##### Table of Contents









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 June 30, 2005                                                
|          
|OR        
|          
|o          |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934
|          
|           |  | For the transition period
    from           to                                             

Commission file number: 0-27234


PHOTON DYNAMICS, INC.


(Exact name of registrant as specified in its charter)


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

5970 Optical Court


San Jose, California 95138-1400


(Address of principal executive offices including zip
code)


(408) 226-9900


(Registrants telephone number, including area code)


þ o


þ o












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INDEX


|                             |  |                                                                                                                    |    |      |    | 
|---------------------------- |  | ------------------------------------------------------------------------------------------------------------------ | -- | ---- | -- | 
|                             |  |                                                                                                                    |    | Page |   
|                             |  |                                                                                                                    |    |      |   
|PART I FINANCIAL INFORMATION
|Item 1.                      |  | Financial Statements (unaudited)                                                                                   |    |      |    | 
|                             |  | Condensed Consolidated Balance Sheets as of
    June 30, 2005 and September 30, 2004                               |    |      | 3  | 
|                             |  | Condensed Consolidated Statements of
    Operations for the Three and Nine Months Ended June 30,
    2005 and 2004 |    |      | 4  | 
|                             |  | Condensed Consolidated Statements of Cash
    Flows for the Nine Months Ended June 30, 2005 and 2004               |    |      | 5  | 
|                             |  | Notes to Condensed Consolidated Financial
    Statements                                                           |    |      | 6  | 
|Item 2.                      |  | Managements Discussion and Analysis
    of Financial Condition and Results of Operations                          |    |      | 26 | 
|Item 3.                      |  | Quantitative and Qualitative Disclosures
    About Market Risk                                                     |    |      | 51 | 
|Item 4.                      |  | Controls and Procedures                                                                                            |    |      | 51 | 
|                            
|PART II OTHER INFORMATION   
|Item 1.                      |  | Legal Proceedings                                                                                                  |    |      | 54 | 
|Item 2.                      |  | Unregistered Sales of Equity Securities and
    Use of Proceeds                                                    |    |      | 54 | 
|Item 3.                      |  | Defaults Upon Senior Securities                                                                                    |    |      | 54 | 
|Item 4.                      |  | Submission of Matters to a Vote of Security
    Holders                                                            |    |      | 54 | 
|Item 5.                      |  | Other Information                                                                                                  |    |      | 55 | 
|Item 6.                      |  | Exhibits                                                                                                           |    |      | 55 | 
|Signatures                   |  |                                                                                                                    | 56 |     
|EXHIBIT 10.47               
|EXHIBIT 10.48               
|EXHIBIT 10.49               
|EXHIBIT 31.1                
|EXHIBIT 31.2                
|EXHIBIT 32.1                



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##### Table of Contents






PART I. FINANCIAL INFORMATION







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

PHOTON DYNAMICS, INC.





CONDENSED CONSOLIDATED BALANCE SHEETS


|                                     |                                        |                                            |        |            |               |  |        |          |         | 
|------------------------------------ | -------------------------------------- | ------------------------------------------ | ------ | ---------- | ------------- |  | ------ | -------- | ------- | 
|                                     |                                        | June 30,                                   |        |            | September 30, | 
|                                     |                                        | 2005                                       |        |            | 2004          | 
|                                     |                                        |                                            |        |            |               | 
|                                     |                                        |                                            |        | (Restated) |              
|                                     |                                        | (Unaudited)                                |       
|                                     |                                        | (In thousands)                             |       
|ASSETS                              
|Current assets:                      |                                        |                                            |        |            |               |  |        |         
|                                     | Cash and cash equivalents              |                                            | $      | 13,099     |               |  | $      | 25,483   |        
|                                     | Short-term investments                 |                                            |        | 76,312     |               |  |        | 58,672   |        
|                                     | Accounts receivable, net               |                                            |        | 38,654     |               |  |        | 58,341   |        
|                                     | Inventories                            |                                            |        | 22,956     |               |  |        | 31,716   |        
|                                     | Other current assets                   |                                            |        | 5,107      |               |  |        | 4,536    |        
|                                     |                                        |                                            |        |            |               | 
|                                     |                                        | Total current assets                       |        |            | 156,128       |  |        |          | 178,748 | 
|Land, property and equipment, net    |                                        |                                            | 20,393 |            |               |  | 20,337 |         
|Other assets                         |                                        |                                            | 3,800  |            |               |  | 3,909  |         
|Intangible assets, net               |                                        |                                            | 3,578  |            |               |  | 4,753  |         
|Goodwill                             |                                        |                                            | 153    |            |               |  | 153    |         
|                                     |                                        |                                            |        |            |               | 
|                                     |                                        | Total assets                               |        | $          | 184,052       |  |        | $        | 207,900 | 
|                                     |                                        |                                            |        |            |               | 
|                                    
|LIABILITIES AND SHAREHOLDERS EQUITY
|Current liabilities:                 |                                        |                                            |        |            |               |  |        |         
|                                     | Accounts payable                       |                                            | $      | 8,708      |               |  | $      | 18,485   |        
|                                     | Warranty                               |                                            |        | 6,334      |               |  |        | 6,194    |        
|                                     | Other current liabilities              |                                            |        | 9,679      |               |  |        | 10,231   |        
|                                     | Deferred gross margin                  |                                            |        | 10,976     |               |  |        | 11,503   |        
|                                     |                                        |                                            |        |            |               | 
|                                     |                                        | Total current liabilities                  |        |            | 35,697        |  |        |          | 46,413  | 
|Other liabilities                    |                                        |                                            | 1,013  |            |               |  | 1,528  |         
|Commitments and contingencies        |                                        |                                            |        |            |               |  |        |         
|Shareholders equity:                |                                        |                                            |        |            |               |  |        |         
|                                     | Common stock, no par value             |                                            |        | 287,590    |               |  |        | 285,790  |        
|                                     | Accumulated deficit                    |                                            |        | (140,390   | )             |  |        | (126,178 | )      
|                                     | Accumulated other comprehensive income |                                            |        | 142        |               |  |        | 347      |        
|                                     |                                        |                                            |        |            |               | 
|                                     |                                        | Total shareholders equity                 |        |            | 147,342       |  |        |          | 159,959 | 
|                                     |                                        |                                            |        |            |               | 
|                                     |                                        | Total liabilities and shareholders equity |        | $          | 184,052       |  |        | $        | 207,900 | 
|                                     |                                        |                                            |        |            |               | 



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PHOTON DYNAMICS, INC.





CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


|                                                                                             |                                              |                                       |        |            |                   |   |        |        |            |   |         |        |        |   |        |        |        | 
|-------------------------------------------------------------------------------------------- | -------------------------------------------- | ------------------------------------- | ------ | ---------- | ----------------- | - | ------ | ------ | ---------- | - | ------- | ------ | ------ | - | ------ | ------ | ------ | 
|                                                                                             |                                              | Three Months Ended                    |        |            | Nine Months Ended |  
|                                                                                             |                                              | June 30,                              |        |            | June 30,          |  
|                                                                                             |                                              |                                       |        |            |                   |  
|                                                                                             |                                              | 2005                                  |        |            | 2004              |   |        | 2005   |            |   | 2004    |       
|                                                                                             |                                              |                                       |        |            |                   |   |        |        |            |   |         |       
|                                                                                             |                                              |                                       |        | (Restated) |                   |   |        |        | (Restated) |  
|                                                                                             |                                              | (Unaudited)                           |       
|                                                                                             |                                              | (In thousands, except per share data) |       
|Revenue                                                                                      |                                              | $                                     | 39,096 |            |                   | $ | 38,522 |        |            | $ | 101,061 |        |        | $ | 89,079 |       
|Cost of revenue                                                                              |                                              |                                       | 26,720 |            |                   |   | 20,711 |        |            |   | 68,269  |        |        |   | 48,306 |       
|                                                                                             |                                              |                                       |        |            |                   |   |        |        |            |   |         |       
|Gross margin                                                                                 |                                              |                                       | 12,376 |            |                   |   | 17,811 |        |            |   | 32,792  |        |        |   | 40,773 |       
|                                                                                             |                                              |                                       |        |            |                   |   |        |        |            |   |         |       
|Operating expenses:                                                                          |                                              |                                       |        |            |                   |   |        |        |            |   |         |        |        |   |        |       
|                                                                                             | Research and development                     |                                       |        | 8,618      |                   |   |        | 8,031  |            |   |         | 27,906 |        |   |        | 19,985 |       
|                                                                                             | Selling, general and administrative          |                                       |        | 7,352      |                   |   |        | 4,594  |            |   |         | 18,143 |        |   |        | 13,158 |       
|                                                                                             | Amortization of intangible assets            |                                       |        | 380        |                   |   |        | 155    |            |   |         | 1,175  |        |   |        | 416    |       
|                                                                                             | Restructuring charges                        |                                       |        | 951        |                   |   |        |       |            |   |         | 951    |        |   |        |       |       
|                                                                                             | Acquired in-process research and development |                                       |        |           |                   |   |        | 210    |            |   |         |       |        |   |        | 210    |       
|                                                                                             | Impairment of goodwill                       |                                       |        |           |                   |   |        |       |            |   |         |       |        |   |        | 665    |       
|                                                                                             | Impairment of purchased intangibles          |                                       |        |           |                   |   |        |       |            |   |         |       |        |   |        | 2,089  |       
|                                                                                             | Gain on sale of property and equipment       |                                       |        | (143       | )                 |   |        | (419   | )          |   |         | (143   | )      |   |        | (449   | )     
|                                                                                             | Impairment of property and equipment         |                                       |        | 174        |                   |   |        |       |            |   |         | 556    |        |   |        | 234    |       
|                                                                                             |                                              |                                       |        |            |                   |   |        |        |            |   |         |       
|                                                                                             |                                              | Total operating expenses              |        |            | 17,332            |   |        |        | 12,571     |   |         |        | 48,588 |   |        |        | 36,308 | 
|                                                                                             |                                              |                                       |        |            |                   |   |        |        |            |   |         |       
|Income (loss) from operations                                                                |                                              |                                       | (4,956 | )          |                   |   | 5,240  |        |            |   | (15,796 | )      |        |   | 4,465  |       
|Interest income and other, net                                                               |                                              |                                       | 472    |            |                   |   | 389    |        |            |   | 1,891   |        |        |   | 4,494  |       
|                                                                                             |                                              |                                       |        |            |                   |   |        |        |            |   |         |       
|Income (loss) from continuing operations before income taxes and
    discontinued operations |                                              |                                       | (4,484 | )          |                   |   | 5,629  |        |            |   | (13,905 | )      |        |   | 8,959  |       
|Provision for income taxes                                                                   |                                              |                                       | 167    |            |                   |   | 134    |        |            |   | 565     |        |        |   | 560    |       
|                                                                                             |                                              |                                       |        |            |                   |   |        |        |            |   |         |       
|Income (loss) from continuing operations before discontinued
    operations                  |                                              |                                       | (4,651 | )          |                   |   | 5,495  |        |            |   | (14,470 | )      |        |   | 8,399  |       
|Income (loss) from discontinued operations                                                   |                                              |                                       | 268    |            |                   |   | (265   | )      |            |   | 258     |        |        |   | (1,494 | )     
|                                                                                             |                                              |                                       |        |            |                   |   |        |        |            |   |         |       
|Net income (loss)                                                                            |                                              | $                                     | (4,383 | )          |                   | $ | 5,230  |        |            | $ | (14,212 | )      |        | $ | 6,905  |       
|                                                                                             |                                              |                                       |        |            |                   |   |        |        |            |   |         |       
|Income (loss) per share from continuing operations:                                          |                                              |                                       |        |            |                   |   |        |        |            |   |         |        |        |   |        |       
|                                                                                             | Basic                                        |                                       | $      | (0.27      | )                 |   | $      | 0.33   |            |   | $       | (0.85  | )      |   | $      | 0.51   |       
|                                                                                             |                                              |                                       |        |            |                   |   |        |        |            |   |         |       
|                                                                                             | Diluted                                      |                                       | $      | (0.27      | )                 |   | $      | 0.32   |            |   | $       | (0.85  | )      |   | $      | 0.49   |       
|                                                                                             |                                              |                                       |        |            |                   |   |        |        |            |   |         |       
|Income (loss) per share from discontinued operations:                                        |                                              |                                       |        |            |                   |   |        |        |            |   |         |        |        |   |        |       
|                                                                                             | Basic                                        |                                       | $      | 0.02       |                   |   | $      | (0.02  | )          |   | $       | 0.02   |        |   | $      | (0.09  | )     
|                                                                                             |                                              |                                       |        |            |                   |   |        |        |            |   |         |       
|                                                                                             | Diluted                                      |                                       | $      | 0.02       |                   |   | $      | (0.02  | )          |   | $       | 0.02   |        |   | $      | (0.09  | )     
|                                                                                             |                                              |                                       |        |            |                   |   |        |        |            |   |         |       
|Net income (loss) per share:                                                                 |                                              |                                       |        |            |                   |   |        |        |            |   |         |        |        |   |        |       
|                                                                                             | Basic                                        |                                       | $      | (0.26      | )                 |   | $      | 0.31   |            |   | $       | (0.84  | )      |   | $      | 0.42   |       
|                                                                                             |                                              |                                       |        |            |                   |   |        |        |            |   |         |       
|                                                                                             | Diluted                                      |                                       | $      | (0.26      | )                 |   | $      | 0.31   |            |   | $       | (0.84  | )      |   | $      | 0.40   |       
|                                                                                             |                                              |                                       |        |            |                   |   |        |        |            |   |         |       
|Weighted average number of shares:                                                           |                                              |                                       |        |            |                   |   |        |        |            |   |         |        |        |   |        |       
|                                                                                             | Basic                                        |                                       |        | 16,984     |                   |   |        | 16,663 |            |   |         | 16,934 |        |   |        | 16,565 |       
|                                                                                             | Diluted                                      |                                       |        | 16,984     |                   |   |        | 17,071 |            |   |         | 16,934 |        |   |        | 17,141 |       



