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  **UNITED STATES SECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549****Form 10-Q**   (Mark One)  þ     **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE    SECURITIES EXCHANGE ACT OF 1934**   **For the quarterly period ended March 31, 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* *(I.R.S. Employer**incorporation or organization)* *Identification No.)***5970 Optical Court****San Jose, California 95138-1400***(Address of principal executive offices including zipcode)***(408) 226-9900***(Registrant’s telephone number, including area code)*    Indicate by check mark whether the registrant (1) has filedall reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has beensubject to such filing requirements for the past90 days.     Yes o          No þ     Indicate by check mark whether the registrant is an acceleratedfiler (as defined in Rule 12b-2 of the ExchangeAct).     Yes þ          No o     As of April 29, 2005, there were 16,986,888 sharesoutstanding of the Registrant’s Common Stock, no par value.  

**INDEX**           **Page**     ** PART I FINANCIAL INFORMATION**     Item 1.      Financial Statements (unaudited)           Condensed Consolidated Balance Sheets as of    March 31, 2005 and September 30, 2004  3        Condensed Consolidated Statements of    Operations for the Three and Six Months Ended March 31,    2005 and 2004  4        Condensed Consolidated Statements of Cash    Flows for the Six Months Ended March 31, 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  23      Item 3.      Quantitative and Qualitative Disclosures    About Market Risk  46      Item 4.      Controls and Procedures  46  ** PART II OTHER INFORMATION**     Item 1.      Legal Proceedings  48      Item 2.      Unregistered Sales of Equity Securities and    Use of Proceeds  49      Item 3.      Defaults Upon Senior Securities  49      Item 4.      Submission of Matters to a Vote of Security    Holders  50      Item 5.      Other Information  50      Item 6.      Exhibits  50      Signatures  52  EXHIBIT 31.1 EXHIBIT 31.2 EXHIBIT 32.1
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**PART I. FINANCIAL INFORMATION****ITEM 1.*****Financial Statements*****PHOTON DYNAMICS, INC.****CONDENSED CONSOLIDATED BALANCE SHEETS**             **March 31,** **September 30,**  **2005** **2004**         **(Restated)**  **(Unaudited)**  **(In thousands)****ASSETS**    Current assets:             Cash and cash equivalents $24,111  $25,483      Short-term investments  76,936   58,672      Accounts receivable, net  17,681   58,341      Inventories  31,458   31,716      Other current assets  5,742   4,536              Total current assets  155,928   178,748     Land, property and equipment, net  21,222   20,337     Other assets  4,160   3,909     Intangible assets, net  3,958   4,753     Goodwill  153   153              Total assets $185,421  $207,900         **LIABILITIES AND SHAREHOLDERS’ EQUITY**    Current liabilities:             Accounts payable $8,215  $18,485      Warranty  6,201   6,194      Other current liabilities  9,556   10,231      Deferred gross margin  8,314   11,503              Total current liabilities  32,286   46,413     Other liabilities  1,508   1,528     Commitments and contingencies            Shareholders’ equity:             Common stock, no par value  287,465   285,790      Accumulated deficit  (136,007)  (126,178)     Accumulated other comprehensive income  169   347              Total shareholders’ equity  151,627   159,959              Total liabilities and shareholders’ equity $185,421  $207,900        See accompanying notes to condensed consolidated financialstatements.
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**PHOTON DYNAMICS, INC.****CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**                     **Three Months Ended** **Six Months Ended**  **March 31,** **March 31,**       **2005** **2004** **2005** **2004**             **(Restated)**   **(Restated)**  **(Unaudited)**  **(In thousands, except per share data)**    Revenue $25,326  $26,182  $61,965  $50,557     Cost of revenue  18,768   14,183   41,549   27,595                  Gross margin  6,558   11,999   20,416   22,962                  Operating expenses:                     Research and development  9,818   6,144   19,288   11,954      Selling, general and administrative  6,107   3,966   10,791   8,564      Amortization of intangible assets  398   60   795   261      Gain on sale of fixed assets  —   (20)  —   (30)     Impairment of goodwill  —   —   —   665      Impairment of purchased intangibles  —   —   —   2,089      Impairment of property and equipment  382   —   382   234                    Total operating expenses  16,705   10,150   31,256   23,737                  Income (loss) from operations  (10,147)  1,849   (10,840)  (775)    Interest income and other, net  164   334   1,419   4,105                  Income (loss) from continuing operations before income taxes and    discontinued operations  (9,983)  2,183   (9,421)  3,330     Provision for income taxes  359   64   398   426                  Income (loss) from continuing operations before discontinued    operations  (10,342)  2,119   (9,819)  2,904     Loss from discontinued operations  (4)  (1,276)  (10)  (1,229)                 Net income (loss) $(10,346) $843  $(9,829) $1,675                  Income (loss) per share from continuing operations:                     Basic $(0.61) $0.13  $(0.58) $0.18                   Diluted $(0.61) $0.12  $(0.58) $0.17                  Loss per share from discontinued operations:                     Basic $(0.00) $(0.08) $(0.00) $(0.07)                  Diluted $(0.00) $(0.07) $(0.00) $(0.07)                 Net income (loss) per share:                     Basic $(0.61) $0.05  $(0.58) $0.10                   Diluted $(0.61) $0.05  $(0.58) $0.10                  Weighted average number of shares:                     Basic  16,948   16,572   16,909   16,517      Diluted  16,948   17,172   16,909   17,174 See accompanying notes to condensed consolidated financialstatements.
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**PHOTON DYNAMICS, INC.****CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**              **Six Months Ended**  **March 31,**     **2005** **2004**         **(Restated)**  **(Unaudited)**  **(In thousands)**    Cash flows from operating activities:             Net income (loss) from continuing operations $(9,819) $2,904      Adjustments to reconcile net income (loss) from continuing    operations to net cash provided by (used in) operating    activities from continuing operations:              Depreciation  2,827   2,082       Amortization of intangible assets  795   261       Impairment of goodwill  —   665       Impairment of purchased intangibles and property and equipment  382   2,323       Stock ownership expense  35   82       Accretion of non-interest bearing notes payable  39   —       Changes in assets and liabilities:               Accounts receivable  40,660   (18,851)       Inventories  260   (11,186)       Other current assets  (1,066)  1,725        Other assets  (251)  (1,363)       Accounts payable  (10,270)  10,224        Other current liabilities  (85)  (895)       Deferred gross margin  (3,189)  (291)       Other liabilities  (45)  (32)            Net cash provided by (used in) operating activities from    continuing operations  20,273   (12,352)     Net cash used in operating activities from discontinued    operations  (436)  (28)            Net cash provided by (used in) operating activities  19,837   (12,380)           Cash flows from investing activities:              Purchase of property and equipment  (4,094)  (7,861)      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  (40,519)  (290,421)      Redemption of short-term investments  21,998   303,247             Net cash provided by (used in) investing activities from    continuing operations  (22,615)  3,527            Cash flows from financing activities:              Issuance of common stock  1,640   3,520       Net repayment of short-term borrowings  (192)  —             Net cash provided by financing activities from continuing    operations  1,448   3,520      Net cash used in financing activities from discontinued    operations  (121)  —             Net cash provided by financing activities  1,327   3,520             Effect of exchange rate changes on cash and cash equivalents  79   (99)            Net decrease in cash and cash equivalents from continuing    operations  (815)  (5,404)     Net decrease in cash and cash equivalents from discontinued    operations  (557)  (28)            Net decrease in cash and cash equivalents  (1,372)  (5,432)     Cash and cash equivalents at beginning of period  25,483   18,305             Cash and cash equivalents at end of period $24,111  $12,873        See accompanying notes to condensed consolidated financialstatements.
