power consumption and heat emission and better picture
quality as compared to cathode ray tube displays, the current standard technology for televisions. The flat panel display market growth during the first half of calendar 2004 was reflected in
the 80% increase in FPD capital equipment spending between 2003 and 2004. In the last half of
calendar year 2004, there was uncertainty in the flat panel display market as supply exceeded
demand. This over-supply was driven primarily by decreasing demand due to record high panel prices
and increasing supply as a result of numerous generation 5 factories coming on line in Korea and
Taiwan. This over-supply has been moderated by longer factory ramp times due to yield issues, and
a shortage of key components such as glass substrates and color filters. Demand is forecasted to
exceed supply some time in the latter half of calendar 2005. Current market indicators show that
demand is rising as a result of significantly reduced panel prices in the latter half of calendar
2004. Growth in the active matrix liquid crystal display (AMLCD) television market is expected to
continue to fuel the overall growth in the flat panel display market. While AMLCD television demand
lagged during the first half of calendar year 2004, it picked up momentum during the second half of
the year and finished slightly above market analyst expectations. AMLCD television demand is
essentially on track due to successful generation 6 factories at Sharp and LG Philips LCD and the
resultant pricing efficiencies offered from these factories. This represents an encouraging
indicator of the future as generation 7 factories are scheduled to come on 18




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line during calendar 2005. However, there are many factors that will dictate how successful
AMLCD manufacturers are in penetrating the television market, including display performance, price
reduction and the ability to maintain profitability. Demand for our Generation 5 and 6 test and repair equipment remains high and our Generation 7
test system installation and acceptance is underway. In addition, we continue to see a growing
interest in our automated cell and module inspection systems. We believe continued growth in demand for AMLCD products will fuel investments in Generation 6
and 7 factories to keep pace and that inspection test and repair systems will continue to represent
a significant percentage of our customers capital spending, driving increased demand for our
products and services. Backlog Our backlog for unshipped system orders as of December 31, 2004, was approximately $60.6
million. Our backlog consists of orders for which we have accepted purchase orders and assigned
shipment dates within the next twelve months from December 31, 2004 and which are reasonably
expected to be filled within that time frame. All orders are subject to delay or cancellation with
limited penalty or no penalty to the customer. Because of possible changes in product delivery
schedules and cancellation of product orders, cyclical nature of customers capital equipment
procurement practices, among other factors, our backlog may vary significantly and, at any
particular date, is not necessarily indicative of actual sales for any succeeding period. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based
upon our condensed consolidated financial statements, which have been prepared in accordance with
U.S. generally accepted accounting principles. The preparation of our financial statements and the
related disclosures requires our management to make judgments, assumptions and estimates that
affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of
contingent assets and liabilities. Note 1 of Notes to Condensed Consolidated Financial Statements
describes significant accounting policies used in the preparation of our condensed consolidated
financial statements. Some of these significant accounting policies are considered to be critical
accounting policies. A critical accounting policy is defined as one that is both material to the presentation of
our financial statements and requires management to make difficult, subjective or complex judgments
that could have a material effect on our financial condition and results of operations. Estimates and assumptions about future events and their effects cannot be determined with
certainty. We base our estimates on historical experience and on various other assumptions that are
believed to be applicable and reasonable under the circumstances. These estimates may change as new
events occur, as additional information is obtained and as our operating environment changes. In
addition, management is periodically faced with uncertainties, the outcomes of which are not within
its control and will not be known for prolonged periods of time. These uncertainties are discussed
in the section below entitled Factors Affecting Operating Results. We believe the following critical accounting policies affect our more significant judgments
and estimates used in the preparation of our consolidated financial statements. Revenue Recognition.Note 1 of our Notes to Condensed Consolidated Financial Statements
provides a description of our revenue recognition policy. For each
arrangement, we recognize revenue when persuasive evidence
of an arrangement exists, delivery has occurred or the services
have been rendered, the selling price is fixed or determinable and
collectibility is
reasonably assured, the latter of which is subject to judgment. If we determine that any of these criteria are not met, we defer revenue
recognition until such time as we determine that all of the criteria are met. In addition, for arrangements with multiple deliverables, we make additional judgments as to
whether each item has value to the customer on a stand-alone basis, the amounts of revenue for each
element that are not subject to refund, all defined customer acceptance experience levels have been
met and the fair values of any undelivered items have been reliably determined. We record a provision for estimated sales returns in the same period as the related revenue is
recorded, which is netted against revenue. These estimates are based on historical sales returns
and other known factors which have not varied widely in the past and we do not reasonably expect
these factors to significantly change in the foreseeable future. If the historical data we use to
calculate these estimates does not properly reflect future returns, additional provisions may be
required. Historically, we have not experienced the return of any of our flat panel display systems
and do not expect this to change in the foreseeable future. However, due to the relatively high
prices of our systems, the actual return of one of these systems would have a material adverse
effect on our results of operations. 19




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Allowance for Doubtful Accounts.Our trade receivables are derived from sales to flat panel
display manufacturers located in Korea, Taiwan, Japan and China. In order to monitor potential
credit losses, we perform periodic evaluations of our customers financial condition. We maintain
an allowance for doubtful accounts for the potential inability of our customers to make required
payments based upon our assessment of the expected collectibility of all accounts receivable. In
estimating the provision, we consider (i) historical experience, (ii) the length of time the
receivables are past due, (iii) any circumstances of which we are aware regarding a customers
inability to meet its financial obligations, and (iv) other known factors. We review this provision
periodically to assess the adequacy of the provision. Our allowance for doubtful accounts was approximately $496,000 and $497,000 at December 31,
2004 and September 30, 2004, respectively. These balances each represent less than 2% of fiscal
2004 revenues. Historically, losses due to customer bad debts in our flat panel display business
have been immaterial, and we expect that this will not change in the foreseeable future. However,
if a single customer was unable to make payments, additional allowances may be required.
Accordingly, the inability of a single customer to make required payments could have a material
adverse effect on our results of operations. Inventories.The valuation of inventory requires us to estimate obsolete or excess inventory
and inventory that is not saleable. The determination of obsolete or excess inventory requires us
to estimate the future demand for our products within specific time horizons, generally twelve
months or less. If our demand forecast for specific products is greater than actual demand and we
fail to reduce manufacturing output accordingly, we could be required to record additional
inventory write-offs, which would have a negative impact on our gross margin. We review the adequacy of our inventory valuation on a quarterly basis. For production
inventory, our methodology involves matching our on-hand inventory with our demand forecast over
the next twelve months on a part-by-part basis. We then evaluate the parts found to be in excess of
the twelve-month demand and take appropriate write-downs to reflect the risk of obsolescence. This
methodology is significantly affected by the demand forecast assumption. Using a longer time period
of estimated demand could result in reduced inventory adjustment requirements. Based on our past
experience, we believe the twelve-month time period to best reflect the reasonable and relative
obsolescence risks. If actual demand or usage were to be substantially lower than estimated,
additional inventory adjustments for excess or obsolete inventory may be required. Warranty.Our warranty policy generally states that we will provide warranty coverage for a
period of one year from final acceptance. We record the estimated cost of warranty coverage,
primarily material and labor to repair and service the equipment, upon product shipment, when the
related revenue is recognized. Our warranty obligation is affected by product failure rates,
consumption of field service parts and the efficiency by which the product failure is corrected. We
estimate our warranty cost based on historical data related to these factors. Our liability for warranty coverage was approximately $6.0 million and $6.2 million at
December 31, 2004 and September 30, 2004, respectively. Should actual product failure rates
material usage and labor efficiencies differ from our estimates, revisions to the estimated
warranty liability would be required. Goodwill and Intangible Assets.We have accounted for goodwill and other intangible assets
resulting from our acquisitions in accordance with Statement of Financial Accounting Standards No.
142, Goodwill and Other Intangible Assets (FAS 142). FAS 142 prohibits the amortization of
goodwill and intangible assets with indefinite useful lives and requires that these assets be
reviewed for impairment at least annually, and more frequently if there are indicators of
impairment. The process for evaluating the potential impairment of goodwill is highly subjective
and requires significant judgment at many points during the analysis. Should actual results differ
from our estimates, revisions to the recorded amount of goodwill could be reported. We amortize intangible assets with finite lives and other long-lived assets over their
estimated useful lives and also subject them to evaluation for impairment. We review long-lived
assets including intangible assets with finite lives for impairment whenever events or changes in
business circumstances indicate that the carrying amount of the assets may not be fully
recoverable, such as a significant industry downturn, significant decline in the market value of
the company, or significant reductions in projected future cash flows. We would recognize an
impairment loss 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. We determine impairment,
if any, using discounted cash flows. In assessing the recoverability of long-lived assets,
including intangible assets, we must make assumptions regarding estimated future cash flows and
other factors to determine the fair value of the respective assets. If these estimates or their
related assumptions change in the future, we may be required to record additional impairment
charges for these assets. As described in Acquisitions and Dispositions above, we recorded both goodwill and
intangible asset impairment charges as part of our transition to a singular focus on our core
business of developing yield management solutions for the flat panel display industry. During
fiscal quarter ended December 31, 2003, we recorded a goodwill impairment charge of approximately
$365,000 and an intangible asset impairment charge of $2.1 million associated with our Akcron
reporting unit and the remaining intangible assets associated with our RTP and Akcron reporting
units. These charges were reflected in our results of operations for the three months ended
December 31, 2003. In October 2003, $1.7 million of the $2.0 million escrow related to the purchase
of certain assets relating to 20