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PHOTON DYNAMICS, INC.





CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


|                                      |                                                                                                                                                                  |                                                                                          |                           |            |         |        |   |         |          |         |  
|------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------- | ------------------------- | ---------- | ------- | ------ | - | ------- | -------- | ------- | -
|                                      |                                                                                                                                                                  | Nine Months Ended                                                                        |                          
|                                      |                                                                                                                                                                  | June 30,                                                                                 |                          
|                                      |                                                                                                                                                                  |                                                                                          |                          
|                                      |                                                                                                                                                                  | 2005                                                                                     |                           |            | 2004    |       
|                                      |                                                                                                                                                                  |                                                                                          |                           |            |         |       
|                                      |                                                                                                                                                                  |                                                                                          |                           | (Restated) |        
|                                      |                                                                                                                                                                  | (Unaudited)                                                                              |                          
|                                      |                                                                                                                                                                  | (In thousands)                                                                           |                          
|Cash flows from operating activities: |                                                                                                                                                                  |                                                                                          |                           |            |         |        |   |        
|                                      | Net income (loss) from continuing operations                                                                                                                     |                                                                                          | $                         | (14,470    | )       |        | $ | 8,399   |         
|                                      | Adjustments to reconcile net income (loss) from continuing
    operations to net cash provided by (used in) operating
    activities from continuing operations: |                                                                                          |                           |            |         |        |   |         |         
|                                      |                                                                                                                                                                  | Depreciation                                                                             |                           |            | 4,331   |        |   |         | 2,721    |        
|                                      |                                                                                                                                                                  | Amortization of intangible assets                                                        |                           |            | 1,175   |        |   |         | 416      |        
|                                      |                                                                                                                                                                  | Impairment of goodwill                                                                   |                           |            |        |        |   |         | 665      |        
|                                      |                                                                                                                                                                  | Impairment of purchased intangibles and fixed assets                                     |                           |            | 556     |        |   |         | 2,323    |        
|                                      |                                                                                                                                                                  | Acquired in-process research and development                                             |                           |            |        |        |   |         | 210      |        
|                                      |                                                                                                                                                                  | Gain on sale of property and equipment                                                   |                           |            | (143    | )      |   |         | (449     | )      
|                                      |                                                                                                                                                                  | Stock ownership expense                                                                  |                           |            | 44      |        |   |         | 164      |        
|                                      |                                                                                                                                                                  | Restructuring charges                                                                    |                           |            | 171     |        |   |         |         |        
|                                      |                                                                                                                                                                  | Accretion of non-interest bearing notes payable                                          |                           |            | 53      |        |   |         |         |        
|                                      |                                                                                                                                                                  | Changes in assets and liabilities:                                                       |                           |            |         |        |   |         |          |        
|                                      |                                                                                                                                                                  |                                                                                          | Accounts receivable       |            |         | 19,687 |   |         |          | (32,099 | )
|                                      |                                                                                                                                                                  |                                                                                          | Inventories               |            |         | 8,762  |   |         |          | (16,776 | )
|                                      |                                                                                                                                                                  |                                                                                          | Other current assets      |            |         | (324   | ) |         |          | 758     |  
|                                      |                                                                                                                                                                  |                                                                                          | Other assets              |            |         | 109    |   |         |          | (1,304  | )
|                                      |                                                                                                                                                                  |                                                                                          | Accounts payable          |            |         | (9,786 | ) |         |          | 15,342  |  
|                                      |                                                                                                                                                                  |                                                                                          | Other current liabilities |            |         | 252    |   |         |          | 1,592   |  
|                                      |                                                                                                                                                                  |                                                                                          | Deferred gross margin     |            |         | (527   | ) |         |          | 724     |  
|                                      |                                                                                                                                                                  |                                                                                          | Other liabilities         |            |         | (66    | ) |         |          | (65     | )
|                                      |                                                                                                                                                                  |                                                                                          |                           |            |         |       
|                                      | Net cash provided by (used in) operating activities from
    continuing operations                                                                               |                                                                                          |                           | 9,824      |         |        |   | (17,379 | )       
|                                      | Net cash used in operating activities from discontinued
    operations                                                                                           |                                                                                          |                           | (589       | )       |        |   | (1,453  | )       
|                                      |                                                                                                                                                                  |                                                                                          |                           |            |         |       
|                                      | Net cash provided by (used in) operating activities                                                                                                              |                                                                                          |                           | 9,235      |         |        |   | (18,832 | )       
|                                      |                                                                                                                                                                  |                                                                                          |                           |            |         |       
|Cash flows from investing activities: |                                                                                                                                                                  |                                                                                          |                           |            |         |        |   |        
|                                      |                                                                                                                                                                  | Purchase of property and equipment                                                       |                           |            | (5,070  | )      |   |         | (12,508  | )      
|                                      |                                                                                                                                                                  | Proceeds from disposal of property and equipment                                         |                           |            | 270     |        |   |         | 511      |        
|                                      |                                                                                                                                                                  | Acquisition of assets of Quantum Composers, Inc.                                         |                           |            |        |        |   |         | (1,000   | )      
|                                      |                                                                                                                                                                  | Acquisition of Rapid Thermal Processing Division from Intevac,
    Inc.                  |                           |            |        |        |   |         | (300     | )      
|                                      |                                                                                                                                                                  | Acquisition of certain intangible assets upon termination of a
    distributor agreement |                           |            |        |        |   |         | (1,138   | )      
|                                      |                                                                                                                                                                  | Purchase of short-term investments                                                       |                           |            | (51,481 | )      |   |         | (378,706 | )      
|                                      |                                                                                                                                                                  | Redemption of short-term investments                                                     |                           |            | 33,678  |        |   |         | 411,554  |        
|                                      |                                                                                                                                                                  |                                                                                          |                           |            |         |       
|                                      | Net cash provided by (used in) investing activities from
    continuing operations                                                                               |                                                                                          |                           | (22,603    | )       |        |   | 18,413  |         
|                                      |                                                                                                                                                                  |                                                                                          |                           |            |         |       
|Cash flows from financing activities: |                                                                                                                                                                  |                                                                                          |                           |            |         |        |   |        
|                                      |                                                                                                                                                                  | Issuance of common stock                                                                 |                           |            | 1,756   |        |   |         | 4,198    |        
|                                      |                                                                                                                                                                  | Net repayment of short-term borrowings                                                   |                           |            | (532    | )      |   |         |         |        
|                                      |                                                                                                                                                                  |                                                                                          |                           |            |         |       
|                                      | Net cash provided by financing activities from continuing
    operations                                                                                         |                                                                                          |                           | 1,224      |         |        |   | 4,198   |         
|                                      | Net cash used in financing activities from discontinued
    operations                                                                                           |                                                                                          |                           | (198       | )       |        |   |        |         
|                                      |                                                                                                                                                                  |                                                                                          |                           |            |         |       
|                                      | Net cash provided by financing activities                                                                                                                        |                                                                                          |                           | 1,026      |         |        |   | 4,198   |         
|                                      |                                                                                                                                                                  |                                                                                          |                           |            |         |       
|                                      | Effect of exchange rate changes on cash and cash equivalents                                                                                                     |                                                                                          |                           | (42        | )       |        |   | 54      |         
|                                      |                                                                                                                                                                  |                                                                                          |                           |            |         |       
|                                      | Net decrease in cash and cash equivalents from continuing
    operations                                                                                         |                                                                                          |                           | (11,597    | )       |        |   | 5,286   |         
|                                      | Net decrease in cash and cash equivalents from discontinued
    operations                                                                                       |                                                                                          |                           | (787       | )       |        |   | (1,453  | )       
|                                      |                                                                                                                                                                  |                                                                                          |                           |            |         |       
|                                      | Net decrease in cash and cash equivalents                                                                                                                        |                                                                                          |                           | (12,384    | )       |        |   | 3,833   |         
|                                      | Cash and cash equivalents at beginning of period                                                                                                                 |                                                                                          |                           | 25,483     |         |        |   | 18,305  |         
|                                      |                                                                                                                                                                  |                                                                                          |                           |            |         |       
|                                      | Cash and cash equivalents at end of period                                                                                                                       |                                                                                          | $                         | 13,099     |         |        | $ | 22,138  |         
|                                      |                                                                                                                                                                  |                                                                                          |                           |            |         |       



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PHOTON DYNAMICS, INC.