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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.* In late March of2005, management of Photon Dynamics, Inc. (“PhotonDynamics” or the “Company”) identified an errorrelated to the timing of a portion of revenue recognized inconnection with a sales transaction for which revenue wasrecorded in the fourth quarter of fiscal 2004. The error relatedto commitments made to a customer for certain system parts andsupply contracts with a fair value amounting to approximately$859,000, that were not delivered by September 30, 2004.These additional commitments were made in the course ofnegotiating a larger sales arrangement with the customer, butwere inadvertently not communicated by the Company’s salespeople to the accounting department as required by theCompany’s policy. These additional commitments wereidentified to the accounting department in late March 2005 whenthe customer notified the Company that it wanted to takedelivery of certain of the additional committed items. Based onthe fair value of the committed but undelivered parts and supplycontracts at September 30, 2004, revenue and net income forthe quarter ended September 30, 2004 were overstated by$859,000, and deferred revenue at September 30, 2004 wasunderstated by $859,000.     Management notified the Company’s Audit Committee, theBoard of Directors and its independent registered publicaccounting firm of the existence of the undelivered elements inearly April after internal confirmation of their discovery. TheAudit Committee immediately undertook an internal investigationto evaluate the impact on the timing of revenue recognized underthe total arrangement, to assess why it had occurred, and todetermine whether any other such transactions might exist forwhich such an error had occurred. In connection with thisinvestigation, the Audit Committee engaged the Company’soutside legal counsel, which then engaged a third-party forensicaccounting firm and an electronic data recovery firm to assistthem in its investigation. As part of its investigation, theAudit Committee, with the assistance of outside legal counsel,the forensic accounting firm and the electronic data recoveryfirm, reviewed sales transactions for fiscal 2004, and for thefirst two quarters of fiscal 2005. In addition to thetransaction described above identified by management, theensuing investigation revealed several other adjustments torevenue due to errors, none of which were individually material,that can be categorized as follows:          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.     Adjustments identified as a result of the investigation,including adjustments related to the additional commitmentsinitially reported by management to the Audit Committee asdiscussed above, aggregate to an overstatement of theCompany’s revenue and net income by approximately$1.4 million in fiscal 2004. In addition, because theamounts erroneously recognized as revenue were not deferred, theCompany’s revenue and net income were understated byapproximately $0.3 million, in the first quarter of fiscal2005. The Company’s current liabilities were understated byapproximately $1.4 million at September 30, 2004, andwere understated by approximately $1.1 million atDecember 31, 2004. For the three and six months endedMarch 31, 2004, revenue and net income were each overstatedby approximately $296,000 and $420,000, respectively. TheCompany’s current liabilities were understated byapproximately $420,000 at March 31, 2004. The Companydetermined that cost of revenue was not impacted by any of theitems discussed above
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**PHOTON DYNAMICS, INC.****NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**for any period. Because of the aggregate significance of theerrors found, all of which impact the timing, but not theeventual amount, of revenue recognizable under the relatedarrangements, the Company determined that it was appropriate torestate its financial statements for the year endedSeptember 30, 2004, the quarters within that year andrestate its financial statements for the quarter endedDecember 31, 2004.     In Note 15 to Part II, Item 8, “QuarterlyConsolidated Results of Operations (unaudited)” in theCompany’s Notes to Consolidated Financial Statements of theCompany’s Annual Report on Form 10-K/ A AmendmentNo. 3 (the “10-K/ A Amendment”) for the yearended September 30, 2004, filed concurrently with thisForm 10-Q, the Company adjusted its quarterly results ofoperations for fiscal 2004 to reflect proper accountingtreatment for the transactions related to the investigation. TheCompany did not amend its Quarterly Reports on Form 10-Qfor any of its reported periods in fiscal 2004. All fiscal 2004amounts reflected in this Form 10-Q reflect the results ofthe restatement set forth in the 10-K/ A Amendment.     For additional information related to this restatement, pleaserefer to the 10-K/ A Amendment.     *Basis of Presentation.* The accompanying unauditedcondensed consolidated financial statements of Photon Dynamics,Inc. have been prepared in accordance with generally acceptedaccounting principles in the United States for interim financialinformation and with the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, they do notinclude all of the information and footnotes required byaccounting principles generally accepted in the United Statesfor complete financial statements. In the opinion of management,the unaudited interim financial statements reflect alladjustments (consisting only of normal recurring adjustments)considered necessary for a fair presentation of the financialposition, results of operations and cash flows for the periodsindicated.     These financial statements and notes should be read inconjunction with “Item 8 Financial Statements andSupplementary Data” included in the 10-K/ A Amendment.Operating results for the three and six month periods endedMarch 31, 2005, are not necessarily indicative of theresults that may be expected for any other interim period or forthe full fiscal year ending September 30, 2005.     The condensed consolidated balance sheet as ofSeptember 30, 2004, is derived from the Company’saudited consolidated financial statements as ofSeptember 30, 2004, included in theCompany’s 10-K/ A Amendment for the fiscal year endedSeptember 30, 2004 filed with the Securities and ExchangeCommission, but does not include all of the information andfootnotes required by generally accepted accounting principlesfor complete financial statements. Certain prior year amounts inthese condensed consolidated financial statements and notesthereto have been reclassified to conform to the currentperiod’s presentation.     *Description of Operations and Principles ofConsolidation.* Photon Dynamics is a supplier of integratedyield management solutions for the flat panel display industry.The condensed consolidated financial statements include theaccounts of the Company and its wholly owned subsidiaries.Intercompany accounts and transactions have been eliminated.     Through January 14, 2003, the Company conducted business inthree operating segments: flat panel display products, cathoderay tube display and high quality glass inspection products andprinted circuit board assembly inspection products. In January2003, the Company implemented a plan to exit the printed circuitboard assembly inspection business. In June 2003, the Companyimplemented a plan to exit the cathode ray tube display and highquality glass inspection businesses. Accordingly, the operatingresults of these former business segments have been presented asdiscontinued operations in accordance with the provisions ofStatement of Financial Accounting Standards No. 144,“Accounting for the Impairment or Disposal of Long-livedAssets,” (“FAS 144”). Accordingly, in thecondensed consolidated statements of operations, the netoperating results of these former businesses have beenclassified as “Income (loss) from discontinuedoperations,” for all periods presented. The cash flows fromthese businesses have been presented as “Net cash flowsfrom discontinued operations” in the operating, investingand financing sections of the condensed consolidated statementsof cash flows.