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the RTP Assets was settled in our favor, and $300,000 was settled in favor of Intevac,
resulting in an additional goodwill impairment charge of $300,000 also reflected in our results of
operations in the three months ended December 31, 2003. Goodwill as of December 31, 2004 and September 30, 2004, was approximately $153,000, related
entirely to our purchase of assets from Summit Imaging in May 2003. Contingencies and Litigation.We make an assessment of the probability of an adverse judgment
resulting from current and threatened litigation. We accrue the cost of an adverse judgment if, in
our estimation and based on the advice of legal counsel, the adverse settlement is probable and we
can reasonably estimate the ultimate cost of such a judgment. We are engaged in two significant
litigation matters as of December 31, 2004, Amtower v. Photon Dynamics, Inc. in which the
plaintiffs are seeking damages of approximately $17.7 million, plus unspecified emotional distress
and punitive damages, and Sanmina SCI Corporation v. Photon Dynamics, Inc. in which the plaintiffs
are seeking damages of approximately $3.1 million, plus unspecified punitive damages. These matters
are as described in Note 8 to the Condensed Consolidated Financial Statements in this Form 10-Q.
We have made our requisite assessments and accruals, as warranted, as of December 31, 2004. We
believe that an adverse judgment in the Amtower litigation could have a material adverse effect on
our financial condition, results of operations or cash flows. We believe that an adverse judgment
in the Sanmina litigation would not have a material adverse effect on our financial condition,
results of operations or cash flows. Results of Operations Selected Financial Data The percentage of net revenue represented by certain line items in our condensed consolidated
statement of operations for the periods indicated, are set forth in the table below. Three Months EndedDecember 31,2004
    
    
    2003Revenue
    
    
    100.0
    %
    
    
    100.0
    %Cost of revenue
    
    
    62.7
    
    
    
    54.7Gross margin
    
    
    37.3
    
    
    
    45.3Operating expenses:Research and development
    
    
    26.0
    
    
    
    23.7Selling, general and administrative
    
    
    12.9
    
    
    
    18.8Amortization of intangible assets
    
    
    1.1
    
    
    
    0.8Goodwill impairment charge
    
    
    
    
    
    
    2.7Impairment of purchased intangibles
    
    
    
    
    
    
    8.5Impairment of fixed assets
    
    
    
    
    
    
    1.0Total operating expenses
    
    
    40.0
    
    
    
    55.5Loss from operations
    
    
    (2.7
    )
    
    
    (10.2
    )Interest income and other, net
    
    
    3.4
    
    
    
    15.4Income from continuing operations before income taxes and discontinued operations
    
    
    0.7
    
    
    
    5.2Provision for income taxes
    
    
    0.1
    
    
    
    1.5Income from continuing operations
    
    
    0.6
    
    
    
    3.7Income (loss) from discontinued operations
    
    
    0.0
    
    
    
    0.2Net income
    
    
    0.6
    
    
    
    3.9
 Revenue Three MonthsEnded December 31,(dollars in millions)2004
    
    
    Change
    
    
    2003Revenue
    
    $
    36.4
    
    
    
    48
    %
    
    $
    24.5
 The increase in revenue for the three months ended December 31, 2004 over the same period of
the prior year was primarily due to the continued expansion of our customers manufacturing
capacity. Flat panel display manufacturers continue to increase capacity 21




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to meet computer notebook, monitor and television demand. Though over-supply in the FPD market
caused revenue in the quarter ended December 31, 2004 to decrease from revenue of $53.8 million in
the quarter ended September 30, 2004, flat panel display manufacturers continued to invest to keep
pace with forecasted AMLCD demand. Total revenue from our Generation 5 and earlier generation products represented approximately
31% and 70% of revenue in the three month periods ended December 31, 2004 and 2003, respectively.
The quarter-over-quarter decrease was due primarily to the increase in revenue from our new
Generation 6 products. Revenue from our Generation 6 products represented approximately 61% and 23%
of revenue in the three month periods ended December 31, 2004 and 2003, respectively. Our products
in each new generation contain new performance and control features designed specifically to
enhance yield improvement and process control. As a result, we have historically experienced
increases in our average selling prices of between 20% and 50% in each new generation product. As
with prior generation products, our Generation 6 ArrayChecker products have greater average
selling prices than previous generations. However, the average selling prices of our Generation 6
ArraySaver products were relatively flat as compared to the prior generations. There is no
assurance that we will be successful at achieving or sustaining average selling price increases on
our Generation 6 and future generation products. The increase in revenue for the three months ended December 31, 2004 as compared to the same
period of the prior fiscal year was due to increased shipments of both our ArrayChecker and
ArraySaver products. Revenue from our ArrayChecker products represented approximately 64% and 80%
of our total revenue for the three months ended December 31, 2004 and 2003, respectively. Revenue
from our test products increased in absolute dollars primarily due to the continued expansion of
our customers manufacturing capacity. Revenue from our test products decreased as a percentage of
revenue due primarily to the increase in revenue from our repair products. Revenue from our
ArraySaver products represented approximately 29% and 14% of our total revenue for the three
months ended December 31, 2004 and 2003, respectively. Revenue from our repair products have
increased in both absolute dollars and as a percentage of total revenue partly in response to the
larger glass size processed in factories that use Generation 6 and due to expansion of customer
manufacturing facilities. The cost of yield loss associated with large panels is driving flat panel
display manufacturers to increase the number of repair systems used in the manufacturing process in
an effort to maximize yields. Our sales terms are typically 80% to 90% of the sales price due upon
shipment with the remaining amount due after installation and upon final customer acceptance.
Revenue for the three months ended December 31, 2004 includes a higher absolute dollar value of
revenue related to the receipt of final customer acceptances following completed installation of
our products compared with the same period in the prior fiscal year. Spare part sales represented
approximately 7% of our total revenue in both three month periods ended December 31, 2004 and 2003. Our international revenue is derived from customers in Korea, Taiwan, Japan and China.
International revenue represented 100% of our revenue in both the three-month periods ended
December 31, 2004 and 2003. For the three month period ended December 31, 2004, revenue from
customers in Korea decreased approximately $5 million, or 44%, revenue from customers in Taiwan
increased approximately $1 million, or 13%, and revenue from customers in Japan increased
approximately $6 million, or 92%, compared to the same period of the prior fiscal year. The
remainder of the revenue in the three months ended December 31, 2004, consisting of approximately
$10 million, was derived from customers based in China. There was no corresponding revenue from
customers in China in the same quarter of the preceding fiscal year. In the three months ended
December 31, 2004, approximately $11.5 million of our sales were made in currencies other than U.S.
dollars. We expect revenue for the second quarter of fiscal 2005 to be between $21.0 and $24.0 million.
Estimated revenue does not include deferred revenue of approximately $21.6 million, due to
uncertainty in the timing of a major customers acceptance for our Generation 7 test, repair and
inspection equipment that we had previously expected to recognize in the second quarter of fiscal
2005. Gross Margin Three MonthsEnded December 31,2004
    