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)




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

Restatement of Financial Statements.






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



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PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)








Basis of Presentation.






Description of Operations and Principles of
Consolidation.




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PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




Management Estimates.


Fair Value of Financial Instruments.


Inventories.


Concentration of Credit and Other Risk.










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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




Revenue Recognition.










Shipping Costs.


Research and Development Cost.


Interest Income.


9



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)


Stock-Based Compensation Plans.




|                     |                                  |              |  |      |             |  |  |      |   |  |      |      |   |  |  |      |  
|-------------------- | -------------------------------- | ------------ |  | ---- | ----------- |  |  | ---- | - |  | ---- | ---- | - |  |  | ---- | -
|                     |                                  | Three Months |  |      | Nine Months | 
|                     |                                  | Ended        |  |      | Ended       | 
|                     |                                  | June 30,     |  |      | June 30,    | 
|                     |                                  |              |  |      |             | 
|                     |                                  | 2005         |  |      | 2004        |  |  | 2005 |   |  | 2004 |     
|                     |                                  |              |  |      |             |  |  |      |   |  |      |     
|Stock option plan:   |                                  |              |  |      |             |  |  |      |   |  |      |      |   |  |  |     
|                     | Expected stock price volatility  |              |  | 0.71 |             |  |  | 0.80 |   |  |      | 0.74 |   |  |  | 0.86 |  
|                     | Average Risk free interest rate  |              |  | 3.89 | %           |  |  | 1.55 | % |  |      | 3.1  | % |  |  | 2.15 | %
|                     | Expected life of options (years) |              |  | 4.0  |             |  |  | 5.4  |   |  |      | 5.4  |   |  |  | 5.2  |  
|Stock purchase plan: |                                  |              |  |      |             |  |  |      |   |  |      |      |   |  |  |     
|                     | Expected stock price volatility  |              |  | 0.58 |             |  |  | 0.96 |   |  |      | 0.65 |   |  |  | 0.96 |  
|                     | Average Risk free interest rate  |              |  | 2.93 | %           |  |  | 2.13 | % |  |      | 2.5  | % |  |  | 2.13 | %
|                     | Expected life of plan (years)    |              |  | 1.2  |             |  |  | 2.0  |   |  |      | 1.3  |   |  |  | 2.0  |  





|                                                  |                                                                                                                               |                                       |        |            |             |   |       |        |            |   |         |        |   |   |       |        |  
|------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------- | ------------------------------------- | ------ | ---------- | ----------- | - | ----- | ------ | ---------- | - | ------- | ------ | - | - | ----- | ------ | -
|                                                  |                                                                                                                               | Three Months                          |        |            | Nine Months |  
|                                                  |                                                                                                                               | Ended                                 |        |            | Ended       |  
|                                                  |                                                                                                                               | June 30,                              |        |            | June 30,    |  
|                                                  |                                                                                                                               |                                       |        |            |             |  
|                                                  |                                                                                                                               | 2005                                  |        |            | 2004        |   |       | 2005   |            |   | 2004    |       
|                                                  |                                                                                                                               |                                       |        |            |             |   |       |        |            |   |         |       
|                                                  |                                                                                                                               |                                       |        | (Restated) |             |   |       |        | (Restated) |  
|                                                  |                                                                                                                               | (In thousands, except per share data) |       
|Net income (loss)  as reported                   |                                                                                                                               | $                                     | (4,383 | )          |             | $ | 5,230 |        |            | $ | (14,212 | )      |   | $ | 6,905 |       
|                                                  | Less: total stock-based employee compensation expense determined
    under fair value based method for all awards, net of tax |                                       |        | (959       | )           |   |       | (1,605 | )          |   |         | (4,886 | ) |   |       | (5,495 | )
|                                                  |                                                                                                                               |                                       |        |            |             |   |       |        |            |   |         |       
|Net income (loss)  pro forma                     |                                                                                                                               | $                                     | (5,342 | )          |             | $ | 3,625 |        |            | $ | (19,098 | )      |   | $ | 1,410 |       
|                                                  |                                                                                                                               |                                       |        |            |             |   |       |        |            |   |         |       
|Basic net income (loss) per share  as reported   |                                                                                                                               | $                                     | (0.26  | )          |             | $ | 0.31  |        |            | $ | (0.84   | )      |   | $ | 0.42  |       
|Diluted net income (loss) per share  as reported |                                                                                                                               | $                                     | (0.26  | )          |             | $ | 0.31  |        |            | $ | (0.84   | )      |   | $ | 0.40  |       
|Basic net loss per share  pro forma              |                                                                                                                               | $                                     | (0.31  | )          |             | $ | 0.22  |        |            | $ | (1.13   | )      |   | $ | 0.09  |       
|Diluted net loss per share  pro forma            |                                                                                                                               | $                                     | (0.31  | )          |             | $ | 0.21  |        |            | $ | (1.13   | )      |   | $ | 0.08  |       

10



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)


Recent Accounting Pronouncements.












11



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)








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

|                                        |                                                                                        |                |   |        |               |  |   |        |        | 
|--------------------------------------- | -------------------------------------------------------------------------------------- | -------------- | - | ------ | ------------- |  | - | ------ | ------ | 
|                                        |                                                                                        | June 30,       |   |        | September 30, | 
|                                        |                                                                                        | 2005           |   |        | 2004          | 
|                                        |                                                                                        |                |   |        |               | 
|                                        |                                                                                        | (In thousands) |  
|Accounts receivable:                    |                                                                                        |                |   |        |               |  |   |       
|                                        | Accounts receivable, gross                                                             |                | $ | 38,824 |               |  | $ | 58,838 |       
|                                        | Allowance for doubtful accounts                                                        |                |   | (170   | )             |  |   | (497   | )     
|                                        |                                                                                        |                |   |        |               | 
|                                        |                                                                                        | Total          |   | $      | 38,654        |  |   | $      | 58,341 | 
|                                        |                                                                                        |                |   |        |               | 
|Inventories:                            |                                                                                        |                |   |        |               |  |   |       
|                                        | Raw materials                                                                          |                | $ | 15,449 |               |  | $ | 15,529 |       
|                                        | Work-in-process                                                                        |                |   | 6,444  |               |  |   | 15,046 |       
|                                        | Finished goods                                                                         |                |   | 1,063  |               |  |   | 1,141  |       
|                                        |                                                                                        |                |   |        |               | 
|                                        |                                                                                        | Total          |   | $      | 22,956        |  |   | $      | 31,716 | 
|                                        |                                                                                        |                |   |        |               | 
|Other current liabilities:              |                                                                                        |                |   |        |               |  |   |       
|                                        | Compensation                                                                           |                | $ | 4,562  |               |  | $ | 3,984  |       
|                                        | Obligation to a manufacturing subcontractor in connection with
    inventory purchases |                |   |       |               |  |   | 623    |       
|                                        | Accrued closing costs associated with discontinued operations                          |                |   | 113    |               |  |   | 449    |       
|                                        | Vendor Obligations                                                                     |                |   | 87     |               |  |   | 669    |       
|                                        | Notes Payable                                                                          |                |   | 1,310  |               |  |   | 1,534  |       
|                                        | Other accrued expenses                                                                 |                |   | 3,607  |               |  |   | 2,972  |       
|                                        |                                                                                        |                |   |        |               | 
|                                        |                                                                                        | Total          |   | $      | 9,679         |  |   | $      | 10,231 | 
|                                        |                                                                                        |                |   |        |               | 
|Accumulated other comprehensive income: |                                                                                        |                |   |        |               |  |   |       
|                                        | Foreign currency translation adjustments                                               |                | $ | 491    |               |  | $ | 533    |       
|                                        | Unrealized losses on available for sale securities                                     |                |   | (349   | )             |  |   | (186   | )     
|                                        |                                                                                        |                |   |        |               | 
|                                        |                                                                                        | Total          |   | $      | 142           |  |   | $      | 347    | 
|                                        |                                                                                        |                |   |        |               | 

12



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




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



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





|                                  |                                     |                          |    |                |             |   |      |      |     |   |      |     |     |   |        |       |       | 
|--------------------------------- | ----------------------------------- | ------------------------ | -- | -------------- | ----------- | - | ---- | ---- | --- | - | ---- | --- | --- | - | ------ | ----- | ----- | 
|                                  |                                     | Three Months             |    |                | Nine Months |  
|                                  |                                     | Ended                    |    |                | Ended       |  
|                                  |                                     | June 30,                 |    |                | June 30,    |  
|                                  |                                     |                          |    |                |             |  
|                                  |                                     | 2005                     |    |                | 2004        |   |      | 2005 |     |   | 2004 |    
|                                  |                                     |                          |    |                |             |   |      |      |     |   |      |    
|                                  |                                     |                          |    | (In thousands) |             |   |     
|Revenue                           |                                     | $                        |   |                |             | $ |     |      |     | $ |     |     |     | $ | 83     |      
|Cost of revenue                   |                                     |                          | 5  |                |             |   |     |      |     |   | (127 | )   |     |   | (71    | )    
|                                  |                                     |                          |    |                |             |   |      |      |     |   |      |    
|Gross margin                      |                                     |                          | (5 | )              |             |   |     |      |     |   | 127  |     |     |   | 154    |      
|                                  |                                     |                          |    |                |             |   |      |      |     |   |      |    
|Operating expenses:               |                                     |                          |    |                |             |   |      |      |     |   |      |     |     |   |        |      
|                                  | Selling, general and administrative |                          |    |               |             |   |      | 231  |     |   |      | 139 |     |   |        | 1,615 |      
|                                  |                                     |                          |    |                |             |   |      |      |     |   |      |    
|                                  |                                     | Total operating expenses |    |                |            |   |      |      | 231 |   |      |     | 139 |   |        |       | 1,615 | 
|                                  |                                     |                          |    |                |             |   |      |      |     |   |      |    
|Loss from discontinued operations |                                     | $                        | (5 | )              |             | $ | (231 | )    |     | $ | (12  | )   |     | $ | (1,461 | )    
|                                  |                                     |                          |    |                |             |   |      |      |     |   |      |    





|                     |                           |                           |    |       |               |  |     |     |     | 
|-------------------- | ------------------------- | ------------------------- | -- | ----- | ------------- |  | --- | --- | --- | 
|                     |                           | June 30,                  |    |       | September 30, | 
|                     |                           | 2005                      |    |       | 2004          | 
|                     |                           |                           |    |       |               | 
|                     |                           | (In thousands)            |   
|ASSETS               |                           |                           |    |       |               |  |     |    
|Current assets:      |                           |                           |    |       |               |  |     |    
|                     | Other current assets      |                           | $  | 1,155 |               |  | $   | 908 |    
|                     |                           |                           |    |       |               | 
|                     |                           | Total assets              |    | $     | 1,155         |  |     | $   | 908 | 
|                     |                           |                           |    |       |               | 
|                    
|LIABILITIES         
|Current liabilities: |                           |                           |    |       |               |  |     |    
|                     | Accounts payable          |                           | $  |      |               |  | $   | 5   |    
|                     | Other current liabilities |                           |    | 496   |               |  |     | 707 |    
|                     |                           |                           |    |       |               | 
|                     |                           | Total current liabilities |    |       | 496           |  |     |     | 712 | 
|Other liabilities    |                           |                           | 60 |       |               |  | 113 |    
|                     |                           |                           |    |       |               | 
|                     |                           | Total liabilities         |    | $     | 556           |  |     | $   | 825 | 
|                     |                           |                           |    |       |               | 