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**PHOTON DYNAMICS, INC.****NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     *Management Estimates.* The preparation of financialstatements in conformity with generally accepted accountingprinciples in the United States requires management to makeestimates and assumptions that affect the reported amounts ofassets and liabilities at the date of the financial statementsand the reported amounts of revenues and expenses during thereporting periods. Actual results could differ from thoseestimates. Significant estimates made by management includerevenue recognition, the allowance for doubtful accounts,inventory write-downs, warranty accruals, impairment ofgoodwill, other acquired intangible assets and long-livedassets, acquired in-process research and development andlitigation and contingency assessments.     *Fair Value of Financial Instruments.* The Companyevaluates the estimated fair value of financial instrumentsusing available market information and certain valuationmethodologies. The use of different market information and/orestimation techniques could have a negative effect on theestimated fair value amounts. The fair value of theCompany’s cash, cash equivalents, accounts receivable,accounts payable and other current liabilities approximates thecarrying amounts due to the relatively short maturity of theseitems.     *Inventories.* Inventories, consisting of raw materials,work in process and finished goods, are stated at the lower ofcost (first-in, first-out) or market. Inventory which isobsolete (defined as inventory that will no longer be used inthe manufacturing process) or in excess of the forecasted usageis written down to its estimated market value based on projecteddemand, historical usage and other known factors. PhotonDynamics reviews the appropriate valuation of its inventories ona quarterly basis. If actual demand were to decline below theCompany’s forecasts, the Company may or would need torecord additional inventory write-downs.     *Concentration of Credit and Other Risk.* Financialinstruments which potentially subject the Company toconcentrations of credit risk consist principally of availablefor sale securities, trade accounts receivable and, atMarch 31, 2004, derivative financial instruments used tomitigate the effect of exchange rate changes.     The Company invests excess cash in securities that the Companybelieves bear minimal risk. These investments are of ashort-term nature and include investments in auction ratepreferred securities, commercial paper and government andcorporate debt securities. The Company has not experienced anylosses due to institutional failure or bankruptcy.     The Company’s customers are located in Korea, Taiwan, Japanand China. Therefore, the Company’s sales to thesecustomers may be adversely affected by the overall health ofthese economies, including the effects of currency exchange ratefluctuations. The Company generally does not require collateralfor its trade accounts receivable. The Company maintains aprovision for potential credit losses based upon expectedcollectability of all accounts receivable. For sales to some ofits customers in certain geographic regions, the Companyrequires letters of credit. The majority of the Company’srevenue is invoiced in U.S. dollars although approximately$6.1 million and $17.6 million of revenue that wasrecognized in the three and six months ended March 31, 2005and approximately $2.5 million and $7.0 million ofrevenue that was recognized in the three and six months endedMarch 31, 2004 were invoiced in currencies other than theU.S. dollar, primarily Japanese Yen. The Company believesits credit evaluation prior to shipment and subsequentmonitoring of customer status mitigates its credit risk.     The Company is exposed to credit loss in the event ofnon-performance by counterparties on the foreign exchangecontracts used to mitigate the effect of exchange rate changes.These counterparties are large international financialinstitutions, and to date, no such counterparty has failed tomeet its financial obligations to the Company. Photon Dynamicsdoes not anticipate nonperformance by these counterparties. TheCompany had no outstanding foreign exchange forward contracts atMarch 31, 2005 or September 30, 2004.     The Company’s products include certain components that arecurrently purchased from a single vendor. The Company believesthat other vendors would be able to provide similar components;however, the
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**PHOTON DYNAMICS, INC.****NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**qualification of such vendors may require start-up time. Inorder to mitigate any adverse impacts from a disruption ofsupply, the Company attempts to maintain an adequate inventoryof critical single-sourced components.     *Revenue Recognition.* Photon Dynamics derives revenueprimarily from the sale and installation of equipment and sparepart sales. The Company recognizes revenue when persuasiveevidence of an arrangement exists, delivery has occurred orservices have been rendered, the selling price is fixed ordeterminable and collectability is reasonably assured.Persuasive evidence of an arrangement exists when a salesquotation outlining the terms and conditions of the arrangementhas been issued to the customer and a purchase order has beenreceived from the customer accepting the terms of the salesquotation and stating, at a minimum, the number of systemsordered and the value of the overall arrangement.     The Company accounts for certain of its product sales, includingsales to a value-added reseller, as arrangements with multipledeliverables in accordance with Emerging Issues Task ForceIssue 00-21 “Revenue Arrangements with MultipleDeliverables.” For arrangements with multiple deliverables,the Company recognizes revenue for the delivered items if thedelivered items have value to the customer on a standalonebasis, the amount of revenue for delivered elements is notsubject to refund, the Company has met defined customeracceptance experience levels for the delivered items, and thefair value of undelivered items, such as installation and systemupgrade rights, can be reliably determined. The Companyallocates revenue to the delivered items based on the lesser ofthe amount due and billable upon shipment and the allocated fairvalue, with the remaining amount recognized after installationand acceptance when the final amount becomes due. The Companyrecognizes all other product sales upon customer acceptance. TheCompany recognizes revenue from the sale of spare parts uponshipment.     Terms and conditions of the Company’s sale of products toits value-added reseller are generally consistent with terms andconditions offered to other customers and title typicallytransfers to the value-added reseller upon shipment. The Companydoes not grant any rights of return, stock rotation or priceprotection for its product sales to its value-added reseller.Accordingly, sales transactions with the value-added reseller,consisting of $0 and $76,000 in the three month period endedMarch 31, 2005 and 2004, respectively, and $0 and$6.0 million in the six month period ending March 31,2005 and 2004, respectively, are recorded in accordance with thepolicy stated above.     The Company has a policy to record a provision based onhistorical rates for estimated sales returns in the same periodas the related revenue is recorded, which is netted againstrevenue.     The Company’s products are subject to warranty and suchestimated costs are provided for in cost of revenue when productrevenue is recognized. Installation is not essential to thefunctionality of the products as this service does not alter theproduct capabilities, does not require specialized skills ortools and can be performed by other vendors.     *Shipping Costs.* The Company’s shipping and handlingcosts are included under cost of revenue for all periodspresented. In those instances where the Company charges itscustomers for shipping and handling, the amounts billed areclassified as revenue.     *Research and Development Cost.* Costs to develop theCompany’s products, which include both hardware andsoftware components are expensed as incurred. Softwareincorporated in the Company’s products is an integral partof the overall product design process and costs to developsoftware, which is deemed to be incidental, are not trackedseparately. The Company does not sell or market any softwareproduct on a standalone basis.     *Interest Income.* Interest income was approximately$512,000 and $393,000 for the three months ended March 31,2005 and 2004, respectively, and $889,000 and $611,000 for thesix months ended March 31, 2005 and 2004, respectively.
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**PHOTON DYNAMICS, INC.****NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     *Stock-Based Compensation Plans.* The Company accounts forits stock-based employee compensation plans using the intrinsicvalue method in accordance with the provisions of AccountingPrinciples Board Opinion No. 25, “Accounting for StockIssued to Employees” (“APB 25”) and relatedinterpretations.     Pro forma information regarding net income (loss) and earningsper share is required by Statement of Financial AccountingStandards No. 123, “Accounting for Stock-BasedCompensation” (“FAS 123”) as amended bySFAS No. 148, “Accounting for Stock-basedCompensation — Transition and disclosure” and hasbeen determined as if the Company had accounted for its employeestock purchase plan and employee stock options granted under thefair value method. The fair value of each option grant isestimated on the date of grant using the Black-Scholes optionpricing model for the multiple option approach with thefollowing weighted-average assumptions:                    **Three Months** **Six Months**  **Ended** **Ended**  **March 31,** **March 31,**       **2005** **2004** **2005** **2004**             Stock option plan:                     Expected stock price volatility  0.84   0.80   0.74   0.88      Average Risk free interest rate  3.74%  2.18%  3.04%  2.38%     Expected life of options (years)  5.0   4.4   5.3   5.1     Stock purchase plan:                     Expected stock price volatility  0.65   0.96   0.65   0.96      Average Risk free interest rate  2.52%  2.13%  2.52%  2.13%     Expected life of plan (years)  1.3   2.0   1.3   2.0      FAS 123 requires the use of option pricing models that werenot developed for use in valuing employee stock options. TheBlack-Scholes option valuation model was developed for use inestimating the fair value of traded options which have novesting restrictions and are fully transferable. In addition,option valuation models require the input of highly subjectiveassumptions, including the expected stock price volatility.Because the Company’s employee stock option and employeestock purchase plans have characteristics significantlydifferent from those of traded options, and because changes inthe subjective input assumptions can materially affect the fairvalue estimate, in management’s opinion, the existingmodels may not necessarily provide a reliable single measure ofthe fair value of such Company options.     For purposes of pro forma disclosures required by FAS 123,the estimated fair value of the options is amortized to expenseover the options’ vesting periods using the straight-linemethod. The Company’s pro forma information for the threeand six months ended March 31, 2005 and 2004 is as follows:                    **Three Months Ended** **Six Months Ended**  **March 31,** **March 31,**       **2005** **2004** **2005** **2004**             **(Restated)**   **(Restated)**  **(In thousands, except per share data)**    Net income (loss) — as reported $(10,346) $843  $(9,829) $1,675      Less: total stock-based employee compensation expense determined    under fair value based method for all awards, net of tax  (1,922)  (1,245)  (3,929)  (3,891)                 Net loss — pro forma $(12,268) $(402) $(13,758) $(2,216)                 Basic net income (loss) per share — as reported $(0.61) $0.05  $(0.58) $0.10     Diluted net income (loss) per share — as reported $(0.61) $0.05  $(0.58) $0.10     Basic net loss per share — pro forma $(0.72) $(0.02) $(0.81) $(0.13)    Diluted net loss per share — pro forma $(0.72) $(0.02) $(0.81) $(0.13)