    
    Change
    
    
    2003Gross Margin
    
    
    37
    %
    
    
    (18
    )%
    
    
    45
    %
 In the first quarter of fiscal 2005, gross margin was impacted by a more heavily weighted
mix of our lower margin ArraySaver systems compared to our higher margin ArrayChecker products
and the under-utilization of our San Jose facilities. We anticipate that our gross margin for our
second quarter of fiscal 2005 will decrease to 20-25% due to the expected decrease in revenue, a
higher mix of our lower margin ArraySaver systems and the continued under-utilization of our San
Jose facilities. Gross margin in the three months ended December 31, 2003 benefited from increased
manufacturing efficiencies attributable to greater utilization of our
then available manufacturing
capacity, a more heavily weighted mix to our higher margin ArrayChecker systems and a higher level
of revenue, as a percent of total revenue, recognized after installation and final customer
acceptance, which typically has a higher margin than revenue billed on the associated items that
were previously delivered. 22




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Key factors that may impact our future gross margin include:  
    Our revenue mix between higher margin ArrayChecker systems and lower margin ArraySaver and PanelMaster systems;
    The costs of increasing customer service staff to support the increased demands of our customers;
    The additional costs in connection with developing new products;
    Competitive pricing pressures, particularly in the array repair market; and
    Fluctuations in the level of revenue due to the cyclical nature of customers capital expenditures. Research and Development Three MonthsEnded December 31,(dollars in millions)2004
    
    
    Change
    
    
    2003Expense
    
    $
    9.5
    
    
    
    63
    %
    
    $
    5.8Percent of Revenue
    
    
    26
    %
    
    
    
    
    
    
    24
    %
 Our research and development expenses consisted primarily of salaries, related personnel
costs, depreciation, prototype materials and fees paid to consultants and outside service
providers, all of which relate to the design, development, testing, pre-manufacturing and
improvement of our products. We increased our overall research and development spending in the
three months ended December 31, 2004 over the same period of the prior fiscal year due to more
engineering programs in process to support simultaneous development of Generation 6 and 7 test,
repair and inspection products. The increased costs related primarily to higher spending on
prototype materials and engineering headcount. We expect our research and development expenses to be flat to slightly higher in absolute
dollars during our second quarter of fiscal 2005 as compared to our first quarter as we continue to
expand our research and development efforts to address three areas:  
    Ramp up our cell and module program to address mass production requirements;
    Increase our efforts on Generation 7 products and launch development programs for
Generation 7.5 products; and
    Expand our repair product offering. We will continue to invest in research and development to maintain technology leadership in
our products. Our customers must continually improve their display quality performance and
production costs in order to be successful in the display market. To meet our customers needs, we
must improve our product performance in defect detection, repair success, cost of ownership, ease
of use and throughput for each of our product generations. Selling, General and Administrative Three MonthsEnded December 31,(dollars in millions)2004
    
    
    Change
    
    
    2003Expense
    
    $
    4.7
    
    
    
    2
    %
    
    $
    4.6Percent of Revenue
    
    
    13
    %
    
    
    
    
    
    
    18
    %
 Our selling, general and administrative expenses consisted primarily of salaries and related
expenses for marketing, sales, finance, administration and human resources personnel, accounting,
commissions, insurance, legal and other corporate expenses. Selling, general and administrative
expenses were relatively flat in absolute dollars in the three month period ended December 31, 2004
compared to the same period in the prior fiscal year. We expect these expenses to increase
significantly in our second quarter of fiscal 2005. We expect our selling, general and
administrative expenses in fiscal 2005 to be higher in absolute dollars as compared to fiscal 2004
due to investments we intend to make in the marketing area and compliance with Section 404 of the
Sarbanes-Oxley Act of 2002. Amortization of Intangibles 23




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Three MonthsEnded December 31,2004
    
    
    Change
    
    
    2003Expense
    
    $
    397,000
    
    
    
    98
    %
    
    $
    201,000Percent of Revenue
    
    
    1
    %
    
    
    
    
    
    
    1
    %
 The increase in amortization expense for the three months ended December 31, 2004 is due
primarily to the purchase of assets from Tucson Optical Research Corporation in August 2004 and the
purchase of assets from Quantum Composers in June 2004. Based on intangible assets recorded at
December 31, 2004, and assuming no subsequent additions to, or impairment of the underlying assets,
we expect our quarterly amortization to remain in the $400,000 range for the remainder of fiscal
2005. Impairment of Goodwill, Purchased Intangibles and Fixed Assets As discussed in the overview and critical accounting policies above, we have exited all
business lines other than the flat panel display products market and have suspended operations in
the LTPS and inverter markets. As a result, in the three months ended December 31, 2003, we took
impairment charges for the remaining goodwill of $665,000 and purchased intangible assets of $2.1
million related to these prior acquisitions and long-lived assets of $234,000. At December 31,
2004, remaining balances for goodwill of $153,000 relates to our acquisition of assets from Summit
Imaging and purchased intangible assets of $4.4 million relate to our acquisition of assets from
Summit Imaging, Quantum Composers and Tucson Optical Research Corporation and license agreement
with Ishikawajima-Harima Heavy Industries Co., Ltd. Interest Income and Other, Net Three MonthsEnded December 31,(dollars in millions)2004
    
    
    Change
    
    
    2003Income
    
    $
    1.3
    
    
    
    (67
    )%
    
    $
    3.8Percent of Revenue
    
    
    4
    %
    
    
    
    
    
    
    15
    %
 Interest income and other, net consisted primarily of interest income, foreign currency
exchange gains and losses, changes in the fair value of derivative financial instruments and other
miscellaneous income and expense. The lower level of interest income and other, net, in the first
quarter of fiscal 2005 as compared to the first quarter of fiscal 2004, was primarily attributable
to having received a one-time technology license fee resulting from a litigation settlement in the
first quarter of fiscal 2004, the terms of which are confidential. Provision for Income Taxes Three MonthsEnded December 31,2004
    
    
    Change
    
    
    2003Expense
    
    $
    39,000
    
    
    
    (89
    )%
    
    $
    362,000Percent of Revenue
    
    
    0
    %
    
    
    
    
    
    
    2
    %
 The effective tax rates for the three month periods ended December 31, 2004 and 2003 were 14%
and 28%, respectively. Our provision for income taxes for the three months ended December 31, 2003
included a foreign withholding tax related to the resolution of the technology license fee
litigation settlement. The effective tax rate in both periods is lower than the statutory rate due
to tax benefits arising from net operating losses. The effective tax rate is a combination of
foreign income taxes and domestic alternative minimum taxes. Our future effective income tax rate depends on various factors, such as tax legislation, the
geographic composition of our pre-tax income, amount of and access to tax loss carryforwards,
expenses incurred in connection with acquisitions that are not deductible for tax purposes, amounts
of tax-exempt interest income and research and development credits as a percentage of aggregate
pre-tax income, and the effectiveness of our tax planning strategies. Discontinued Operations Three MonthsEnded December 31,2004
    
    
    2003Income (loss)
    
    $
    (6,000
    )
    