13



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)








|                             |                               |                |      |   |             |   |       |       |  |   |        |     | 
|---------------------------- | ----------------------------- | -------------- | ---- | - | ----------- | - | ----- | ----- |  | - | ------ | --- | 
|                             |                               | One-Time       |      |   |             |   |      
|                             |                               | Termination    |      |   |             |   |      
|                             |                               | Benefits       |      |   | Other Costs |   |       | Total | 
|                             |                               |                |      |   |             |   |       |       | 
|                             |                               | (In thousands) |     
|Inception of liability       |                               | $              | 696  |   |             | $ | 1,326 |       |  | $ | 2,022  |    
|Cash expenditures            |                               |                | (614 | ) |             |   | (447  | )     |  |   | (1,061 | )  
|Adjustments to the liability |                               |                | (82  | ) |             |   | (342  | )     |  |   | (424   | )  
|                             |                               |                |      |   |             |   |       |       | 
|                             | Balance at September 30, 2004 |                |      |  |             |   |       | 537   |  |   |        | 537 | 
|Cash payments                |                               |                |     |   |             |   | (205  | )     |  |   | (205   | )  
|Adjustments to the liability |                               |                |     |   |             |   | (132  | )     |  |   | (132   | )  
|                             |                               |                |      |   |             |   |       |       | 
|                             | Balance at June 30, 2005      |                | $    |  |             |   | $     | 200   |  |   | $      | 200 | 
|                             |                               |                |      |   |             |   |       |       | 





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





|                                           |                                                      |                          |      |                |             |   |     |      |    |   |      |      |      |   |     |     |    | 
|------------------------------------------ | ---------------------------------------------------- | ------------------------ | ---- | -------------- | ----------- | - | --- | ---- | -- | - | ---- | ---- | ---- | - | --- | --- | -- | 
|                                           |                                                      | Three Months             |      |                | Nine Months |  
|                                           |                                                      | Ended                    |      |                | Ended       |  
|                                           |                                                      | June 30,                 |      |                | June 30,    |  
|                                           |                                                      |                          |      |                |             |  
|                                           |                                                      | 2005                     |      |                | 2004        |   |     | 2005 |    |   | 2004 |     
|                                           |                                                      |                          |      |                |             |   |     |      |    |   |      |     
|                                           |                                                      |                          |      | (In thousands) |             |   |    
|Cost of revenue                            |                                                      | $                        | (150 | )              |             | $ |    |      |    | $ | (150 | )    |      | $ |    |    
|                                           |                                                      |                          |      |                |             |   |     |      |    |   |      |     
|Gross margin                               |                                                      |                          | 150  |                |             |   |    |      |    |   | 150  |      |      |   |    |    
|                                           |                                                      |                          |      |                |             |   |     |      |    |   |      |     
|Operating expenses:                        |                                                      |                          |      |                |             |   |     |      |    |   |      |      |      |   |     |    
|                                           | Selling, general and administrative                  |                          |      | (123           | )           |   |     | 3    |    |   |      | (120 | )    |   |     | (32 | ) 
|                                           | Impairment of purchased intangibles and fixed assets |                          |      |               |             |   |     | 31   |    |   |      |     |      |   |     | 65  |   
|                                           |                                                      |                          |      |                |             |   |     |      |    |   |      |     
|                                           |                                                      | Total operating expenses |      |                | (123        | ) |     |      | 34 |   |      |      | (120 | ) |     |     | 33 | 
|                                           |                                                      |                          |      |                |             |   |     |      |    |   |      |     
|Income (loss) from discontinued operations |                                                      | $                        | 273  |                |             | $ | (34 | )    |    | $ | 270  |      |      | $ | (33 | )  
|                                           |                                                      |                          |      |                |             |   |     |      |    |   |      |     

14



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






|                           |                           |                |     |     |               |   |     |     | 
|-------------------------- | ------------------------- | -------------- | --- | --- | ------------- | - | --- | --- | 
|                           |                           | June 31,       |     |     | September 30, |  
|                           |                           | 2005           |     |     | 2004          |  
|                           |                           |                |     |     |               |  
|                           |                           | (In thousands) |    
|LIABILITIES                |                           |                |     |     |               |   |     |    
|Other current liabilities: |                           | $              | 263 |     |               | $ | 797 |    
|                           |                           |                |     |     |               |  
|                           | Total current liabilities |                | $   | 263 |               |   | $   | 797 | 
|                           |                           |                |     |     |               |  





|                             |                               |             |        |                |             |   |      |             |  |   |       |   |  |   |        |     | 
|---------------------------- | ----------------------------- | ----------- | ------ | -------------- | ----------- | - | ---- | ----------- |  | - | ----- | - |  | - | ------ | --- | 
|                             |                               | One-Time    |        |                | Contract    |   |      |             |  |  
|                             |                               | Termination |        |                | Termination |   |      |             |  |  
|                             |                               | Benefits    |        |                | Costs       |   |      | Other Costs |  |   | Total |  
|                             |                               |             |        |                |             |   |      |             |  |   |       |  
|                             |                               |             |        | (In thousands) |             |   |     
|Inception of liability       |                               | $           | 1,116  |                |             | $ | 771  |             |  | $ | 11    |   |  | $ | 1,898  |    
|Cash expenditures            |                               |             | (1,116 | )              |             |   | (322 | )           |  |   | (61   | ) |  |   | (1,499 | )  
|Adjustments to the liability |                               |             |       |                |             |   |     |             |  |   | 50    |   |  |   | 50     |    
|                             |                               |             |        |                |             |   |      |             |  |   |       |  
|                             | Balance at September 30, 2004 |             |        |               |             |   |      | 449         |  |   |       |  |  |   |        | 449 | 
|Cash payments                |                               |             |       |                |             |   | (66  | )           |  |   |      |   |  |   | (66    | )  
|Adjustments to the liability |                               |             |       |                |             |   | (270 | )           |  |   |      |   |  |   | (270   | )  
|                             |                               |             |        |                |             |   |      |             |  |   |       |  
|                             | Balance at June 30, 2005      |             | $      |               |             |   | $    | 113         |  |   | $     |  |  |   | $      | 113 | 
|                             |                               |             |        |                |             |   |      |             |  |   |       |  





|         |                                            
|-------- | -------------------------------------------
|NOTE 4  | Non-Recurring Acquisitions and Dispositions



| |                                             
| | --------------------------------------------
| | Nine months ended June 30, 2004 dispositions



15



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




| |                                             
| | --------------------------------------------
| | Nine months ended June 30, 2004 acquisitions





| |                                                    
| | ---------------------------------------------------
| | Purchase Price Allocation and Pro Forma Information









|                                                                       |  |                |       | 
|---------------------------------------------------------------------- |  | -------------- | ----- | 
|                                                                       |  | Quantum        |      
|                                                                       |  | Assets         |      
|                                                                       |  |                |      
|                                                                       |  | (In thousands) |      
|Acquired core technology                                               |  | $              | 699   | 
|Acquired developed technology                                          |  |                | 1,006 | 
|Acquired in-process research and development                           |  |                | 210   | 
|Non-compete agreement                                                  |  |                | 769   | 
|Net fair value of acquired tangible assets and assumed
    liabilities |  |                | 397   | 
|                                                                       |  |                |      
|Total                                                                  |  | $              | 3,081 | 
|                                                                       |  |                |      



16



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)








|                                                       |         |                   |        |      | 
|------------------------------------------------------ | ------- | ----------------- | ------ | ---- | 
|                                                       |         | Nine Months Ended |       
|                                                       |         | June 30, 2004     |       
|                                                       |         |                   |       
|                                                       |         | (Restated)        |       
|                                                       |         | (In thousands,    |       
|                                                       |         | except per        |       
|                                                       |         | share data)       |       
|Total revenue                                          |         | $                 | 92,554 |     
|Net income from continuing operations                  |         |                   | 9,132  |     
|Net income                                             |         |                   | 7,638  |     
|Pro forma income per share from continuing operations: |         |                   |        |     
|                                                       | Basic   |                   | $      | 0.55 | 
|                                                       | Diluted |                   | $      | 0.53 | 
|Pro forma income loss per share:                       |         |                   |        |     
|                                                       | Basic   |                   | $      | 0.46 | 
|                                                       | Diluted |                   | $      | 0.45 | 



|         |                                               
|-------- | ----------------------------------------------
|NOTE 5  | Goodwill and Other Purchased Intangible Assets



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







17



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)








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



|                                 |                                |            |     |                |            |   |       |           |   |   |          |      |   |       |     |      |   |   |       |        |  
|-------------------------------- | ------------------------------ | ---------- | --- | -------------- | ---------- | - | ----- | --------- | - | - | -------- | ---- | - | ----- | --- | ---- | - | - | ----- | ------ | -
|                                 |                                |            |     |                |            |   |       | Non       |   |   |         
|                                 |                                | Developed  |     |                | Core       |   |       | License   |   |   | Compete  |      |   |      
|                                 |                                | Technology |     |                | Technology |   |       | Agreement |   |   | Contract |      |   | Total |    
|                                 |                                |            |     |                |            |   |       |           |   |   |          |      |   |       |    
|                                 |                                |            |     | (In thousands) |            |   |       |           |  
|Balance as of September 30, 2004 |                                | $          | 932 |                |            | $ | 2,109 |           |   | $ | 949      |      |   | $     | 763 |      |   | $ | 4,753 |       
|                                 | Amortization during the period |            |     | (189           | )          |   |       | (452      | ) |   |          | (284 | ) |       |     | (250 | ) |   |       | (1,175 | )
|                                 |                                |            |     |                |            |   |       |           |   |   |          |      |   |       |    
|Balance as of June 30, 2005      |                                | $          | 743 |                |            | $ | 1,657 |           |   | $ | 665      |      |   | $     | 513 |      |   | $ | 3,578 |       
|                                 |                                |            |     |                |            |   |       |           |   |   |          |      |   |       |    











|         |                                 
|-------- | --------------------------------
|NOTE 6  | Derivative Financial Instruments