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**PHOTON DYNAMICS, INC.****NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     *Recent Accounting Pronouncements.* In March 2005, the FASBpublished FASB Interpretation No. 47, “Accounting forConditional Asset Retirement Obligations,” which clarifiesthat the term, conditional asset retirement obligations, as usedin SFAS No. 143, “Accounting for Asset RetirementObligations,” refers to a legal obligation to perform anasset retirement activity in which the timing and(or) method of settlement are conditional on a future eventthat may or may not be within the control of the entity. Theuncertainty about the timing and (or) method of settlementof a conditional asset retirement obligation should be factoredinto the measurement of the liability when sufficientinformation exists. The interpretation also clarifies when anentity would have sufficient information to reasonably estimatethe fair value of an asset retirement obligation. Thisinterpretation is effective no later than the end of theCompany’s fiscal 2006. The adoption of this Interpretationis not expected to have a material effect on the Company’sconsolidated financial position or results of operations.     In March 2004, the Emerging Issues Task Force (“EITF”)reached a consensus on recognition and measurement guidancepreviously discussed under EITF Issue No. 03-01, “TheMeaning of Other-Than-Temporary Impairment and Its Applicationto Certain Investments” (“EITF 03-01”). Theconsensus clarifies the meaning of other-than temporaryimpairment and its application to investments in debt and equitysecurities, in particular investments within the scope of FASBStatement No. 115, “Accounting for Certain Investmentsin Debt and Equity Securities,” and investments accountedfor under the cost method. In September 2004, the FinancialAccounting Standards Board approved the issuance of a FASB staffposition to delay the requirement to record impairment lossesunder EITF 03-1. The approved delay applies to allsecurities within the scope of EITF 03-01. The Company willevaluate the impact of EITF 03-1 once the final guidance isissued.     In November 2004, the FASB issued SFAS No. 151,“Inventory Costs, an amendment of ARB No. 43,Chapter 4.” SFAS No. 151 clarifies thatabnormal inventory costs such as costs of idle facilities,excess freight and handling costs, and wasted materials(spoilage) are required to be recognized as current periodcharges. The provisions of SFAS No. 151 are effectivefor fiscal periods beginning after June 15, 2005. Theadoption of SFAS No. 151 is not expected to havematerial impact on the Company’s consolidated results ofoperations, financial position or cash flows.     In December 2004, the FASB issued SFAS No. 153,“Exchanges of Nonmonetary Assets, an amendment of APBOpinion No. 29.” SFAS No. 153 addresses themeasurement of exchanges of nonmonetary assets and redefines thescope of transactions that should be measured based on the fairvalue of the assets exchanged. SFAS No. 153 iseffective for the Company for nonmonetary asset exchangesbeginning in the first quarter of fiscal 2006. The adoption ofSFAS No. 153 is not expected to have a material effecton the Company’s consolidated financial position or resultsof operations.     In December 2004, the FASB issued FASB Staff PositionNo. FAS 109-2, “Accounting and DisclosureGuidance for the Foreign Earnings Repatriation Provision withinthe American Jobs Creation Act of 2004.” The American JobsCreation Act introduces a special one-time dividends receiveddeduction on the repatriation of certain foreign earnings to aU.S. taxpayer (repatriation provision), provided certaincriteria are met. FSP FAS 109-2 provides accounting anddisclosure guidance for the repatriation provision. The Companyhas yet to complete its evaluation of the Foreign EarningsRepatriation Provision. However, at this time it is notanticipated that the Provision will result in a material impacton the Company’s effective tax rate.     In December 2004, the FASB issued SFAS 123 (revised 2004),“Share-Based Payment.” SFAS 123R requiresmeasurement of all employee stock-based compensation awardsusing a fair value method and the recording of such expense inthe consolidated financial statements. In addition, the adoptionof SFAS 123R will require additional accounting related tothe income tax effects and additional disclosure regarding thecash flow effects resulting from share-based paymentarrangements. SFAS 123R is effective for the Companybeginning in the first quarter of fiscal 2006. The Company isevaluating the requirements of SFAS 123R and expects thatthe adoption of SFAS 123R will have a material impact onthe Company’s results of operations
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**PHOTON DYNAMICS, INC.****NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**and financial condition. The Company has not yet determinedwhether the adoption of SFAS 123R will result instock-based compensation charges that are similar to the currentpro forma disclosures under SFAS 123.**NOTE 2 —****Financial Statement Components**             **March 31,** **September 30,**  **2005** **2004**       **(Unaudited)**  **(In thousands)**    Accounts receivable:             Accounts receivable, gross $17,852  $58,838      Allowance for doubtful accounts  (171)  (497)             Total $17,681  $58,341            Inventories:             Raw materials $14,901  $15,529      Work-in-process  16,070   15,046      Finished goods  487   1,141              Total $31,458  $31,716            Other current liabilities:      **(Restated****)**     Compensation $3,718  $3,984      Obligation to a manufacturing subcontractor in connection with    inventory purchases  —   623      Accrued closing costs associated with discontinued operations  423   449      Vendor Obligations  1,669   669      Notes Payable  1,058   1,534      Other accrued expenses  2,688   2,972              Total $9,556  $10,231            Accumulated other comprehensive income:             Foreign currency translation adjustments $612  $533      Unrealized losses on available for sale securities  (443)  (186)             Total $169  $347        **NOTE 3 —****Discontinued Operations*****Printed Circuit Board Assembly Inspection Business***     The Company formerly had a business which sold printed circuitboard assembly inspection products. In January 2003, the Companyimplemented a plan to exit this business. Accordingly, theoperating results of this former business segment have beenreclassified as a discontinued operation for all periodspresented. As of March 31, 2005, the Company is attemptingto sublease the facilities associated with the discontinuedoperations, but there can be no assurances that the Company willbe successful in recovering any additional costs associated withthis discontinued operation.
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**PHOTON DYNAMICS, INC.****NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     The following table summarizes the results of discontinuing theprinted circuit board assembly inspection products reportingsegment for the three and six months ended March 31, 2005and 2004:                     **Three Months Ended** **Six Months Ended**  **March 31,** **March 31,**       **2005** **2004** **2005** **2004**           **(In thousands)**    Revenue $—  $ —  $—  $83     Cost of revenue  (132)  (102)  (132)  (93)                 Gross margin  132   102   132   176                  Operating expenses:                     Selling, general and administrative  135   1,344   139   1,406                    Total operating expenses  135   1,344   139   1,406                  Loss from discontinued operations $(3) $(1,242) $(7) $(1,230)                  Loss from discontinued operations for the three and six monthsended March 31, 2005 includes approximately $132,000 forthe reversal of a liability related to the settlement of vendorobligations and approximately $113,000 of additional legalaccruals related to the Amtower v Photon Dynamics Inc. lawsuit(See Note 9). The loss from discontinued operations for thethree and six months ended March 31, 2004 includeslitigation costs of approximately $1.2 million for thesettlement of prior inventory purchase commitments and for thesettlement of the Thomason v. Photon Dynamics’ lawsuit.     The following summarizes the assets and liabilities of theprinted circuit board assembly inspection products discontinuedoperations:             **March 31,** **September 30,**  **2005** **2004**       **(In thousands)****ASSETS**            Current assets:             Other current assets $1,048  $908              Total assets $1,048  $908        **LIABILITIES**            Current liabilities:             Accounts payable $—  $5      Other current liabilities  482   707              Total current liabilities  482   712     Other liabilities  78   113              Total liabilities $560  $825             Other current assets at March 31, 2005, include areceivable of approximately $873,000 against shares that arebeing held in escrow related to the Company’s acquisitionof Intelligent Reasoning Systems, Inc., and $175,000 in securitydeposits on various leases. The escrow is to be settled inDecember, 2006.     Other current liabilities at March 31, 2005, includeapproximately $79,000 related to current operating leaseobligations, approximately $200,000 related to accrued legalcosts and approximately $200,000 related to potential vendorobligations. Other liabilities of approximately $78,000 relateentirely to non-current operating lease obligations. These leaseobligations are to be paid out through December of 2006.