    $
    47,000
 24




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In January 2003, we implemented a plan to exit the printed circuit board assembly inspection
business. In June 2003, we implemented a plan to exit the cathode ray tube display and high quality
glass inspection business. The loss from discontinued operations related to the disposition of
these businesses for the three months ended December 31, 2004 and 2003 were not material and we do
not expect losses from these businesses to be material in the foreseeable future. Liquidity and Capital Resources We have financed our growth primarily by a combination of cash flows from operations and
public stock offerings. Working capital was $134.3 million as of December 31, 2004, compared to
$133.7 million as of September 30, 2004. A major component of working capital is $99.4 million of
cash, cash equivalents and short-term investments as of December 31, 2004, compared to $84.1
million as of September 30, 2004. Operating Activities of Continuing Operations Cash provided by operating activities from continuing operations was $15.7 million in the
first three months of fiscal 2005. In the first quarter of fiscal 2005, cash was provided by net
income adjusted for non-cash related items. We generated $14.0 million of cash by reducing our
investment in working capital, the primary sources being: (a) a decrease of approximately $22.5
million in our net accounts receivable, resulting primarily from collections on the September 30,
2004 balance and from sales decreasing from approximately $53.8 million in the fourth quarter of
fiscal 2004 to approximately $36.4 million in our first quarter of fiscal 2005, and the timing of
shipments in our first quarter; and (b) an increase of approximately $2.0 million in our net
inventory partially offset by a $6.5 million decrease in accounts payable primarily related to
inventory purchases. Investing Activities of Continuing Operations Cash used in investing activities from continuing operations was $7.3 million in the first
three months of fiscal 2005. Cash used in investing activities in the first quarter of fiscal 2005
was primarily the result of approximately $6.4 million of net purchases of short-term investments
and capital expenditures of $922,000. Financing Activities of Continuing Operations Cash
provided by financing activities was $499,000 in the first three
months of fiscal 2005 resulting solely from sales of our common stock under our employee equity compensation plans. The
timing of and amounts received from employee stock option exercises are dependent upon the
decisions of the respective option holders, and are not controlled by us. Therefore, funds raised
from the issuance of common stock upon the exercise of employee stock options should not be
considered an indication of additional funds to be received in future periods. In March 2000, we entered into a bank line of credit which had an initial term of one year. We
have renegotiated the line of credit on an annual basis and currently have a $4.0 million borrowing
capacity on the line of credit with an interest rate of floating prime, expiring in October 2005.
The line of credit is secured by substantially all of our assets and contains certain financial and
other covenants. At December 31, 2004, no amounts were outstanding under the line of credit and we
are in compliance with all covenants. We currently expect that upon expiration of the line of
credit, we will seek to renew it. Operating, Investing and Financing Activities of Discontinued Operations In January 2003, we implemented a plan to exit the printed circuit board assembly inspection
business and in June 2003, we implemented a plan to exit the cathode ray tube display and high
quality glass inspection business. Accordingly, the operating results of these business segments
have been reclassified as discontinued operations. Net cash provided by (used in) discontinued
operations, consisting primarily of changes in working capital balances, during the three month
period ended December 31, 2004 and 2003 is as follows: Three Months EndedDecember 31,2004
    
    
    2003(in thousands)Printed circuit board business
    
    $
    (94
    )
    
    $
    397Cathode ray tube display and high quality glass inspection business
    
    
    144
    
    
    
    256Net cash provided by discontinued operations
    
    $
    50
    
    
    $
    653
 25




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##### Table of Contents



Contractual Obligations The following table summarizes the approximate contractual obligations that we have at
December 31, 2004. Such obligations include both non-cancelable obligations and other obligations
that are generally non-cancelable except under certain limited conditions. Payments Due by Fiscal YearContractual Obligations
    
    Total
    
    
    2005
    
    
    2006
    
    
    2007
    
    
    2008
    
    
    2009
    
    
    Thereafter(in thousands)Notes payable
    
    $
    2,638
    
    
    $
    1,255
    
    
    $
    1,383
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Operating lease obligations
    
    
    18,019
    
    
    
    2,802
    
    
    
    3,533
    
    
    
    3,007
    
    
    
    2,652
    
    
    
    2,627
    
    
    
    3,398Purchase obligations
    
    
    25,604
    
    
    
    20,515
    
    
    
    1,568
    
    
    
    2,805
    
    
    
    715
    
    
    
    1
    
    
    
    Total
    
    $
    46,261
    
    
    $
    24,572
    
    
    $
    6,484
    
    
    $
    5,812
    
    
    $
    3,367
    
    
    $
    2,628
    
    
    $
    3,398
 In August 2003, we signed a lease agreement for a 128,520 square-foot building in San Jose,
California into which we consolidated our former San Jose facilities, effective January 5, 2004.
The lease on our prior San Jose location terminated concurrently with the inception date of the new
lease. The new facility is leased under a non-cancelable operating lease that expires in 2010, with
two renewal options at fair market value for additional five year periods and is reflected in the
operating lease obligations in the table above. We maintain certain open inventory purchase commitments with our suppliers to help provide a
smooth and continuous supply chain for key components. Our liability in these purchase commitments
is generally restricted to purchase commitments over a forecasted time horizon as mutually agreed
upon between the parties and is reflected in purchase obligations in the table above. The
majority of these purchase commitments are covered by confirmed customer orders. Working Capital We believe that cash generated from operations, together with the liquidity provided by
existing cash balances and borrowing capability, will be sufficient to meet our operating and
capital requirements and obligations for at least the next twelve months. However, this
forward-looking statement is based upon our current plans and assumptions, which may change, and
our capital requirements may increase in future periods. In addition, we believe that success in
our industry requires substantial capital in order to maintain the flexibility to take advantage of
opportunities as they may arise. We may, from time to time, invest in or acquire complementary
businesses, products or technologies and may seek additional equity or debt financing to fund such
activities. There can be no assurance that such funding will be available to us on commercially
reasonable terms, if at all, and if we were to proceed with acquisitions without this funding or
with limited funding it would decrease our capital resources. The sale of additional equity or
convertible debt securities could result in dilution to our existing shareholders. Impact of Accounting Pronouncements In December 2004, the FASB issued SFAS 123 (revised 2004), Share-Based Payment. SFAS 123R
requires measurement of all employee stock-based compensation awards using a fair value method and
the recording of such expense in the consolidated financial statements. In addition, the adoption
of SFAS 123R will require additional accounting related to the income tax effects and additional
disclosure regarding the cash flow effects resulting from share-based payment arrangements. SFAS
123R is effective beginning in our fourth quarter of fiscal 2005. We are evaluating the
requirements of SFAS 123R and we expect that the adoption of SFAS 123R will have a material impact
on our results of operations and financial condition. We have not yet determined whether the
adoption of SFAS 123R will result in stock-based compensation charges that are similar to the
current pro forma disclosures under SFAS 123. In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43,
Chapter 4. SFAS No. 151 clarifies that abnormal inventory costs such as costs of idle facilities,
excess freight and handling costs, and wasted materials (spoilage) are required to be recognized as
current period charges. The provisions of SFAS No. 151 are effective for fiscal periods beginning
after June 15, 2005. The adoption of SFAS No. 151 is not expected to have material impact on our
consolidated results of operations, financial position or cash flows. In March 2004, the Emerging Issues Task Force (EITF) reached a consensus on recognition and
measurement guidance previously discussed under EITF Issue No. 03-01, The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments. (EITF 03-01). The
consensus clarifies the meaning of other-than temporary impairment and its application to
investments in debt and equity securities, in particular investments within the scope of FASB
Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, and
investments accounted for under the cost method. In September 2004, the Financial Accounting
Standards Board approved the issuance of a FASB staff position to delay the requirement to record
impairment 26