18



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)








|         |                    
|-------- | -------------------
|NOTE 7  | Restructuring Costs

tm






19



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






|                                      |                          |                |      |     |             |   |     |       |  |   |      |     | 
|------------------------------------- | ------------------------ | -------------- | ---- | --- | ----------- | - | --- | ----- |  | - | ---- | --- | 
|                                      |                          | One-Time       |      |     | Contract    |   |     |      
|                                      |                          | Termination    |      |     | Termination |   |     |      
|                                      |                          | Benefits       |      |     | Costs       |   |     | Total | 
|                                      |                          |                |      |     |             |   |     |       | 
|                                      |                          | (In thousands) |      |     |             |   |    
|Inception of liability                |                          | $              | 431  |     |             | $ | 234 |       |  | $ | 665  |    
|Cash payments                         |                          |                | (294 | )   |             |   | (15 | )     |  |   | (309 | )  
|Costs incurred and charged to expense |                          |                | 286  |     |             |   |    |       |  |   | 286  |    
|Adjustments to the liability          |                          |                | (1   | )   |             |   | (7  | )     |  |   | (8   | )  
|                                      |                          |                |      |     |             |   |     |       | 
|                                      | Balance at June 30, 2005 |                | $    | 422 |             |   | $   | 212   |  |   | $    | 634 | 
|                                      |                          |                |      |     |             |   |     |       | 







|         |                     
|-------- | --------------------
|NOTE 8  | Comprehensive Income



|                                  |                                                |                          |        |                |                   |   |       |      |            |   |         |      |      |   |       |      |      |  
|--------------------------------- | ---------------------------------------------- | ------------------------ | ------ | -------------- | ----------------- | - | ----- | ---- | ---------- | - | ------- | ---- | ---- | - | ----- | ---- | ---- | -
|                                  |                                                | Three Months Ended       |        |                | Nine Months Ended |  
|                                  |                                                | June 30,                 |        |                | June 30,          |  
|                                  |                                                |                          |        |                |                   |  
|                                  |                                                | 2005                     |        |                | 2004              |   |       | 2005 |            |   | 2004    |     
|                                  |                                                |                          |        |                |                   |   |       |      |            |   |         |     
|                                  |                                                |                          |        | (Restated)     |                   |   |       |      | (Restated) |  
|                                  |                                                |                          |        | (In thousands) |                   |   |      
|Net income (loss)                 |                                                | $                        | (4,383 | )              |                   | $ | 5,230 |      |            | $ | (14,212 | )    |      | $ | 6,905 |     
|Other comprehensive loss:         |                                                |                          |        |                |                   |   |       |      |            |   |         |      |      |   |       |     
|                                  | Net change in unrealized losses on investments |                          |        | 94             |                   |   |       | (383 | )          |   |         | (163 | )    |   |       | (559 | )   
|                                  | Change in foreign currency translation         |                          |        | (121           | )                 |   |       | 153  |            |   |         | (42  | )    |   |       | 54   |     
|                                  |                                                |                          |        |                |                   |   |       |      |            |   |         |     
|                                  |                                                | Other comprehensive loss |        |                | (27               | ) |       |      | (230       | ) |         |      | (205 | ) |       |      | (505 | )
|                                  |                                                |                          |        |                |                   |   |       |      |            |   |         |     
|Total comprehensive income (loss) |                                                | $                        | (4,410 | )              |                   | $ | 5,000 |      |            | $ | (14,417 | )    |      | $ | 6,400 |     
|                                  |                                                |                          |        |                |                   |   |       |      |            |   |         |     



|         |                     
|-------- | --------------------
|NOTE 9  | Shareholders Equity

Stock Option Plans.


20



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






|          |                     
|--------- | --------------------
|NOTE 10  | Net Income Per Share





|                    |                                                                                 |                                                          |   |            |                   |   |   |        |            |   |      |         |         |   |   |        |        |  
|------------------- | ------------------------------------------------------------------------------- | -------------------------------------------------------- | - | ---------- | ----------------- | - | - | ------ | ---------- | - | ---- | ------- | ------- | - | - | ------ | ------ | -
|                    |                                                                                 | Three Months Ended                                       |   |            | Nine Months Ended |  
|                    |                                                                                 | June 30,                                                 |   |            | June 30,          |  
|                    |                                                                                 |                                                          |   |            |                   |  
|                    |                                                                                 | 2005                                                     |   |            | 2004              |   |   | 2005   |            |   | 2004 |        
|                    |                                                                                 |                                                          |   |            |                   |   |   |        |            |   |      |        
|                    |                                                                                 |                                                          |   | (Restated) |                   |   |   |        | (Restated) |  
|                    |                                                                                 | (In thousands, except per share data)                    |  
|Numerator:          |                                                                                 |                                                          |   |            |                   |   |   |        |            |   |      |         |         |   |   |       
|                    | Net income (loss) from continuing operations before discontinued
    operations |                                                          | $ | (4,651     | )                 |   | $ | 5,495  |            |   | $    | (14,470 | )       |   | $ | 8,399  |       
|                    | Net income (loss) from discontinued operations                                  |                                                          |   | 268        |                   |   |   | (265   | )          |   |      | 258     |         |   |   | (1,494 | )     
|                    |                                                                                 |                                                          |   |            |                   |   |   |        |            |   |      |        
|                    |                                                                                 | Net income (loss)                                        |   | $          | (4,383            | ) |   | $      | 5,230      |   |      | $       | (14,212 | ) |   | $      | 6,905  |  
|                    |                                                                                 |                                                          |   |            |                   |   |   |        |            |   |      |        
|Denominator:        |                                                                                 |                                                          |   |            |                   |   |   |        |            |   |      |         |         |   |   |       
|                    | Weighted average shares for basic net income per share                          |                                                          |   | 16,984     |                   |   |   | 16,663 |            |   |      | 16,934  |         |   |   | 16,565 |       
|                    | Effect of dilutive securities: Employee stock options                           |                                                          |   |           | (1)               |   |   | 408    |            |   |      |        | (1)     |   |   | 576    |       
|                    |                                                                                 |                                                          |   |            |                   |   |   |        |            |   |      |        
|                    |                                                                                 | Weighted average shares for diluted net income per share |   |            | 16,984            |   |   |        | 17,071     |   |      |         | 16,934  |   |   |        | 17,141 |  
|                    |                                                                                 |                                                          |   |            |                   |   |   |        |            |   |      |        
|Earnings per share: |                                                                                 |                                                          |   |            |                   |   |   |        |            |   |      |         |         |   |   |       
|                    | Basic net income (loss) per share:                                              |                                                          |   |            |                   |   |   |        |            |   |      |         |         |   |   |        |       
|                    |                                                                                 | Net income (loss) from continuing operations             |   | $          | (0.27             | ) |   | $      | 0.33       |   |      | $       | (0.85   | ) |   | $      | 0.51   |  
|                    |                                                                                 | Net income (loss) from discontinued operations           |   |            | 0.02              |   |   |        | (0.02      | ) |      |         | 0.02    |   |   |        | (0.09  | )
|                    |                                                                                 |                                                          |   |            |                   |   |   |        |            |   |      |        
|                    |                                                                                 | Net income (loss) per share                              |   | $          | (0.26             | ) |   | $      | 0.31       |   |      | $       | (0.84   | ) |   | $      | 0.42   |  
|                    |                                                                                 |                                                          |   |            |                   |   |   |        |            |   |      |        
|                    | Diluted net income (loss) per share:                                            |                                                          |   |            |                   |   |   |        |            |   |      |         |         |   |   |        |       
|                    |                                                                                 | Net income (loss) from continuing operations             |   | $          | (0.27             | ) |   | $      | 0.32       |   |      | $       | (0.85   | ) |   | $      | 0.49   |  
|                    |                                                                                 | Net income (loss) from discontinued operations           |   |            | 0.02              |   |   |        | (0.02      | ) |      |         | 0.02    |   |   |        | (0.09  | )
|                    |                                                                                 |                                                          |   |            |                   |   |   |        |            |   |      |        
|                    |                                                                                 | Net income (loss) per share                              |   | $          | (0.26             | ) |   | $      | 0.31       |   |      | $       | (0.84   | ) |   | $      | 0.40   |  
|                    |                                                                                 |                                                          |   |            |                   |   |   |        |            |   |      |        






|    |                                                                                                                                                                                                                                                                                                                                           
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The effect of potentially dilutive securities from employee
    stock options to purchase 95,096 and 132,667 shares of
    common stock for the three and nine month periods ended
    June 30, 2005 were not included in the computation of
    diluted net income (loss) per share as the effect is
    anti-dilutive due to net losses.

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PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






|          |                              
|--------- | -----------------------------
|NOTE 11  | Commitments and Contingencies



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





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





|                  |                                                                             |                   |       |        |      |   |       |        |  
|----------------- | --------------------------------------------------------------------------- | ----------------- | ----- | ------ | ---- | - | ----- | ------ | -
|                  |                                                                             | Nine Months Ended |      
|                  |                                                                             | June 30,          |      
|                  |                                                                             |                   |      
|                  |                                                                             | 2005              |       |        | 2004 |  
|                  |                                                                             |                   |       |        |      |  
|                  |                                                                             | (In thousands)    |      
|Beginning balance |                                                                             | $                 | 6,194 |        |      | $ | 2,363 |       
|                  | Estimated warranty cost of new shipments during the period                  |                   |       | 3,975  |      |   |       | 4,030  |  
|                  | Warranty costs during the period                                            |                   |       | (3,556 | )    |   |       | (2,840 | )
|                  | Changes in liability for pre-existing warranties, including
    expirations |                   |       | (279   | )    |   |       | 545    |  
|                  |                                                                             |                   |       |        |      |  
|Ending balance    |                                                                             | $                 | 6,334 |        |      | $ | 4,098 |       
|                  |                                                                             |                   |       |        |      |  



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



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)










|          |                       
|--------- | ----------------------
|NOTE 12  | Geographic Information



23



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PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|         |        |                |   |            |             |  |   |        |            |  |      |        |         |  |   |        |        | 
|-------- | ------ | -------------- | - | ---------- | ----------- |  | - | ------ | ---------- |  | ---- | ------ | ------- |  | - | ------ | ------ | 
|         |        | Three Months   |   |            | Nine Months | 
|         |        | Ended          |   |            | Ended       | 
|         |        | June 30,       |   |            | June 30,    | 
|         |        |                |   |            |             | 
|         |        | 2005           |   |            | 2004        |  |   | 2005   |            |  | 2004 |       
|         |        |                |   |            |             |  |   |        |            |  |      |       
|         |        |                |   | (Restated) |             |  |   |        | (Restated) | 
|         |        | (In thousands) |  
|Revenue: |        |                |   |            |             |  |   |        |            |  |      |        |         |  |   |       
|         | Korea  |                | $ | 19,550     |             |  | $ | 20,984 |            |  | $    | 30,585 |         |  | $ | 44,885 |       
|         | Taiwan |                |   | 18,420     |             |  |   | 16,507 |            |  |      | 40,994 |         |  |   | 36,243 |       
|         | Japan  |                |   | 1,126      |             |  |   | 1,031  |            |  |      | 16,200 |         |  |   | 7,951  |       
|         | China  |                |   |           |             |  |   |       |            |  |      | 13,282 |         |  |   |       |       
|         |        |                |   |            |             |  |   |        |            |  |      |       
|         |        | Total          |   | $          | 39,096      |  |   | $      | 38,522     |  |      | $      | 101,061 |  |   | $      | 89,079 | 
|         |        |                |   |            |             |  |   |        |            |  |      |       