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**PHOTON DYNAMICS, INC.****NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     In the second quarter of fiscal 2003, in accordance withStatement of Financial Accounting Standards No. 146,“Accounting for Costs Associated with Exit or DisposalActivities” (“FAS 146”), the Companyrecorded a liability of approximately $2.0 million forcosts associated with the discontinuation of the business,including termination benefits of approximately $700,000 andapproximately $1.3 million of purchase obligations tosuppliers. The following summarizes the liability sinceinception:                **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 March 31, 2005 $—  $200  $200                In March of 2005, the Company settled certain vendor obligationsfor $205,000 and reversed $132,000 of remaining accrual relatedto those obligations. The balance of $200,000 remaining atMarch 31, 2005, consists primarily of potential vendorobligations that the Company is currently negotiating.***Cathode Ray Tube Display and High Quality    Glass Inspection Business***     The Company formerly had a business which sold cathode ray tubedisplay and high quality glass inspection products. In June2003, the Company implemented a plan to exit this business.Accordingly, the operating results of this former businesssegment have been reclassified as a discontinued operation forall periods presented.     The following table summarizes the results of discontinuing thecathode ray tube display and high quality glass inspectionproducts reporting segment for the three and six months endedMarch 31, 2005 and 2004:                     **Three Months** **Six Months**  **Ended** **Ended**  **March 31,** **March 31,**       **2005** **2004** **2005** **2004**           **(In thousands)**     Selling, general and administrative $1  $—  $3  $35      Impairment of purchased intangibles and fixed assets  —   34   —   (36)                   Total operating expenses  1   34   3   (1)                 Income (loss) from discontinued operations $(1) $(34) $(3) $1                   The following summarizes the assets and liabilities of thecathode ray tube display and high quality glass inspectiondiscontinued operations:            **March 31,** **September 30,**  **2005** **2004**       **(In thousands)****LIABILITIES**            Other current liabilities: $651  $797             Total current liabilities $651  $797        
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**PHOTON DYNAMICS, INC.****NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     Other current liabilities at March 31, 2005, includeapproximately $203,000 related to warranty obligations,approximately $220,000 related to operating lease obligationsand approximately $228,000 related to a loan payable. Leaseobligations are to be paid out through October of 2007.     In the third quarter of fiscal 2003, in accordance withFAS 146, the Company recorded a liability of approximately$1.9 million for costs associated with the discontinuationof the business. The following summarizes the liability sinceinception:                    **One-Time** **Contract**      **Termination** **Termination**      **Benefits** **Costs** **Other Costs** **Total**           **(In thousands)**    Inception of liability $1,116  $771  $11  $1,898     Cash payments  (1,116)  (322)  (61)  (1,499)    Adjustments to the liability  —   —   50   50                   Balance at September 30, 2004  —   449   —   449     Cash expenditures  —   (26)  —   (26)                  Balance at March 31, 2005 $—  $423  $—  $423                   Future minimum lease payments, due by fiscal year areapproximately: $61,000 in fiscal 2005; $83,000 in fiscal 2006;and $76,000 in fiscal 2007. In April of 2005, the Companyentered into a sublease agreement in connection with the closingof its facilities in Canada (See Note 13).**NOTE 4 —****Goodwill and Other Purchased Intangible Assets*****Goodwill***     The carrying value of goodwill was approximately $153,000 atboth March 31, 2005 and September 30, 2004. There wereno additions or adjustments to goodwill during the six monthsended March 31, 2005. There have been no significant eventsor circumstances affecting the valuation of goodwill subsequentto the Company’s impairment test performed during thefourth quarter of fiscal 2004.     During the three months ended December 31, 2003, theCompany recorded approximately $665,000 in goodwill impairmentcharges. This impairment charge included charges associated withthe Company’s RTP and Akcron reporting units of $300,000and $365,000, respectively. The RTP reporting unit consists ofrapid thermal processing technology. The Akcron reporting unitconsists of thin film transistor liquid crystal display(“TFT-LCD”) backlight inverter technology. Thesecharges have been reflected in the results of operations for thesix months ended March 31, 2004.     In November 2002, as part of the acquisition of the RTP Assets,$2.0 million was placed into escrow to be released eitherto the Company or to Intevac depending on the occurrence ofcertain future events during the escrow period. In September2003, the Company filed a claim against the escrow for the full$2.0 million. In October 2003, the Company received$1.7 million on its claim against the $2.0 millionescrow related to the RTP Asset purchase from Intevac. The claimfor the remaining $300,000 was resolved in favor of Intevac.Because the Company has written off all goodwill resulting fromthe acquisition of the RTP Assets, the $300,000 resolved infavor of Intevac resulted in an adjustment to record additionalgoodwill, which was deemed to be impaired due to continuingdeterioration in business conditions during the three monthperiod ended December 31, 2003.     Goodwill of $153,000 as of March 31, 2005 relates entirelyto the Company’s purchase of assets from Summit Imaging inMay 2003.
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**PHOTON DYNAMICS, INC.****NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS — (Continued)*****Intangible Assets***     Information regarding the Company’s intangible assets is asfollows:                              **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  (126)  (301)  (190)  (178)  (795)                    Balance as of March 31, 2005 $806  $1,808  $759  $585  $3,958                      During the three months ended December 31, 2003, theCompany recorded impairment charges of approximately$2.1 million related to the remaining portion of theacquired developed technology and core technology related to theAkcron and RTP reporting units. These charges have beenreflected in the results of operations for the six months endedMarch 31, 2005.     During the three months ended March 31, 2004, the Companysigned a Termination and Assignment Agreement (the“Agreement”) with Ishikawajima-Harima Heavy Industries(“IHI”), the Company’s value-added reseller ofits flat panel display products in Japan. Under the terms of theAgreement, all prior existing agreements between IHI and theCompany were terminated, including IHI’s rights to sell andsupport the Company’s flat panel display products on anexclusive basis in Japan. As part of this agreement IHI assignedto the Company the right to use all intellectual property rightsassociated with the Company’s products held by IHI,including any patents and patent applications associated withthe intellectual property rights. The Company paid to IHI$1.5 million, consisting of $339,000 for IHI’sremaining field spares inventory and $1.1 million for theaforementioned intellectual property rights and other intangibleassets. These intangible assets are being amortized over threeyears.     Based on intangible assets recorded at March 31, 2005, andassuming no subsequent additions to, or impairment of theunderlying assets, the remaining estimated amortization expenserelating to intangible assets at March 31, 2005 isapproximately $753,000, $1.5 million, $1.2 million and$558,000 in fiscal 2005 through 2008, respectively.     In assessing the recoverability of its intangible assets, theCompany must make assumptions regarding estimated future cashflows and other factors to determine the fair value of therespective assets. It is reasonably possible that theseestimates, or their related assumptions, may change in thefuture, in which case the Company may be required to recordadditional impairment charges for these assets.**NOTE 5 —****Derivative Financial Instruments**     Under its foreign currency risk management strategy, the Companymay utilize derivative instruments to protect its interests fromunanticipated fluctuations in earnings and cash flows caused byvolatility in currency exchange rates. This financial exposureis monitored and managed by the Company as an integral part ofits overall risk management program which focuses on theunpredictability of financial markets and seeks to reduce thepotentially adverse effects that the volatility of these marketsmay have on its operating results.     The Company accounts for its derivatives instruments accordingto Statement of Financial Accounting Standards No. 133,“Accounting for Derivative Instruments and HedgingActivities” (“FAS 133”), which requires thatall derivatives be recorded on the balance sheet at fair value.Changes in the fair value of derivatives which do not qualify orare not effective as hedges must be recognized currently inearnings. The Company does not use derivative financialinstruments for speculative or trading purposes, nor does ithold or issue leveraged derivative financial instruments.