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losses under EITF 03-1. The approved delay applies to all securities within the scope of EITF
03-01 and is expected to end when new guidance is issued and comes into effect. Adoption of this
consensus is not expected to have a material impact on our consolidated results of operations,
financial position or cash flows. Factors Affecting Operating Results We have sustained losses and we may sustain losses in the future. We reported net losses for each of the fiscal years ended September 30, 2003 and 2002.
Although we reported profits in each of the four quarters of fiscal 2004 and in the first quarter
of fiscal 2005, in the future our revenue may decline, remain flat or grow at a rate slower than
expected. We recently announced that we expect a net loss in the second quarter of fiscal 2005
primarily due to uncertainty in the timing of a major customers acceptance for our test, repair
and inspection equipment. Our ability to maintain profitability is dependent in part on the
success of our efforts to increase revenues and to reduce operating expenses as a percentage of
revenue through our ongoing cost-cutting measures and our gross margin improvement programs.
However, we recently increased our manufacturing capacity to meet greater demand for our products,
and this has caused us to experience increased operating expenses. In
addition, we expect our selling, general and administrative expenses
in fiscal 2005 to be higher in absolute dollars as compared to fiscal
2004 due to investments we intend to make in the marketing area and
compliance with section 404 of the Sarbanes-Oxley Act of 2002. If the increase in demand for
our products is not sustained, or if we are not able to increase our manufacturing capacity in a
cost-efficient manner, this would impair our ability to maintain our recently achieved
profitability. For all of these reasons, there is no assurance that we will be successful in
achieving or maintaining increased revenue, reduced operating expenses, positive cash flows or
profitability. Our operating results are difficult to predict and may vary from investors expectations, which
could cause our stock price to fall. We have experienced, and expect to continue to experience, significant fluctuations in our
quarterly results. Consequently, past financial results may not be indicative of future financial
results. A substantial percentage of our revenue is derived from the sale of a small number of
yield management systems ranging in price from $400,000 to $3.4 million. Therefore, the timing of
the sale of a single system could have a significant impact on our quarterly results. After we ship
our products, customers may reject or delay acceptance, which would adversely impact our revenues.
Moreover, customers may cancel or reschedule shipments, and production difficulties could delay
shipments. For example, in the fourth quarter of 2004, we incurred additional costs such as
expedite fees, premiums and delivery penalties in an effort to meet customer delivery schedules and
quality related costs such as rework and higher warranty. In December 2002, we experienced
technical delays with respect to the introduction of our next generation ArrayChecker 3500 system.
This delay had a significant impact on the timing of both our revenue and net income for the second
quarter of fiscal 2003. 27




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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;
    global economic uncertainty;
    changing international economic conditions;
    worldwide political instability;
    our ability to design, manufacture and introduce new products on a cost-effective and timely basis;
    the delay between expenses to further develop marketing and service capabilities and
the realization of benefits from those improved capabilities; and
    the introduction of new products by our competitors. Our operating results also could be affected by sudden changes in customer requirements,
currency exchange rate fluctuations and other economic conditions affecting customer demand and the
cost of operations in the global markets in which we do business. As a result of these or other
factors, our operating results could be significantly and adversely affected and our stock price
could decline. In addition, it is possible that in some future quarter our operating results may be
below the expectations of public market analysts and investors, which could cause our stock price
to fall. If our products experience performance, reliability or quality problems, our customers may reduce
their orders. We believe that future orders of our products will depend in part on our ability to satisfy
the performance, reliability and quality standards required by our customers. Particularly as
customers seek increased yields, greater throughput and higher quality end products, we must
continually redesign our products to meet the needs of our customers. As with the introduction of
any new product, our customers may experience yield loss. For example, with our ArraySaver 650,
ArrayChecker 3628 and ArrayChecker 3500, certain customers experienced yield loss higher than
expected when the products were first introduced. If our products have performance, reliability or
quality problems, then we may experience:  
    delays in collecting accounts receivable;
    reduced orders;
    additional 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. Warranty claim expense may, at times, exceed the estimated cost
of warranty coverage we record in our warranty provision. For example, in our fourth quarter of
fiscal 2004, we incurred higher warranty costs and recorded incremental warranty provisions to
cover certain identified quality problems. In the future, we may incur substantial warranty claim
expenses on our products and actual warranty claims may exceed recorded allowances, resulting in
harm to our business. 28




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##### Table of Contents



Capital investment by manufacturers of flat panel display products can be highly cyclical and may
decline in the future. Our business depends in large part on capital expenditures by manufacturers of flat panel
display products, which in turn depends on the current and anticipated market demand for the end
products in that industry. The market for flat panel display products is highly cyclical and has
experienced periods of oversupply resulting in significantly reduced demand for capital equipment.
For example, the flat panel display industry experienced a downturn in 1998, which led many flat
panel display manufacturers to delay or cancel capital expenditures. Additionally, in 2001, due to
the general deteriorating economic environment, flat panel display manufacturers reduced capital
expenditures resulting in a decrease in our revenue. In fiscal 2004, we saw AMLCD product supply
exceed demand. Though this oversupply has been moderated given the panel price decreases, it has
resulted in a slowdown in capacity increases, with flat panel display manufacturers pressing
forward with carefully considered new capacity investments. If the flat panel display markets in which we sell our products experience further slowdowns
in the future, it could cause our revenue to decrease significantly. We do not control the timing
or volume of orders placed by our customers. Whether and to what extent our customers place orders
for any specific products, as well as the mix and quantities of products included in those orders,
are factors beyond our control. Insufficient orders, especially in a down cycle, will result in
under-utilization of our manufacturing facilities and infrastructure and will negatively affect our
operating results and financial condition. In addition, the need to invest in the engineering,
research and development, and marketing required to penetrate targeted foreign markets and maintain
extensive service and support capabilities limits our ability to reduce expenses during these
downturns. We depend on sales to a few large customers in the flat panel display industry, and if we lose any
of our large customers our revenue could decrease significantly. The flat panel display industry is extremely concentrated with a small number of manufacturers
producing the majority of the worlds flat panel displays. If one or more of our major customers
ceased or significantly curtailed their purchases, our revenue could drop significantly. We may be
unable to replace sales to these customers. Sales to our greater than 10% customers in the first
quarter of fiscal 2005 and 2004 is as follows: our top four customers accounted for 96% of our revenue in the first three months of fiscal 2005;
and our top five customers accounted for 93% of our revenue in the first three months of fiscal
2004. We rely upon sales of a limited range of products, and if demand for one product decreases for any
reason it could cause our revenue to decline significantly. All of our revenue is expected to come from a limited range of products for the flat panel
display industry. As a result, we are solely reliant on the flat panel display industry. Any
decline in demand for, or failure to achieve continued market acceptance of, our primary products
or any new version of these products could harm our business. Continued market acceptance of our
array test, array repair and cell and module inspection products is critical to our success. We may not be able to develop and introduce new products that respond to evolving industry
requirements in a timely manner, which could reduce our ability to compete effectively. The markets for our products are characterized by rapidly changing technologies and frequent
new product introductions. The failure to develop new products and introduce them successfully and
in a timely manner could harm our competitive position and results of operations. We believe that
our future success will depend in part upon our ability to continue to enhance our existing
products and to develop and manufacture new products. For example, the size of glass plates for
flat panel displays and the resolution of flat panel displays have changed frequently and may
continue to change, requiring us to redesign or reconfigure our flat panel display products. We expect to continue to incur significant research and development costs. There can be no
assurance that we will be successful in the introduction, marketing and cost effective manufacture
of any of our new products, that we will be able to timely develop and introduce new products and
enhance our existing products and processes to satisfy customer needs or achieve market acceptance,
or that the new markets for which we are developing new products or expect to sell current products
will develop sufficiently. For example, we experienced technical delays relating to the
introduction of our ArrayChecker 3500 system causing us to reschedule several shipments from the
first quarter to the second quarter of fiscal 2003. In addition, beginning in the third quarter of
fiscal 2004, initial shipments of the Generation 7 ArrayChecker, ArraySaver and PanelMaster
systems were shipped later than the customers requested delivery dates. In addition, we depend on close relationships with our customers and the willingness of those
customers to share information with us, and the failure to maintain these relationships could harm
our product development efforts. 29