|         |                  |              |  |            |             |   |  |      |            |   |      |    |     |   |  |    |     |  
|-------- | ---------------- | ------------ |  | ---------- | ----------- | - |  | ---- | ---------- | - | ---- | -- | --- | - |  | -- | --- | -
|         |                  | Three Months |  |            | Nine Months |  
|         |                  | Ended        |  |            | Ended       |  
|         |                  | June 30,     |  |            | June 30,    |  
|         |                  |              |  |            |             |  
|         |                  | 2005         |  |            | 2004        |   |  | 2005 |            |   | 2004 |   
|         |                  |              |  |            |             |   |  |      |            |   |      |   
|         |                  |              |  | (Restated) |             |   |  |      | (Restated) |  
|Revenue: |                  |              |  |            |             |   |  |      |            |   |      |    |     |   |  |   
|         | ArrayCheckertm   |              |  | 71         | %           |   |  | 84   | %          |   |      | 63 | %   |   |  | 83 | %  
|         | ArraySavertm     |              |  | 21         | %           |   |  | 11   | %          |   |      | 27 | %   |   |  | 12 | %  
|         | PanelMastertm    |              |  |           |             |   |  |     |            |   |      | 1  | %   |   |  |   |    
|         | Spares and other |              |  | 8          | %           |   |  | 5    | %          |   |      | 9  | %   |   |  | 5  | %  
|         |                  |              |  |            |             |   |  |      |            |   |      |   
|         |                  | Total        |  |            | 100         | % |  |      | 100        | % |      |    | 100 | % |  |    | 100 | %
|         |                  |              |  |            |             |   |  |      |            |   |      |   



|           |  |              |    |            |             |  |    |      |            |  |      |   |  |  |    |  
|---------- |  | ------------ | -- | ---------- | ----------- |  | -- | ---- | ---------- |  | ---- | - |  |  | -- | -
|           |  | Three Months |    |            | Nine Months | 
|           |  | Ended        |    |            | Ended       | 
|           |  | June 30,     |    |            | June 30,    | 
|           |  |              |    |            |             | 
|           |  | 2005         |    |            | 2004        |  |    | 2005 |            |  | 2004 |  
|           |  |              |    |            |             |  |    |      |            |  |      |  
|           |  |              |    | (Restated) |             |  |    |      | (Restated) | 
|Customer A |  |              | 42 | %          |             |  | 53 | %    |            |  | 26   | % |  |  | 37 | %
|Customer B |  |              | *  |            |             |  | *  |      |            |  | *    |   |  |  | 10 | %
|Customer C |  |              | *  |            |             |  | *  |      |            |  | 15   | % |  |  | *  |  
|Customer E |  |              | 15 | %          |             |  | *  |      |            |  | *    |   |  |  | 13 | %
|Customer F |  |              | *  |            |             |  | *  |      |            |  | 14   | % |  |  | *  |  
|Customer G |  |              | *  |            |             |  | *  |      |            |  | 12   | % |  |  | *  |  
|Customer H |  |              | 14 | %          |             |  | 19 | %    |            |  | *    |   |  |  | *  |  
|Customer I |  |              | 12 | %          |             |  | *  |      |            |  | *    |   |  |  | *  |  
|Customer J |  |              | *  |            |             |  | 14 | %    |            |  | *    |   |  |  | *  |  






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

24



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|           |  |         |    |   |              |  |    |  
|---------- |  | ------- | -- | - | ------------ |  | -- | -
|           |  | June 30 |    |   | September 30 | 
|           |  | 2005    |    |   | 2004         | 
|           |  |         |    |   |              | 
|Customer A |  |         | 41 | % |              |  | 29 | %
|Customer E |  |         | 14 | % |              |  | 16 | %
|Customer F |  |         | *  |   |              |  | 13 | %
|Customer H |  |         | 16 | % |              |  | 12 | %






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



|              |       |                |        |        |              |   |        |        | 
|------------- | ----- | -------------- | ------ | ------ | ------------ | - | ------ | ------ | 
|              |       | June 30        |        |        | September 30 |  
|              |       | 2005           |        |        | 2004         |  
|              |       |                |        |        |              |  
|              |       | (In thousands) |       
|United States |       | $              | 22,106 |        |              | $ | 22,889 |       
|Canada        |       |                | 894    |        |              |   | 1,947  |       
|Other         |       |                | 1,124  |        |              |   | 407    |       
|              |       |                |        |        |              |  
|              | Total |                | $      | 24,124 |              |   | $      | 25,243 | 
|              |       |                |        |        |              |  



|          |                           
|--------- | --------------------------
|NOTE 13  | Related Party Transactions





|          |                           
|--------- | --------------------------
|NOTE 14  | Provision for Income Taxes



25



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##### Table of Contents








|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|ITEM 2. | Managements Discussion and Analysis of Financial
    Condition and Results of Operations

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


The following discussion and analysis should be read in
conjunction with the condensed consolidated financial statements
and notes thereto in Item 1 above and with our financial
statements and notes thereto for the year ended
September 30, 2004, contained in Amendment No. 3 to
our Annual Report on Form 10-K/ A filed with the SEC on
August 9, 2005.


Restatement of Financial Statements








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





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

26



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##### Table of Contents





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











Overview




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



27



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##### Table of Contents











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





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











| |   |                                                                                                                                                                                                                                                                                                                                                                                 
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Product Focus: We continue to improve our product
    performance in defect detection, repair success, cost of
    ownership, ease of use and throughput for each of our product
    generations. We seek to couple this improved system performance
    with our expert applications engineering services to provide the
    best possible business solutions to our customers.

28



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##### Table of Contents





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



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







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









29



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##### Table of Contents











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



Critical Accounting Policies and Estimates










Revenue Recognition.


30



---



##### Table of Contents









Allowance for Doubtful Accounts.




Inventories.




Warranty.


31



---



##### Table of Contents





Goodwill and Intangible Assets.






Contingencies and Litigation.


32



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##### Table of Contents



Results of Operations




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



|                                                                                             |                                              |                          |       |            |                   |  |       |      |            |  |       |      |      |  |       |      |      | 
|-------------------------------------------------------------------------------------------- | -------------------------------------------- | ------------------------ | ----- | ---------- | ----------------- |  | ----- | ---- | ---------- |  | ----- | ---- | ---- |  | ----- | ---- | ---- | 
|                                                                                             |                                              | Three Months Ended       |       |            | Nine Months Ended | 
|                                                                                             |                                              | June 30,                 |       |            | June 30,          | 
|                                                                                             |                                              |                          |       |            |                   | 
|                                                                                             |                                              | 2005                     |       |            | 2004              |  |       | 2005 |            |  | 2004  |     
|                                                                                             |                                              |                          |       |            |                   |  |       |      |            |  |       |     
|                                                                                             |                                              |                          |       | (Restated) |                   |  |       |      | (Restated) | 
|Revenue                                                                                      |                                              |                          | 100.0 | %          |                   |  | 100.0 | %    |            |  | 100.0 | %    |      |  | 100.0 | %   
|Cost of revenue                                                                              |                                              |                          | 68.3  |            |                   |  | 53.8  |      |            |  | 67.5  |      |      |  | 54.2  |     
|                                                                                             |                                              |                          |       |            |                   |  |       |      |            |  |       |     
|Gross margin                                                                                 |                                              |                          | 31.7  |            |                   |  | 46.2  |      |            |  | 32.5  |      |      |  | 45.8  |     
|                                                                                             |                                              |                          |       |            |                   |  |       |      |            |  |       |     
|Operating expenses:                                                                          |                                              |                          |       |            |                   |  |       |      |            |  |       |      |      |  |       |     
|                                                                                             | Research and development                     |                          |       | 22.0       |                   |  |       | 20.9 |            |  |       | 27.6 |      |  |       | 22.4 |     
|                                                                                             | Selling, general and administrative          |                          |       | 18.8       |                   |  |       | 11.9 |            |  |       | 18.0 |      |  |       | 14.8 |     
|                                                                                             | Amortization of intangible assets            |                          |       | 1.0        |                   |  |       | 0.4  |            |  |       | 1.1  |      |  |       | 0.5  |     
|                                                                                             | Restructuring charges                        |                          |       | 2.5        |                   |  |       |     |            |  |       | 0.9  |      |  |       |     |     
|                                                                                             | Acquired in-process research and development |                          |       |           |                   |  |       | 0.5  |            |  |       |     |      |  |       | 0.2  |     
|                                                                                             | Impairment of goodwill                       |                          |       |           |                   |  |       |     |            |  |       |     |      |  |       | 0.8  |     
|                                                                                             | Impairment of purchased intangibles          |                          |       |           |                   |  |       |     |            |  |       |     |      |  |       | 2.3  |     
|                                                                                             | Gain on sale of property and equipment       |                          |       | (0.4       | )                 |  |       | (1.1 | )          |  |       | (0.1 | )    |  |       | (0.5 | )   
|                                                                                             | Impairment of property and equipment         |                          |       | 0.5        |                   |  |       |     |            |  |       | 0.6  |      |  |       | 0.3  |     
|                                                                                             |                                              |                          |       |            |                   |  |       |      |            |  |       |     
|                                                                                             |                                              | Total operating expenses |       |            | 44.4              |  |       |      | 32.6       |  |       |      | 48.1 |  |       |      | 40.8 | 
|                                                                                             |                                              |                          |       |            |                   |  |       |      |            |  |       |     
|Income (loss) from operations                                                                |                                              |                          | (12.7 | )          |                   |  | 13.6  |      |            |  | (15.6 | )    |      |  | 5.0   |     
|Interest income and other, net                                                               |                                              |                          | 1.2   |            |                   |  | 1.0   |      |            |  | 1.9   |      |      |  | 5.0   |     
|                                                                                             |                                              |                          |       |            |                   |  |       |      |            |  |       |     
|Income (loss) from continuing operations before income taxes and
    discontinued operations |                                              |                          | (11.5 | )          |                   |  | 14.6  |      |            |  | (13.7 | )    |      |  | 10.0  |     
|Provision for income taxes                                                                   |                                              |                          | 0.4   |            |                   |  | 0.3   |      |            |  | 0.6   |      |      |  | 0.6   |     
|                                                                                             |                                              |                          |       |            |                   |  |       |      |            |  |       |     
|Income (loss) from continuing operations                                                     |                                              |                          | (11.9 | )          |                   |  | 14.3  |      |            |  | (14.3 | )    |      |  | 9.4   |     
|Income (loss) from discontinued operations                                                   |                                              |                          | 0.7   |            |                   |  | (0.7  | )    |            |  | 0.2   |      |      |  | (1.6  | )   
|                                                                                             |                                              |                          |       |            |                   |  |       |      |            |  |       |     
|Net income (loss)                                                                            |                                              |                          | (11.2 | )%         |                   |  | 13.6  | %    |            |  | (14.1 | )%   |      |  | 7.8   | %   
|                                                                                             |                                              |                          |       |            |                   |  |       |      |            |  |       |     