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**PHOTON DYNAMICS, INC.****NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     The Company’s international sales are primarily denominatedin U.S. dollars although approximately $6.1 and$17.6 million of revenue that was recognized in the threeand six month periods ending March 31, 2005 andapproximately $2.5 million and $7.0 million of revenuethat was recognized in the three and six months endedMarch 31, 2004 were invoiced in currencies other than theU.S. dollar, primarily Japanese Yen. For foreign currencydenominated sales however, the volatility of the foreigncurrency markets could impact the Company’s margin. TheCompany defines its exposure as the risk of changes in thefunctional-currency-equivalent cash flows (generallyU.S. dollars) attributable to changes in the relatedforeign currency exchange rates. The Company records themark-to-market change in fair value of its derivativeinstruments within “Other current liabilities” in theCompany’s Condensed Consolidated Balance Sheets. TheCompany did not have any forward sales contracts atMarch 31, 2005 or September 30, 2004. AtMarch 31, 2004, the Company had foreign exchange forwardcontracts maturing throughout fiscal 2004 to sell approximately$2.8 million in foreign currencies, primarily Japanese Yen.The Company did not qualify these forward sales contract ashedging instruments, as defined by FAS 133, and, as such,recorded the changes in the fair value of these derivativesimmediately in “Interest income and other, net” in theCondensed Consolidated Statements of Operations. Losses fromchanges in fair values for the three and six month periods endedMarch 31, 2004 were approximately $87,000 and $208,000,respectively, and are included in “Interest income andother, net” in the Condensed Consolidated Statements ofOperations.**NOTE 6 —****Comprehensive Income**     The components of comprehensive income (loss) were as follows:                     **Three Months Ended** **Six Months Ended**  **March 31,** **March 31,**       **2005** **2004** **2005** **2004**             **(Restated)**   **(Restated)**  **(In thousands)**    Net income (loss) $(10,346) $843  $(9,829) $1,675     Other comprehensive loss:                     Net change in unrealized losses on investments  (101)  (46)  (257)  (176)     Change in foreign currency translation  (49)  48   79   (99)                   Other comprehensive loss  (150)  2   (178)  (275)                 Total comprehensive income (loss) $(10,496) $845  $(10,007) $1,400              **NOTE 7 —****Shareholders’ Equity**     *Stock Option Plans.* On March 7, 2005, at theCompany’s Annual Meeting of Shareholders, theCompany’s shareholders approved the Company’s 2005Equity Incentive Plan, which reserves an aggregate of1,450,000 shares of common stock for grant under the plan.The Company’s shareholders also approved the 2005 EmployeeStock Purchase Plan, which reserves an aggregate of1,000,000 shares of common stock for grant under the plan.The Company’s shareholders also approved the 2005Non-Employee Directors’ Stock Option Plan, which reservesan aggregate of 400,000 shares of common stock for grantunder the plan.**NOTE 8 —****Net Income Per Share**     Basic earnings per share is computed by dividing incomeavailable to common shareholders by the weighted-average numberof shares of common stock outstanding during the period. Dilutedearnings per share is computed by dividing income available tocommon shareholders by the weighted-average number of shares ofcommon stock outstanding during the period increased to giveeffect to all dilutive potential common shares outstandingduring the period. Common equivalent shares consist of stockoptions issued to employees under employee stock option plans.
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**PHOTON DYNAMICS, INC.****NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     The following table sets forth the computation of basic anddiluted net income per share:                     **Three Months Ended** **Six Months Ended**  **March 31,** **March 31,**       **2005** **2004** **2005** **2004**             **(Restated)**   **(Restated)**  **In thousands, except per share data)**    Numerator:                     Net income (loss) from continuing operations before discontinued    operations $(10,342) $2,119  $(9,819) $2,904      Net loss from discontinued operations  (4)  (1,276)  (10)  (1,229)                   Net income (loss) $(10,346) $843  $(9,829) $1,675                  Denominator:                     Weighted average shares for basic net income per share  16,948   16,572   16,909   16,517      Effect of dilutive securities: Employee stock options  —(1)  600   —(1)  657                    Weighted average shares for diluted net income per share  16,948   17,172   16,909   17,174                  Earnings per share:                     Basic net income (loss) per share:                      Net income (loss) from continuing operations $(0.61) $0.13  $(0.58) $0.18       Net loss from discontinued operations  (0.00)  (0.08)  (0.00)  (0.07)                   Net income (loss) per share $(0.61) $0.05  $(0.58) $0.10                   Diluted net income (loss) per share:                      Net income (loss) from continuing operations $(0.61) $0.12  $(0.58) $0.17       Net loss from discontinued operations  (0.00)  (0.07)  (0.00)  (0.07)                   Net income (loss) per share $(0.61) $0.05  $(0.58) $0.10               (1)     The effect of potentially dilutive securities from employee    stock options to purchase 165,339 and 150,761 shares    of common stock for the three and six month periods ended    March 31, 2005 were not included in the computation of    diluted net income (loss) per share as the effect is    anti-dilutive due to net losses.     During the three and six month periods ended March 31,2005, options to purchase 1,213,453 and1,244,078 shares, respectively, were not included in thecomputation of diluted earnings per share because the exerciseprice was greater than the average market price of common sharesfor the respective periods and hence, their effect would havebeen anti-dilutive. During the three and six month periods endedMarch 31, 2004, options to purchase 240,828 and203,215 shares, respectively, were not included in thecomputation of diluted earnings per share because the exerciseprice was greater than the average market price of common sharesfor the respective periods and hence, their effect would havebeen anti-dilutive.