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If we are not able to obtain critical components from our single or limited source suppliers, we
may experience significant delays in producing our products, which could decrease our revenue for
an extended period of time. We obtain some equipment for our systems from a single source or a limited group of suppliers.
For example, we currently obtain materials handling platforms from a single source supplier.
Although we seek to reduce dependence on our sole and limited source suppliers, alternative sources
of supply for this equipment may not be available or may be available on unfavorable terms. The
partial or complete loss of our sole and limited source suppliers could significantly delay
our shipments or otherwise harm our results of operations and damage customer relationships.
Further, a significant increase in the price of one or more of these pieces of equipment could harm
our results of operations. All of our revenue is derived from sales to companies located outside the United States, which
exposes us to risks that we would not experience with domestic sales. We expect sales to customers in foreign countries to continue to represent 100% of our revenue
in the foreseeable future. A number of factors may adversely affect our international sales and
operations, including:  
    political instability and the possibility of hostilities, terrorist attacks, or war;
    imposition of governmental controls;
    fluctuations in interest and currency exchange rates;
    export license requirements;
    restrictions on the export of technology;
    limited foreign protection of intellectual property rights;
    trade restrictions;
    periodic or local international downturns;
    changes in tariffs; and
    difficulties in staffing and managing international operations. If any of these factors occur, our operating results and revenue could be materially and
adversely affected. Compliance with new reporting requirements may strain our resources and we may be unable to
implement in a timely manner additional finance and accounting systems, procedures and controls in
the future to satisfy new reporting requirements, which could cause our stock price to fall. Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we will be required, beginning with
our Annual Report on Form 10-K for our fiscal year 2005, to perform an evaluation of our internal
control over financial reporting and have our auditor publicly attest to such evaluation. We have
prepared an internal plan of action for compliance, which includes a timeline and scheduled
activities, although as of the date of this filing we have not yet prepared the evaluation.
Compliance with these requirements is expected to be expensive and time-consuming. If we are unable
to complete the required assessment as to the adequacy of our internal control reporting or if our
independent registered public accounting firm is unable to provide us with an unqualified report as
to the effectiveness of our internal controls over financial reporting, we could be subject to
regulatory scrutiny and a loss of public confidence in our internal control over financial
reporting. In addition, any failure to implement required new or improved controls, or difficulties
encountered in their implementation, could harm our operating results or cause us to fail to meet
our reporting obligation and result in a decline of our stock price. We may have difficulty integrating the businesses or assets we have acquired and may acquire in the
future, and we may not realize the benefits that we expect from these acquisitions. In addition to our efforts to develop new technologies from internal sources, we also may seek
to acquire new technologies from external sources. For example, in August 2004, we acquired all of
the assets relating to the design and manufacture of pellicle products used in our modulators from
Tucson Optical Research Corporation. In June 2004, we acquired from Quantum Composers, Inc. all of
the assets related to the design and manufacture of laser assembly products for our repair systems.
In May 2003, we acquired all of the 30




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##### Table of Contents



assets of Summit Imaging related to the design and manufacture of cooled cameras. All three
of these acquisitions were to purchase technology that we use in our products, so that we are not
dependent on independent suppliers to provide the technology and related components. In the future,
we may make additional acquisitions of, or significant investments in, businesses with
complementary products, services and/or technologies. Integrating businesses can be a complex,
time-consuming and expensive process. If we are not able to do so effectively, we will not be able
to realize the benefits that we expect to receive from either our past or future acquisitions. For
each acquisition, we must integrate separate technologies, product lines, business cultures and
practices, employees and systems. Acquisitions are subject to numerous risks, including:  
    difficulty in the assimilation of the technologies and products of the acquired company;
    entering markets in which we have no or limited direct prior experience;
    loss of key customers of the acquired company;
    diversion of management resources from the business of the combined company;
    incompatibility of business cultures or practices;
    loss of key employees of the acquired company;
    costs and delays in implementing common systems and procedures;
    potential inefficiencies in delivering services to the customers of the combined company; and
    assumption of unknown or undisclosed liabilities. Any of these difficulties could increase our operating costs or result in impairment of
purchased assets, which could harm our financial performance. In addition, we may also elect to change our strategic direction and may no longer have need
for the acquired businesses or technologies. For example, in 2004 we determined not to pursue new
business for RTP Systems acquired from Intevac Corporation in November 2002. In 2003, we exited the
printed circuit board assembly inspection and high quality glass inspection businesses. As a
result, some or all of the technologies acquired in connection with certain of our prior
acquisitions have been abandoned. In the third quarter of fiscal 2004, we sold all of our assets
related to our TFT-LCD backlight inverter business. Future acquisitions may also result in
potentially dilutive issuances of equity securities, incurrence of debt and contingent liabilities
and amortization expenses related to acquired intangible assets, which could harm our
profitability. Any failure of, or other problems at or with, our third party manufacturers could delay shipments
of our flat panel display products, harm our relationships with our customers or otherwise
negatively impact our business. We use a wide range of materials in the production of our products, including custom
electronic and mechanical components, and we use numerous suppliers to supply these materials. If
any third party that we use to manufacture our products is unable to satisfy our quality
requirements or provide us with the products and services in a timely manner, our shipments of
these products may be delayed, our customer relationships may be harmed and our results of
operations may be adversely impacted. There can be no assurance that our relationship with any
third party that we use to manufacture our products will result in a reduction of our expenses or
enable us to satisfy our customers quality requirements or to deliver our products to our
customers in a timely manner. If we do not compete effectively in our target markets, we will lose market share. The markets for yield management systems in the flat panel display industry are highly
competitive. We face substantial competition from established competitors that have greater
financial, engineering and manufacturing resources than us and have larger service organizations
and long-standing customer relationships. Our competitors can be expected to continue to improve
the design and performance of their products and to introduce new products with competitive price
and performance characteristics. Competitive pressures may force price reductions that could harm
our results of operations. Our customers may also develop technology and equipment that may reduce
or eliminate their need to purchase our products. Although we believe we have certain technological
and other advantages over our competitors, maintaining and capitalizing on these advantages will
require us to continue a high level of investment in engineering, research and development,
marketing and customer service support. There can be no assurance that we will have sufficient
resources to continue to make these investments or that we will be able to make the technological
advances necessary to maintain our competitive advantages. 31




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Our success depends in large part on the strength of the active matrix liquid crystal display in
the flat panel display industry. 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. We derive 100% of our revenue
from flat panel display products, substantially all of which were based on the active matrix liquid
crystal display technology. An industry shift away from active matrix liquid crystal display
technology to existing or new competing technologies could reduce the demand for our existing
products and require significant expenditures to develop new products, each of which could harm our
business. Our business could be harmed if we fail to properly protect our intellectual property. Our success depends largely on our ability to protect our intellectual property. While we
attempt to protect our intellectual property through patents, copyrights and trade secrets in the
United States and other countries, there can be no assurance that we will successfully protect our
technology or that competitors will not be able to develop similar technology independently. We
cannot assure you that the claims allowed on any patents held by us will be sufficiently broad to
protect our technology against competition from third parties with similar technologies or
products. In addition, we cannot assure you that any patents issued to us will not be challenged,
invalidated or circumvented or that the rights granted there under will provide competitive
advantages to us. Moreover, the laws of some foreign countries do not protect intellectual property
rights to the same extent as the laws of the United States, and we could experience various
obstacles and high costs in protecting our intellectual property rights in foreign countries. If we
are unable to obtain or maintain these protections, we may not be able to prevent third parties
from using our intellectual property. We also rely on trade secrets, proprietary know-how and continuing technological innovation to
remain competitive. We have taken measures to protect our trade secrets and know-how, including the
use of confidentiality agreements with our employees. It is possible that these agreements may be
breached and that the available remedies for any breach will not be sufficient to compensate us for
damages incurred. Litigation may be necessary to enforce or defend against claims of intellectual property
infringement, which could be expensive and, if we lose, could prevent us from selling our products. Litigation may be necessary in the future to enforce our patents and other intellectual
property rights, to protect our trade secrets or to determine the validity and scope of the
proprietary rights of others. Any litigation, regardless of the outcome, could be costly and
require significant time and attention of key members of our management and technical personnel. Our domestic and international competitors, many of which have substantially greater resources
and have made substantial investments in competing technologies, may have patents that will
prevent, limit or interfere with our ability to manufacture and sell our products. We have not
conducted an independent review of patents issued to third parties. Third parties may assert
infringement claims, successful or otherwise, against us, and litigation may be necessary to defend
against claims of infringement or invalidity. An adverse outcome in the defense of a patent suit
could subject us to significant liabilities to third parties, require disputed rights to be
licensed from third parties or require us to cease selling our products. Even successful defenses
of patent suits can be costly and time-consuming. We must attract and retain key employees and our management team and employees must work
effectively together to maintain and grow our business. Our future success depends in part on our ability to retain key personnel, particularly senior
management and engineers. We also need to attract additional skilled personnel in significant areas
of our business to grow. There can be no assurance that we will be able to retain our existing
personnel or attract additional qualified employees in the future. We generally do not have
employment contracts with our employees and do not maintain key person life insurance on any of our
employees. 32