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

|        |  |                       |      |  |                   |            |   |      |  |   |      |  |            |        |       |  |      |  |    |   |  |   |      | 
|------- |  | --------------------- | ---- |  | ----------------- | ---------- | - | ---- |  | - | ---- |  | ---------- | ------ | ----- |  | ---- |  | -- | - |  | - | ---- | 
|        |  | Three Months Ended    |      |  | Nine Months Ended |           
|        |  | June 30,              |      |  | June 30,          |           
|        |  |                       |      |  |                   |           
|        |  | 2005                  |      |  | Change            |            |   | 2004 |  |   | 2005 |  |            | Change |       |  | 2004 | 
|        |  |                       |      |  |                   |            |   |      |  |   |      |  |            |        |       |  |      | 
|        |  |                       |      |  |                   | (Restated) |   |      |  |   |      |  | (Restated) |       
|        |  | (Dollars in millions) |     
|Revenue |  | $                     | 39.1 |  |                   |            | 1 | %    |  | $ | 38.5 |  |            | $      | 101.1 |  |      |  | 13 | % |  | $ | 89.1 | 



tm tm tm


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34



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|       |  |                       |      |  |                   |            |    |      |  |   |      |  |            |        |       |  |      |  |     |    |  |   |      | 
|------ |  | --------------------- | ---- |  | ----------------- | ---------- | -- | ---- |  | - | ---- |  | ---------- | ------ | ----- |  | ---- |  | --- | -- |  | - | ---- | 
|       |  | Three Months Ended    |      |  | Nine Months Ended |           
|       |  | June 30,              |      |  | June 30,          |           
|       |  |                       |      |  |                   |           
|       |  | 2005                  |      |  | Change            |            |    | 2004 |  |   | 2005 |  |            | Change |       |  | 2004 | 
|       |  |                       |      |  |                   |            |    |      |  |   |      |  |            |        |       |  |      | 
|       |  |                       |      |  |                   | (Restated) |    |      |  |   |      |  | (Restated) |       
|       |  | (Dollars in millions) |     
|Korea  |  | $                     | 19.6 |  |                   |            | (7 | )%   |  | $ | 21.0 |  |            | $      | 30.6  |  |      |  | (32 | )% |  | $ | 44.9 | 
|Taiwan |  |                       | 18.4 |  |                   |            | 12 | %    |  |   | 16.5 |  |            |        | 41.0  |  |      |  | 13  | %  |  |   | 36.2 | 
|Japan  |  |                       | 1.1  |  |                   |            | 10 | %    |  |   | 1.0  |  |            |        | 16.2  |  |      |  | 103 | %  |  |   | 8.0  | 
|China  |  |                       |     |  |                   |            |   |      |  |   |     |  |            |        | 13.3  |  |      |  |    |    |  |   |     | 
|       |  |                       |      |  |                   |            |    |      |  |   |      |  |            |        |       |  |      | 
|       |  | $                     | 39.1 |  |                   |            | 2  | %    |  | $ | 38.5 |  |            | $      | 101.1 |  |      |  | 13  | %  |  | $ | 89.1 | 
|       |  |                       |      |  |                   |            |    |      |  |   |      |  |            |        |       |  |      | 









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

|             |  |                    |    |   |                   |            |     |      |  |  |      |   |            |        |    |   |      |  |     |    |  |  |    |  
|------------ |  | ------------------ | -- | - | ----------------- | ---------- | --- | ---- |  |  | ---- | - | ---------- | ------ | -- | - | ---- |  | --- | -- |  |  | -- | -
|             |  | Three Months Ended |    |   | Nine Months Ended |           
|             |  | June 30,           |    |   | June 30,          |           
|             |  |                    |    |   |                   |           
|             |  | 2005               |    |   | Change            |            |     | 2004 |  |  | 2005 |   |            | Change |    |   | 2004 | 
|             |  |                    |    |   |                   |            |     |      |  |  |      |   |            |        |    |   |      | 
|             |  |                    |    |   |                   | (Restated) |     |      |  |  |      |   | (Restated) |       
|Gross Margin |  |                    | 32 | % |                   |            | (32 | )%   |  |  | 46   | % |            |        | 32 | % |      |  | (29 | )% |  |  | 46 | %





| |   |                                                                                                                                           
| | - | ------------------------------------------------------------------------------------------------------------------------------------------
| |  | A high mix of Generation 5 and earlier generation test and
    repair products sold at lower margins than current generation
    products;
|
| |  | The under-utilization of our San Jose facilities.                                                                                         







| |   |                                                                                                                                              
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------
| |  | Our revenue mix between higher margin
    ArrayCheckertm
    systems and lower margin
    ArraySavertm
    and
    PanelMastertm
    systems;

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| |   |                                                                                                                                      
| | - | -------------------------------------------------------------------------------------------------------------------------------------
| |  | The costs of increasing customer service staff to support the
    increased demands of our customers;                                
|
| |  | The additional costs in connection with inefficiencies of
    manufacturing newly-introduced products;                               
|
| |  | Competitive pricing pressures, particularly in the array repair
    market;                                                          
|
| |  | Reduced production levels as a consequence of either industry
    slowdown, order cancellations or pushouts by our
    customers; and
|
| |  | Fluctuations in the level of revenue due to the cyclical nature
    of customers capital expenditures.                              



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

|                   |  |                       |     |   |                   |  |   |      |  |   |      |   |  |        |      |   |      |  |    |   |  |   |      |  
|------------------ |  | --------------------- | --- | - | ----------------- |  | - | ---- |  | - | ---- | - |  | ------ | ---- | - | ---- |  | -- | - |  | - | ---- | -
|                   |  | Three Months Ended    |     |   | Nine Months Ended | 
|                   |  | June 30,              |     |   | June 30,          | 
|                   |  |                       |     |   |                   | 
|                   |  | 2005                  |     |   | Change            |  |   | 2004 |  |   | 2005 |   |  | Change |      |   | 2004 | 
|                   |  |                       |     |   |                   |  |   |      |  |   |      |   |  |        |      |   |      | 
|                   |  | (Dollars in millions) |    
|Expense            |  | $                     | 8.6 |   |                   |  | 7 | %    |  | $ | 8.0  |   |  | $      | 27.9 |   |      |  | 40 | % |  | $ | 20.0 |  
|Percent of Revenue |  |                       | 22  | % |                   |  |   |      |  |   | 21   | % |  |        | 28   | % |      |  |    |   |  |   | 22   | %







| |   |                                                                                                         
| | - | --------------------------------------------------------------------------------------------------------
| |  | Ramp up our cell and module program to address mass production
    requirements;                        
|
| |  | Increase our efforts on Generation 7 and 7.5 products and launch
    programs for Generation 8 products;
|
| |  | Invest funds in reliability and cost reduction
    initiatives; and                                     
|
| |  | Expand our repair product offering.                                                                     





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

|                   |  |                       |     |   |                   |  |    |      |  |   |      |   |  |        |      |   |      |  |    |   |  |   |      |  
|------------------ |  | --------------------- | --- | - | ----------------- |  | -- | ---- |  | - | ---- | - |  | ------ | ---- | - | ---- |  | -- | - |  | - | ---- | -
|                   |  | Three Months Ended    |     |   | Nine Months Ended | 
|                   |  | June 30,              |     |   | June 30,          | 
|                   |  |                       |     |   |                   | 
|                   |  | 2005                  |     |   | Change            |  |    | 2004 |  |   | 2005 |   |  | Change |      |   | 2004 | 
|                   |  |                       |     |   |                   |  |    |      |  |   |      |   |  |        |      |   |      | 
|                   |  | (Dollars in millions) |    
|Expense            |  | $                     | 7.4 |   |                   |  | 60 | %    |  | $ | 4.6  |   |  | $      | 18.1 |   |      |  | 38 | % |  | $ | 13.2 |  
|Percent of Revenue |  |                       | 19  | % |                   |  |    |      |  |   | 12   | % |  |        | 18   | % |      |  |    |   |  |   | 15   | %



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| |   |                                                                                                                                                                                                                                                                                                                 
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Amounts spent on the internal investigation and resulting
    restatement of our fiscal 2004 Annual Report on Form 10-K/
    A and our fiscal 2005 Quarterly Report on Form 10-Q/ A for
    the three month period ended December 31, 2004. Expenses
    incurred in the quarter were approximately $16 million;
|
| |  | Amounts spent on preparation work for compliance with
    Section 404 of the Sarbanes-Oxley Act of 2002; and                                                                                                                                                                                                    
|
| |  | Additional investments in the marketing area.                                                                                                                                                                                                                                                                   





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

|                   |  |                    |         |   |                   |  |     |      |  |   |         |   |  |        |             |   |      |  |     |   |  |   |         |  
|------------------ |  | ------------------ | ------- | - | ----------------- |  | --- | ---- |  | - | ------- | - |  | ------ | ----------- | - | ---- |  | --- | - |  | - | ------- | -
|                   |  | Three Months Ended |         |   | Nine Months Ended | 
|                   |  | June 30,           |         |   | June 30,          | 
|                   |  |                    |         |   |                   | 
|                   |  | 2005               |         |   | Change            |  |     | 2004 |  |   | 2005    |   |  | Change |             |   | 2004 | 
|                   |  |                    |         |   |                   |  |     |      |  |   |         |   |  |        |             |   |      | 
|Expense            |  | $                  | 380,000 |   |                   |  | 145 | %    |  | $ | 155,000 |   |  | $      | 1.2 million |   |      |  | 182 | % |  | $ | 416,000 |  
|Percent of Revenue |  |                    | 1       | % |                   |  |     |      |  |   | 0.4     | % |  |        | 1           | % |      |  |     |   |  |   | 0.5     | %







| |                      
| | ---------------------
| | Restructuring Charges







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| |                                             
| | --------------------------------------------
| | Acquired In-Process Research and Development











| |                                                                             
| | ----------------------------------------------------------------------------
| | Impairment of Goodwill, Purchased Intangibles and Property
    and Equipment







| |                                       
| | --------------------------------------
| | Gain on Sale of Property and Equipment



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

|                   |  |                    |         |   |                   |  |    |      |  |   |         |   |  |        |             |   |      |  |     |    |  |   |             |  
|------------------ |  | ------------------ | ------- | - | ----------------- |  | -- | ---- |  | - | ------- | - |  | ------ | ----------- | - | ---- |  | --- | -- |  | - | ----------- | -
|                   |  | Three Months Ended |         |   | Nine Months Ended | 
|                   |  | June 30,           |         |   | June 30,          | 
|                   |  |                    |         |   |                   | 
|                   |  | 2005               |         |   | Change            |  |    | 2004 |  |   | 2005    |   |  | Change |             |   | 2004 | 
|                   |  |                    |         |   |                   |  |    |      |  |   |         |   |  |        |             |   |      | 
|Income             |  | $                  | 472,000 |   |                   |  | 21 | %    |  | $ | 389,000 |   |  | $      | 1.9 million |   |      |  | (58 | )% |  | $ | 4.5 million |  
|Percent of Revenue |  |                    | 1       | % |                   |  |    |      |  |   | 1       | % |  |        | 2           | % |      |  |     |    |  |   | 5           | %