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**PHOTON DYNAMICS, INC.****NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS — (Continued)****NOTE 9 —****Commitments and Contingencies*****Purchase Agreements***     The Company maintains certain open inventory purchasecommitments with suppliers to ensure a smooth and continuoussupply chain for key components. The Company’s liability inthese purchase commitments is generally restricted to aforecasted time horizon as mutually agreed upon between theparties. The Company’s open inventory purchase commitmentswere approximately $39.5 million as of March 31, 2005and $27.3 million as of September 30, 2004.***Warranty Obligations***     The Company generally offers warranty coverage for a period ofone year from the date of final customer acceptance. Uponproduct shipment, the Company records the estimated cost ofwarranty coverage, primarily material and labor to repair andservice the equipment. Factors that affect the Company’swarranty liability include the number of installed units underwarranty, product failure rates, material usage rates and theefficiency by which the product failure is corrected. TheCompany periodically assesses the adequacy of its recordedwarranty liability and adjusts the amount as necessary.     Changes in the Company’s product liability during the sixmonth periods ended March 31, 2005 and 2004 were as follows:            **Six Months Ended**  **March 31,**     **2005** **2004**       **(In thousands)**    Beginning balance $6,194  $2,363      Estimated warranty cost of new shipments during the period  2,255   2,100      Warranty costs during the period  (2,532)  (1,710)     Changes in liability for pre-existing warranties, including    expirations  284   481            Ending balance $6,201  $3,234        ***Legal Proceedings***     The Company and certain of its directors and officers have beennamed as defendants in a lawsuit captioned Amtower v.Photon Dynamics, Inc., No. CV797876, filed on April 30,2001 in the Superior Court of the State of California, County ofSanta Clara. The plaintiff, who previously served as one ofthe Company’s officers, has asserted several causes ofaction arising out of alleged misrepresentations made toplaintiff regarding the existence and enforcement of theCompany’s insider trading policy. The plaintiff is seekingdamages of approximately $17.7 million for defendants’alleged refusal to allow plaintiff to sell shares of theCompany’s stock in May of 2000, plus unspecified emotionaldistress and punitive damages. On December 6, 2001, thecourt granted defendants’ motion to dismiss the complaintfor failure to allege facts sufficient to state a cause ofaction, with leave to file an amended complaint. OnJanuary 17, 2002, plaintiff filed his amended complaint anddefendants again moved to dismiss the action. On June 27,2002, the court issued an order granting in part and denying inpart the motion, and further granted plaintiff an opportunity torestate certain claims. On October 1, 2002, plaintiff filedhis Second Amended Complaint, which was heard on April 8,2003, and defendants again moved to dismiss the action. OnApril 21, 2003, the court granted in part and denied inpart the Company’s motion. The pleadings have beenfinalized and certain claims against the Company and theindividual defendants will proceed. Defendants have filed amotion for summary judgment, which has been continued toSeptember 29, 2005, and a trial, if necessary, is scheduledto begin on November 7, 2005. Discovery is ongoing. TheCompany believes the plaintiff’s case is without merit andit
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**PHOTON DYNAMICS, INC.****NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**intends to defend this action vigorously. The Company cannotpredict the outcome of this litigation and no provision orliability has been recorded in the accompanying condensedconsolidated financial statement should the outcome of thismatter be adverse to the Company. The Company believes that anadverse judgment in this litigation could be material and couldhave an adverse effect on the Company’s financialcondition, results of operations or cash flows.     The Company was named as a defendant in a lawsuit captionedSanmina SCI Corporation v. Photon Dynamics, Inc.,No. CV 013715, filed on February 3, 2004 in theSuperior Court of the State of California, County ofSanta Clara. The plaintiff in this action, which previouslywas a third-party manufacturer of the Company, asserted severalcauses of action arising out of the alleged nonperformance bythe Company of the manufacturing outsourcing agreement betweenthe Company and the plaintiff, and sought approximately$3.1 million in compensatory damages and punitive damagesin an unknown amount. The Company responded to the complaint onMarch 19, 2004, by filing an answer and cross complaintseeking damages of at least $135,000. The Company amended itscross complaint on June 26, 2004. The parties settled thisdispute in March 2005, pursuant to which the Company paidSanmina SCI Corporation $1.4 million, and the courtdismissed the matter on April 1, 2005. The Company hadpreviously accrued a liability of approximately $622,000 formanagement’s estimates of the amount owed upon terminationof its relationship with Sanmina SCI. The difference between the$778,000 additional liability arising from the settlement andthe value assigned to the inventory received was recorded as acharge to Cost of revenue of approximately $278,000 and as arecovery of approximately $132,000 in discontinued operations.     Photon Dynamics is subject to certain other legal proceedingsand claims that have arisen in the ordinary course of businessand have not been fully adjudicated. Other than with respect tothe Amtower matter as described above, in the opinion ofmanagement, the Company does not have a potential liabilityrelated to any current legal proceedings and claims that wouldindividually, or in the aggregate, have a material adverseeffect on its financial condition, liquidity or results ofoperations. However, litigation in general, and intellectualproperty and securities litigation in particular, can beexpensive and disruptive to normal business operations.Moreover, the results of complex legal proceedings are difficultto predict. The Company believes that it has defenses in each ofthe aforementioned matters and it is vigorously contesting eachof these matters.**NOTE 10 —****Geographic Information**     The Company sells its products for the flat panel displayindustry directly to customers in Korea, Taiwan, China andJapan. For geographical reporting, revenue is attributed to thegeographic location to which the product was shipped. Long-livedassets consist primarily of property, plant and equipment,goodwill and intangibles and are attributed to the geographiclocation in which they are located.     The following is a summary of revenue by geographic area basedon location where the product was shipped:                     **Three Months Ended** **Six Months Ended**  **March 31,** **March 31,**       **2005** **2004** **2005** **2004**             **(Restated)**   **(Restated)**  **(In thousands)**    Revenue:                     Korea $4,655  $12,606  $11,035  $23,901      Taiwan  14,235   12,586   22,574   19,736      Japan  3,541   990   15,074   6,920      China  2,895   —   13,282   —                    Total $25,326  $26,182  $61,965  $50,557              
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**PHOTON DYNAMICS, INC.****NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     The following is a summary of revenue by product line (as apercentage of total revenue):                     **Three Months Ended** **Six Months Ended**  **March 31,** **March 31,**       **2005** **2004** **2005** **2004**             **(Restated)**   **(Restated)**    Revenue:                     ArrayCheckertm  48%  83%  58%  81%     ArraySavertm  35%  10%  31%  12%     PanelMastertm  1%  —   —   —      Spares and other  16%  7%  11%  7%                   Total  100%  100%  100%  100%                  Sales to individual unaffiliated customers in excess of 10% oftotal revenue were as follows:                   **Three Months Ended** **Six Months Ended**  **March 31,** **March 31,**       **2005** **2004** **2005** **2004**             **(Restated)**   **(Restated)**    Customer A  15%  33%  16%  25%    Customer B  *   *   *   17%    Customer C  12%  *   22%  *     Customer D  *   *   *   12%    Customer E  *   22%  *   19%    Customer F  *   *   20%  *     Customer G  14%  10%  16%  11%    Customer I  16%  *   *   *     Customer J  10%  *   *   *     Customer K  11%  *   *   *  *     Customer accounted for less than 10% of total revenue for the    period     Accounts receivable from individual unaffiliated customers inexcess of 10% of total gross accounts receivable were as follows:           **March 31,** **September 30,**  **2005** **2004**         Customer A  44%  29%    Customer C  14%  *     Customer E  *   16%    Customer F  *   13%    Customer H  *   12%    Customer J  13%  *  *     Customer accounted for less than 10% of total gross accounts    receivable for the period
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**PHOTON DYNAMICS, INC.****NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     Long-lived assets by geographical area are as follows:            **March 31,** **September 30,**  **2005** **2004**       **(In thousands)**    United States $23,486  $22,889     Canada  1,275   1,947     Other  572   407             Total $25,333  $25,243        **NOTE 11 —****Related Party Transactions**     During the three and six month periods ended March 31,2005, the Company paid $36,000 and $72,000, respectively, to onemember of the Company’s board of directors for consultingservices rendered to the Company. During the three and six monthperiods ended March 31, 2004, the Company paid $78,000 and$80,000, respectively, to this member of the Company’sboard of directors for consulting services rendered to theCompany. During the three and six month periods endedMarch 31, 2005, the Company recorded approximately $0 and$35,000, respectively, in stock ownership expense related tooptions granted to this consultant. During both the three andsix month periods ended March 31, 2004, the Companyrecorded approximately $82,000 in stock ownership expenserelated to options granted to this consultant.**NOTE 12 —****Provision for Income Taxes**     For the three and six month periods ended March 31, 2005the Company recorded a provision for income taxes of $359,000and $398,000, respectively. For the three and six month periodsended March 31, 2004 the Company recorded a provision forincome taxes of $64,000 and $426,000, respectively. Theprovision for income taxes for the six months endedMarch 31, 2004 included a foreign withholding tax relatedto the resolution of the technology license fee litigationsettlement. The Company had a provision for income taxes despitea net loss position in both the three and six month periodsended March 31, 2005 due primarily to foreign income taxes.The effective tax rate for the three and six month periods endedMarch 31, 2004 is lower than the statutory rate due to taxbenefits arising from net operating losses. The effective taxrate for the three and six month periods ended March 31,2004 is a combination of foreign income taxes and domesticalternative minimum taxes.**NOTE 13 —****Subsequent Events**     On April 15, 2005, the Company implemented a restructuringplan to relocate all activities in its Markham, Ontario, Canadalocation — consisting of research and developmentrelated to the Company’sPanelMastertminspection systems — to the Company’s Daejon,Korea and San Jose, California locations. Terminationsaffecting up to 32 employees are expected to take place in threephases through March 31, 2006. Certain employees wereoffered permanent employment elsewhere in the Company and willbe provided with certain relocation benefits in lieu of theseverance benefits, should they accept the offer. The Companyplans to record a restructuring charge of approximately $951,000in its third quarter, comprised of approximately $717,000 foremployee severance and related benefits and $234,000 related toexcess facilities. Management expects to settle all employeeseverance benefits by the end of the second quarter of fiscal2006. The charge for excess facilities relates to rentobligations under a long-term operating lease agreement whichare to be paid in cash through October of fiscal 2007 andunamortized leasehold improvements on the facilities. Thelease-related charge for excess facilities is net of a subleaseagreement the Company entered into on April 15, 2005.     On April 8, 2005, the Company extended the consultingagreement with one member of the Company’s board ofdirectors for consulting services rendered to the Company. Theagreement extends through December, 2005.