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##### Table of Contents



Terrorism and international political instability may negatively affect our operations. The threat of terrorism targeted at the regions of the world in which we do business increases
the uncertainty in our markets and may delay any recovery in the general economy, which could
threaten our business. Increased international political instability, particularly resulting from the threat of
terrorist attacks, and further enhanced security measures as a result of the threat of terrorist
attacks may hinder our ability to do business and may increase our costs of operations. Such
continuing instability could cause us to incur increased costs in transportation, make such
transportation unreliable, increase our insurance costs and cause international markets to
fluctuate. This instability could have the same effects on our suppliers and their ability to
timely deliver their products to us. If this international political instability continues or
increases, our business and results of operations could be harmed. Our manufacturing facilities may be subject to disruption from natural disasters. Operations at our manufacturing facilities are subject to disruption for a variety of reasons,
including work stoppages, acts of war, terrorism, fire, earthquake, energy shortages, flooding or
other natural disasters. Our corporate and manufacturing facilities in California are located near
major earthquake faults, which have experienced earthquakes in the past. Such disruption could
cause delays in shipments of products to our customers. We cannot ensure that alternate production
capacity would be available if a major disruption were to occur or that, if it were available, it
could be obtained on favorable terms. Such disruption could result in cancellation of orders or
loss of customers and could seriously harm our business. It could also significantly delay our
research and engineering efforts for the development of new products, most of which is conducted at
our California facilities. In addition, some of our customers in Asia are located near fault lines. A major earthquake in
Asia could disrupt our operations or the operations of our customers, which could reduce demand for
our products. Our stock price may fluctuate significantly. The market price of our common stock could fluctuate significantly in response to variations
in quarterly 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 industry 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. 33




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New regulations related to equity compensation will negatively impact our financial statements and
could adversely affect our ability to attract and retain key personnel. Since our inception, we have used stock options and other long-term equity incentives as a
fundamental component of our employee compensation packages. We believe that stock options and
other long-term equity incentives directly motivate our employees to maximize long-term stockholder
value and, through the use of vesting, encourage employees to remain with Photon Dynamics. The
Financial Accounting Standards Board (FASB) has announced changes to U.S. generally accepted
accounting principles that will require us to record charges to earnings for employee stock option
grants. These rules become effective in the fourth quarter of fiscal 2005. We believe this
accounting standard will negatively impact our earnings. For example, recording a charge for
employee stock options under Statement of Financial Accounting Standards No. 123, Accounting for
Stock-Based Compensation would have decreased net income by $1.9 million and $1.9 million for the
first quarter of fiscal 2005 and 2004, respectively. See Note 1 to the Notes to Condensed
Consolidated Financial Statements  Summary of Significant Accounting Policies  Stock-Based
Compensation Plans. In addition, new regulations implemented by The Nasdaq National Market
requiring shareholder approval for all stock option plans, as well as new regulations implemented
by the New York Stock Exchange prohibiting NYSE member organizations from giving a proxy to vote on
equity-compensation plans unless the beneficial owner of the shares has given voting instructions,
could make it more difficult for us to grant options to employees in the future. To the extent that
new regulations make it more difficult or expensive to grant stock options to employees, we may
incur increased compensation costs, change our equity compensation strategy or find it difficult to
attract, retain and motivate employees, each of which could materially and adversely affect our
business. 
 ITEM 3.Quantitative and Qualitative Disclosures About Market Risk Foreign Currency Exchange Rate Risk We are exposed to changes in foreign currency exchange rates primarily related to the
operating results of our foreign affiliates. Actual changes in foreign exchange rates could
adversely affect our operating results or financial condition. The potential impact depends upon
the magnitude of the rate change. In fiscal 2004, approximately $4.4 million of our revenue was
denominated in currencies other than U.S. dollars, all of which was
in Japanese yen, and, at September 30, 2004, approximately $13.2 million of our accounts receivable was denominated in currencies other than
U.S. dollars, all of which was in Japanese yen. In the three months ended December 31, 2004,
approximately $11.5 million of our revenue was denominated in currencies other than U.S. dollars, all of
which was in Japanese yen. At December 31, 2004, approximately $11.8 million of our accounts
receivable was denominated in currencies other than U.S. dollars, all of which was in Japanese yen. Our accounts receivable denominated in currencies other than U.S. dollars are subject to
exchange rate risk and can fluctuate with the changes in exchange
rates. A hypothetical 10%
immediate and uniform adverse move in all currency exchange rates affecting the accounts receivable
from the rates at December 31, 2004 would have decreased the fair value of the accounts receivable
by approximately $1.3 million. A hypothetical 10% immediate and
uniform adverse move in all currency exchange rates affecting the
accounts receivable from the rates at September 30, 2004 would
have decreased the fair value of the accounts receivable by
approximately $1.5 million. Although a relatively considerable portion of our revenue and accounts receivable for the
three months ended December 31, 2004 was denominated in currencies other than U.S. dollars, we
expect that our cash, accounts receivable and accounts payable generally will be denominated in
U.S. dollars and, therefore, our exposure to changes in foreign currency exchange rates for our cash, accounts
receivable and accounts payable is limited. Market Risk Our market risk as described under the heading Market Risk in Item 7A of our Annual Report
on form 10-K for the fiscal year ended September 30, 2004, have not changed significantly. 
 ITEM 4.Controls and Procedures Evaluation of Disclosure Controls and Procedures.Based on our managements evaluation (with
the participation of our chief executive officer and chief financial officer), as of the end of the
period covered by this report, our chief executive officer and chief financial officer have
concluded that, subject to limitations described below, our disclosure controls and procedures (as
defined in Securities Exchange Act Rules 13a-15(e) and 15d-15(e)) are effective to provide
reasonable assurance that the information required to be disclosed by us in reports that we file or
submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported
within the time periods specified in Securities and Exchange Commission rules and forms. Efforts
to Address Existing Material Weaknesses and Other Deficiencies.In our Annual Report
on Form 10-K filed on December 14, 2004 for our fiscal year ended September 30, 2004, we disclosed
that in connection with our year end close and audit processes, a number of issues were discovered,
which resulted in adjustments in our financial statements. Further analysis of the 34




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nature of the adjustments and the associated internal controls led us to conclude that these
adjustments were the result of material weaknesses in our internal controls over the financial
close process. The material weaknesses consist of failures to ensure:  an appropriate level of review of those significant financial statement accounts
requiring a higher degree of judgment and estimates, in part due to the need for more
personnel as well as more highly skilled and trained personnel in certain positions;  a formal review process of the financial statements and supporting schedules of our
international subsidiaries; and  consistent processes and controls over revenue transactions entered into and recorded
by our Japanese subsidiary with those processes and controls in place in the U.S. In addition to the material weaknesses identified above, we also identified a number of
internal control deficiencies that we have concluded do not constitute material weaknesses. As
part of our financial close process for the quarter ended December 31, 2004, no additional material
weaknesses or other internal control deficiencies were identified. We have taken a number of steps to remediate the above material weaknesses and otherwise
strengthen our internal controls over financial reporting. We have contracted with several
independent consultants to help manage the workload associated with the increasing demands in
preparation for our fiscal year 2005 compliance with Section 404 of the Sarbanes Oxley Act of 2002
and to help with the financial close process. These additional
resources are intended to allow certain members of our
financial staff adequate time to perform a more detailed level of review of the financial
statements and supporting documentation, including a more
comprehensive review process of the financial statements and
supporting schedules of our international subsidiaries. These resources were contracted late in the quarter ended
December 31, 2004 and as a result did not make a significant contribution in our financial close
for the quarter. During the quarter ended December 31, 2004, we also added personnel in the area
of cost accounting and provided additional training to our personnel in certain areas where we had
identified deficiencies. We continue to have active searches underway for qualified candidates in
the areas of general and international accounting. In the quarter ended December 31, 2004, we expanded our domestic review of revenue
transactions in Japan, including instituting certain procedures for review of revenue in Japan that
are consistent with those procedures utilized for revenue review in the U.S. We plan to strengthen
our accounting capability in all of our major international locations in the second quarter of
fiscal year 2005 through a combination of added personnel, training and more in-depth reviews of
financial results. We currently expect that the material weaknesses and internal control deficiencies we
previously identified will be fully remediated by the end of our second quarter of fiscal year
2005. However, there are risks associated with these remediation efforts, including certain
variables not directly under our control, such as our ability to hire qualified personnel on a
timely basis, that could delay our efforts to remediate these weaknesses. Changes in Internal Control over Financial Reporting.Other than as set forth above, there
was no change in our internal control over financial reporting during the quarter ended December
31, 2004, that has materially affected, or is reasonably likely to materially affect, our internal
control over financial reporting. Limitations on the Effectiveness of Disclosure Controls and Procedures.Our management,
including the chief executive officer and chief financial officer, do not expect that our
disclosure controls and procedures or internal control over financial reporting will prevent all
error and all fraud. A control system no matter how well designed and implemented, can provide only
reasonable, not absolute, assurance that the control systems objectives will be met. Further, the
design of a control system must reflect the fact that there are resource constraints, and the
benefits of controls must be considered relative to their costs. Because of the inherent
limitations in all control systems, no evaluation of controls can provide absolute assurance that
all control issues within a company are detected. The inherent limitations include the realities
that judgments in decision-making can be faulty, and that breakdowns can occur because of simple
error or mistakes. Controls can also be circumvented by the individual acts of some persons, by
collusion of two or more people or by management override of the controls. Because of the inherent
limitations in a cost-effective control system, misstatements due to error or fraud may occur and
not be detected. 35