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

|                   |  |                    |         |   |                   |            |    |      |  |   |         |   |            |        |         |   |      |  |   |   |  |   |         |  
|------------------ |  | ------------------ | ------- | - | ----------------- | ---------- | -- | ---- |  | - | ------- | - | ---------- | ------ | ------- | - | ---- |  | - | - |  | - | ------- | -
|                   |  | Three Months Ended |         |   | Nine Months Ended |           
|                   |  | June 30,           |         |   | June 30,          |           
|                   |  |                    |         |   |                   |           
|                   |  | 2005               |         |   | Change            |            |    | 2004 |  |   | 2005    |   |            | Change |         |   | 2004 | 
|                   |  |                    |         |   |                   |            |    |      |  |   |         |   |            |        |         |   |      | 
|                   |  |                    |         |   |                   | (Restated) |    |      |  |   |         |   | (Restated) |       
|Expense            |  | $                  | 167,000 |   |                   |            | 25 | %    |  | $ | 134,000 |   |            | $      | 565,000 |   |      |  | 1 | % |  | $ | 560,000 |  
|Percent of Revenue |  |                    | 0       | % |                   |            |    |      |  |   | 0       | % |            |        | 1       | % |      |  |   |   |  |   | 1       | %







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

|              |  |                    |         |  |                   |   |          |      |  |   |         |  |  |   |              |  
|------------- |  | ------------------ | ------- |  | ----------------- | - | -------- | ---- |  | - | ------- |  |  | - | ------------ | -
|              |  | Three Months Ended |         |  | Nine Months Ended |  
|              |  | June 30,           |         |  | June 30,          |  
|              |  |                    |         |  |                   |  
|              |  | 2005               |         |  | 2004              |   |          | 2005 |  |   | 2004    | 
|              |  |                    |         |  |                   |   |          |      |  |   |         | 
|Income (loss) |  | $                  | 268,000 |  |                   | $ | (265,000 | )    |  | $ | 258,000 |  |  | $ | (1.5 million | )





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Liquidity and Capital Resources






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





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





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









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



40



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|                                         |                                                                         |                   |      |      |      |   |        |      |  
|---------------------------------------- | ----------------------------------------------------------------------- | ----------------- | ---- | ---- | ---- | - | ------ | ---- | -
|                                         |                                                                         | Nine Months Ended |     
|                                         |                                                                         | June 31,          |     
|                                         |                                                                         |                   |     
|                                         |                                                                         | 2005              |      |      | 2004 |  
|                                         |                                                                         |                   |      |      |      |  
|                                         |                                                                         | (In thousands)    |     
|Printed circuit board business           |                                                                         | $                 | (523 | )    |      | $ | (1,225 | )   
|                                         | Cathode ray tube display and high quality glass inspection
    business |                   |      | (264 | )    |   |        | (228 | )
|                                         |                                                                         |                   |      |      |      |  
|Net cash used in discontinued operations |                                                                         | $                 | (787 | )    |      | $ | (1,453 | )   
|                                         |                                                                         |                   |      |      |      |  



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



|                            |       |                             |        |        |         |                |        |        |  |   |       |        |  |      |       |       |      |   |       |            |  |   |       |       |  |   |       |       | 
|--------------------------- | ----- | --------------------------- | ------ | ------ | ------- | -------------- | ------ | ------ |  | - | ----- | ------ |  | ---- | ----- | ----- | ---- | - | ----- | ---------- |  | - | ----- | ----- |  | - | ----- | ----- | 
|                            |       | Payments Due by Fiscal Year |       
|                            |       |                             |       
|Contractual Obligations     |       | Total                       |        |        | 2005(1) |                |        | 2006   |  |   | 2007  |        |  | 2008 |       |       | 2009 |   |       | Thereafter | 
|                            |       |                             |        |        |         |                |        |        |  |   |       |        |  |      |       |       |      |   |       |            | 
|                            |       |                             |        |        |         | (In thousands) |        |        |  |   |      
|Notes payable               |       | $                           | 2,251  |        |         | $              | 333    |        |  | $ | 977   |        |  | $    | 941   |       |      | $ |      |            |  | $ |      |       |  | $ |      |      
|Operating lease obligations |       |                             | 15,920 |        |         |                | 948    |        |  |   | 3,572 |        |  |      | 2,748 |       |      |   | 2,627 |            |  |   | 2,627 |       |  |   | 3,398 |      
|Purchase obligations        |       |                             | 32,671 |        |         |                | 20,062 |        |  |   | 8,132 |        |  |      | 3,762 |       |      |   | 715   |            |  |   |      |       |  |   |      |      
|                            |       |                             |        |        |         |                |        |        |  |   |       |        |  |      |       |       |      |   |       |            | 
|                            | Total |                             | $      | 50,842 |         |                | $      | 21,343 |  |   | $     | 12,681 |  |      | $     | 7,451 |      |   | $     | 3,342      |  |   | $     | 2,627 |  |   | $     | 3,398 | 
|                            |       |                             |        |        |         |                |        |        |  |   |       |        |  |      |       |       |      |   |       |            | 






|    |                   
|--- | ------------------
|(1) | Remaining 3 months









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



41



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Impact of Accounting Pronouncements














42



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Factors Affecting Operating Results




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





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







| |   |                                                                                                     
| | - | ----------------------------------------------------------------------------------------------------
| |  | 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;                                                         

43



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| |   |                                                                                                                                                               
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the outcome of our litigation with a former executive officer;                                                                                                
|
| |  | worldwide political instability;                                                                                                                              
|
| |  | our ability to design, manufacture and introduce new products on
    a cost-effective and timely basis;                                                       
|
| |  | the delay between expenses to further develop marketing and
    service capabilities and the realization of benefits from those
    improved capabilities; and
|
| |  | the introduction of new products by our competitors.                                                                                                          





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

tm tm tm




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







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



44



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





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





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



tm tm tm tm




45



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##### Table of Contents





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





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





| |   |                                                                                         
| | - | ----------------------------------------------------------------------------------------
| |  | political instability and the possibility of hostilities,
    terrorist attacks, or war;
|
| |  | imposition of governmental controls;                                                    
|
| |  | fluctuations in interest and currency exchange rates;                                   
|
| |  | export license requirements;                                                            
|
| |  | restrictions on the export of technology;                                               
|
| |  | limited foreign protection of intellectual property rights;                             
|
| |  | trade restrictions;                                                                     
|
| |  | periodic or local international downturns;                                              
|
| |  | changes in tariffs; and                                                                 
|
| |  | difficulties in staffing and managing international operations.                         





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



46



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





| |   |                                                                                                  
| | - | -------------------------------------------------------------------------------------------------
| |  | 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.                                                





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





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





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





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





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







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





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







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



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





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





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





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





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



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|        |                                                               
|------- | --------------------------------------------------------------
|ITEM 3. | Quantitative and Qualitative Disclosures About Market
    Risk



| |                                    
| | -----------------------------------
| | Foreign Currency Exchange Rate Risk







Market Risk









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

Evaluation of Disclosure Controls and Procedures.


Efforts to Address Existing Material Weaknesses and Other
Deficiencies.




| |   |                                                                                                                                                                                                                                                                        
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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;

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| |   |                                                                                                                                                                                
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | a formal review process of the financial statements and
    supporting schedules of our international subsidiaries; and                                                        
|
| |  | consistent processes and controls over revenue transactions
    entered into and recorded by our Japanese subsidiary with those
    processes and controls in place in the U.S.













| |                                                                                                   
| | --------------------------------------------------------------------------------------------------
| | Changes in Internal Control Over Financial Reporting Prior
    to the Third Quarter of Fiscal 2005



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





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

Limitations on the Effectiveness of Disclosure Controls and
Procedures.


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PART II. OTHER INFORMATION







|        |                  
|------- | -----------------
|ITEM 1. | Legal Proceedings














|        |                                                                
|------- | ---------------------------------------------------------------
|ITEM 2. | Unregistered Sales of Equity Securities and Use of
    Proceeds








|        |                                
|------- | -------------------------------
|ITEM 3. | Defaults Upon Senior Securities








|        |                                                    
|------- | ---------------------------------------------------
|ITEM 4. | Submission of Matters to a Vote of Security Holders



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|        |                  
|------- | -----------------
|ITEM 5. | Other Information








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

Exhibits


|       |    |         |  |                                                                                                                                                                
|------ | -- | ------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------
|Number |    | Exhibit
|       |    |        
|       | 3  | .1(1)   |  | Amended and Restated Articles of Incorporation of the Registrant.                                                                                              
|      
|       | 3  | .2(1)   |  | Certificate of Amendment to Articles of Incorporation of the
    Registrant.                                                                                   
|      
|       | 3  | .3(2)   |  | Bylaws of the Registrant and amendments thereto.                                                                                                               
|      
|       | 4  | .1      |  | Reference is made to Exhibits 3.1, 3.2 and 3.3.                                                                                                                
|      
|       | 10 | .4(3)   |  | Letter Agreement Extending Consulting Contract with Malcolm
    Thompson, dated April 8, 2005.                                                                 
|      
|       | 10 | .47     |  | Sublease, dated April 15, 2005, among Photon Dynamics
    Canada, Inc., Service Results Technology, and Huntley
    Contracting Limited.                       
|      
|       | 10 | .48     |  | Offer letter, dated April 29, 2005, between Photon
    Dynamics, Inc. and Maureen L. Lamb.                                                                     
|      
|       | 10 | .49     |  | Separation Agreement, dated May 5, 2005, between Photon
    Dynamics, Inc., and Richard Okumoto.                                                               
|      
|       | 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 as Exhibit 10.4 to the Registrants
    Current Report on Form 8-K as filed with the Securities and
    Exchange Commission on April 11, 2005, 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.

55



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##### Table of Contents






SIGNATURES






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



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

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



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##### Table of Contents



Exhibit Index


|       |    |         |  |                                                                                                                                                                
|------ | -- | ------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------
|Number |    | Exhibit
|       |    |        
|       | 3  | .1(1)   |  | Amended and Restated Articles of Incorporation of the Registrant.                                                                                              
|      
|       | 3  | .2(1)   |  | Certificate of Amendment to Articles of Incorporation of the
    Registrant.                                                                                   
|      
|       | 3  | .3(2)   |  | Bylaws of the Registrant and amendments thereto.                                                                                                               
|      
|       | 4  | .1      |  | Reference is made to Exhibits 3.1, 3.2 and 3.3.                                                                                                                
|      
|       | 10 | .4(3)   |  | Letter Agreement Extending Consulting Contract with Malcolm
    Thompson, dated April 8, 2005.                                                                 
|      
|       | 10 | .47     |  | Sublease, dated April 15, 2005, among Photon Dynamics
    Canada, Inc., Service Results Technology, and Huntley
    Contracting Limited.                       
|      
|       | 10 | .48     |  | Offer letter, dated April 29, 2005, between Photon
    Dynamics, Inc. and Maureen L. Lamb.                                                                     
|      
|       | 10 | .49     |  | Separation Agreement, dated May 5, 2005, between Photon
    Dynamics, Inc., and Richard Okumoto.                                                               
|      
|       | 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 as Exhibit 10.4 to the Registrants
    Current Report on Form 8-K as filed with the Securities and
    Exchange Commission on April 11, 2005, 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.

57