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PART II. OTHER INFORMATION 
 ITEM 1.Legal Proceedings Photon Dynamics and certain of our directors and officers have been named as defendants in a
lawsuit captioned Amtower v. Photon Dynamics, Inc., No. CV797876, filed on April 30, 2001 in the
Superior Court of the State of California, County of Santa Clara. The plaintiff, who previously
served as one of 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, and we again moved
to dismiss the action. On April 21, 2003, the court granted in part and denied in part our motion.
The pleadings have been finalized and certain claims against us and the individual defendants will
proceed. Defendants have filed a motion for summary judgment, which is set for hearing on April 5,
2005, and a trial, if necessary, is scheduled to begin on May 2, 2005. Discovery is ongoing. We
believe the plaintiffs case is without merit and intend to defend this action vigorously. Although
we cannot predict the outcome of this litigation, we believe that any adverse judgment in this
litigation could have a material adverse effect on our financial condition or results of
operations. We have been named as a defendant in a lawsuit captioned Sanmina SCI Corporation v. Photon
Dynamics, Inc., No. CV 013715, filed on February 3, 2004 in the Superior Court of the State of
California, County of Santa Clara. The plaintiff in this action, which previously was a third-party
manufacturer of Photon Dynamics, has asserted several causes of action arising out of our alleged
nonperformance of our manufacturing outsourcing agreement with the plaintiff and is seeking
approximately $3.1 million in compensatory damages and punitive damages in a unknown amount. We
responded to the complaint on March 19, 2004, by filing an answer and cross complaint seeking
damages of at least $135,000. We amended our cross complaint on June 26, 2004. The parties
attempted to mediate this dispute, which attempt was not successful. The parties are currently
engaged in discovery. Although we cannot predict the outcome of this litigation, we believe that an
adverse judgment in this litigation would not have a material adverse effect on our financial
condition or results of operations. From time to time we are subject to other legal proceedings and claims, either asserted or
unasserted, which arise in the ordinary course of business. While the outcome of these other
proceedings and claims cannot be predicted with certainty, management does not believe that the
outcome of any of these legal matters will have a material adverse effect on our results of
operations or financial condition. 
 ITEM 2.Unregistered Sales of Equity Securities and Use of Proceeds None. 
 ITEM 3.Defaults Upon Senior Securities None. 
 ITEM 4.Submission of Matters to a Vote of Security Holders None. 
 ITEM 5.Other Information None. 36




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ITEM 6. Exhibits Exhibits Number
    
    Exhibit3.1(1)
    
    Amended and Restated Articles of Incorporation of the Registrant.3.2(1)
    
    Certificate of Amendment to Articles of Incorporation of the Registrant.3.3(2)
    
    Bylaws of the Registrant and amendments thereto.4.1
    
    Reference is made to Exhibits 3.1, 3.2 and 3.3.10.41
    
    Amendment to Consulting Agreement between the Registrant and Malcolm Thompson dated December 22, 2004.10.42(3)
    
    Cash Compensation Policy for the Registrants outside directors.10.43(4)
    
    Form of Indemnification Agreement to be used between the Registrant and each of its executive officers and directors.31.1
    
    Certification required by Rule 13a-14(a) or Rule 15d-14(a).31.2
    
    Certification required by Rule 13a-14(a) or Rule 15d-14(a).32.1*
    
    Certifications required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United
States Code (18 U.S.C. §1350).
 Key to Exhibits:  (1)
    Previously filed as the like-numbered exhibit to the Registrants Registration Statement on
Form S-1 (Commission File No. 333-76650) as filed with the Securities and Exchange Commission
on January 14, 2002, as amended, and incorporated herein by reference.  (2)
    Previously filed as the like-numbered exhibit to the Registrants Annual Report on Form
10-KSB for the fiscal year ended September 30, 1998 as filed with the Securities and Exchange
Commission on December 18, 1998, and incorporated herein by reference.  (3)
    Previously filed under the heading Change in Compensation of Outside Directors of Item 1.01
of the Registrants Current Report on form 8-K as filed with the Securities and Exchange
Commission on October 25, 2004, and incorporated herein by reference.  (4)
    Previously filed as Exhibit 10.1 to the Registrants Current Report on Form 8-K as filed with
the Securities and Exchange Commission on December 20, 2004, and incorporated herein by
reference.  *
    The certification attached as Exhibit 32.1 accompanies the Quarterly Report on Form 10-Q
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed filed by
the Company for purposes of Section 18 of the Securities Exchange Act of 1934, as amended. 37




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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:
    

/s/
Richard OkumotoBy:
    
    Richard OkumotoChief Financial Officer and Secretary(Duly authorized and principal financial officer)
 Dated: February 9, 2005 38




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Exhibit Index Number
    
    Exhibit3.1(1)
    
    Amended and Restated Articles of Incorporation of the Registrant.3.2(1)
    
    Certificate of Amendment to Articles of Incorporation of the Registrant.3.3(2)
    
    Bylaws of the Registrant and amendments thereto.4.1
    
    Reference is made to Exhibits 3.1, 3.2 and 3.3.10.41
    
    Amendment to Consulting Agreement between the Registrant and Malcolm Thompson dated December 22, 2004.10.42(3)
    
    Cash Compensation Policy for the Registrants outside directors.10.43(4)
    
    Form of Indemnification Agreement to be used between the Registrant and each of its executive officers and directors.31.1
    
    Certification required by Rule 13a-14(a) or Rule 15d-14(a).31.2
    
    Certification required by Rule 13a-14(a) or Rule 15d-14(a).32.1*
    
    Certifications required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United
States Code (18 U.S.C. §1350).
 Key to Exhibits:  (1)
    Previously filed as the like-numbered exhibit to the Registrants Registration Statement on
Form S-1 (Commission File No. 333-76650) as filed with the Securities and Exchange Commission
on January 14, 2002, as amended, and incorporated herein by reference.  (2)
    Previously filed as the like-numbered exhibit to the Registrants Annual Report on Form
10-KSB for the fiscal year ended September 30, 1998 as filed with the Securities and Exchange
Commission on December 18, 1998, and incorporated herein by reference.  (3)
    Previously filed under the heading Change in Compensation of Outside Directors of Item 1.01
of the Registrants Current Report on Form 8-K as filed with the Securities and Exchange
Commission on October 25, 2004, and incorporated herein by reference.  (4)
    Previously filed as Exhibit 10.1 to the Registrants Current Report on Form 8-K as filed with
the Securities and Exchange Commission on December 20, 2004, and incorporated herein by
reference.  *
    The certification attached as Exhibit 32.1 accompanies the Quarterly Report on Form 10-Q
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed filed by
the Company for purposes of Section 18 of the Securities Exchange Act of 1934, as amended. 39