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**ITEM 2.*****Management’s Discussion and Analysis of Financial    Condition and Results of Operations***     *This Quarterly Report on Form 10-Q containsforward-looking statements within the meaning ofSection 27A of the Securities Act of 1933 andSection 21E of the Securities Exchange Act of 1934. Actualresults could differ materially from those projected in theforward-looking statements as a result of a number of factors,risks and uncertainties, including the risk factors set forth inthis discussion, especially under the caption “FactorsAffecting Operating Results” in this Form 10-Q.Financial projections for future periods are forward-lookingstatements, and generally other statements using the words“anticipate”, “expect”, “intend”,“believe” and similar expressions identifyforward-looking statements. The forward-looking statements madein this Form 10-Q are made as of the filing date with theSecurities and Exchange Commission and future events orcircumstances could cause results that differ significantly fromthe forward-looking statements included here. Accordingly, wecaution readers not to place undue reliance on these statements.We expressly disclaim any obligation to update or alter ourforward-looking statements, whether as a result of newinformation, future events or otherwise.*     *The following discussion and analysis should be read inconjunction with the condensed consolidated financial statementsand notes thereto in Item 1 above and with our financialstatements and notes thereto for the year endedSeptember 30, 2004, contained in Amendment No. 3 toour Annual Report on Form 10-K/ A filed with the SEC onAugust 9, 2005.***Restatement of Financial Statements**     In late March of 2005, management identified an error related tothe timing of a portion of revenue recognized in connection witha sales transaction for which revenue was recorded in the fourthquarter of fiscal 2004. The error related to commitments made toa customer for certain system parts and supply contracts with afair value amounting to approximately $859,000, that were notdelivered by September 30, 2004. These additionalcommitments were made in the course of negotiating a largersales arrangement with the customer, but were inadvertently notcommunicated by Photon Dynamics’ sales people to theaccounting department as required by Photon Dynamics’policy. These additional commitments were identified to theaccounting department in late March 2005 when the customernotified Photon Dynamics that it wanted to take delivery ofcertain of the additional committed items. Based on the fairvalue of the committed but undelivered parts and supplycontracts at September 30, 2004, revenue and net income forthe quarter ended September 30, 2004 were overstated by$859,000, and deferred revenue at September 30, 2004 wasunderstated by $859,000.     Management notified Photon Dynamics’ Audit Committee, theBoard of Directors and Photon Dynamics’ independentregistered public accounting firm of the existence of theundelivered elements in early April after internal confirmationof their discovery. The Audit Committee immediately undertook aninternal investigation to evaluate the impact on the timing ofrevenue recognized under the total arrangement, to assess why ithad occurred, and to determine whether any other suchtransactions might exist for which such an error had occurred.In connection with this investigation, the Audit Committeeengaged Photon Dynamics’ outside legal counsel, which thenengaged a third-party forensic accounting firm and an electronicdata recovery firm to assist them in its investigation. TheAudit Committee also had the full cooperation of management inthe process.***Results of Investigation***     As part of its investigation, the Audit Committee, with theassistance of outside legal counsel, the forensic accountingfirm and the electronic data recovery firm, reviewed salestransactions for fiscal 2004, and for the first two quarters offiscal 2005. In addition to the transaction described aboveidentified by management, the ensuing investigation revealedseveral other adjustments to revenue due to errors, none ofwhich were individually material, that can be categorized asfollows:          1) Incomplete documentation of sales arrangements: Certain    elements of certain sales arrangements with customers were not    reflected in Photon Dynamics’ customary sales documents    and, as a result, Photon Dynamics overstated revenue for the    value of the undelivered elements within those arrangements.
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          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.     Adjustments identified as a result of the investigation,including adjustments related to the additional commitmentsinitially reported by management to the Audit Committee asdiscussed above, aggregate to an overstatement of PhotonDynamics’ revenue and net income by approximately$1.4 million in fiscal 2004. In addition, because theamounts erroneously recognized as revenue were not deferred,Photon Dynamics’ revenue and net income were understated byapproximately $0.3 million, in the first quarter of fiscal2005. Photon Dynamics’ current liabilities were understatedby approximately $1.4 million at September 30, 2004,and were understated by approximately $1.1 million atDecember 31, 2004. For the three and six months endedMarch 31, 2004, revenue and net income were each overstatedby approximately $296,000 and $420,000, respectively. PhotonDynamics’ current liabilities were understated byapproximately $420,000 at March 31, 2004. Photon Dynamicsdetermined that cost of revenue was not impacted by any of theitems discussed above for any period. Because of the aggregatesignificance of the errors found, all of which impact thetiming, but not the eventual amount, of revenue recognizableunder the related arrangements, Photon Dynamics determined thatit was appropriate to restate its financial statements for theyear ended September 30, 2004, the quarters within thatyear and restate its financial statements for the quarter endedDecember 31, 2004.     As a result of the investigation, Photon Dynamics filed aForm 10-K/ A, Amendment No. 3 (the “10-K/ AAmendment”) and a Form 10-Q/ A, Amendment No. 1to reflect proper accounting treatment for transactions relatedto its review of its fiscal year ended September 30, 2004and its fiscal quarter ended December 31, 2004,respectively. The restated results of operations primarilyreflect the timing of revenues between quarters and betweenfiscal periods 2004 and 2005 and do not represent an overallreduction in revenue that would ultimately be recognized on thesales transactions.     In Note 15 to Part II, Item 8, “QuarterlyConsolidated Results of Operations (unaudited)” in thePhoton Dynamics’ Notes to Consolidated Financial Statementsof the 10-K/ A Amendment No. 3 for the year endedSeptember 30, 2004, Photon Dynamics adjusted its quarterlyresults of operations for fiscal 2004 to reflect properaccounting treatment for the transactions related to theinvestigation. Photon Dynamics did not amend its QuarterlyReports on Form 10-Q for any of its reported periods infiscal 2004. All fiscal 2004 amounts reflected in this QuarterlyReport on Form 10-Q reflect the results of the restatementset forth in the 10K/ A Amendment.     The Audit Committee’s investigation did not support aconclusion that any fraudulent or deceptive act had beencommitted, but rather that the errors were due to internalcontrol weaknesses as mentioned above.     For additional information related to this restatement, pleaserefer to the 10-K/ A Amendment, filed concurrently withthis Form 10-Q.**Overview*****Our Company***     We are a leading provider of yield management solutions to theflat panel display industry. Our customers use our systems toincrease manufacturing yields of high performance flat paneldisplays used in a number of products, including notebook anddesktop computers, televisions and advanced mobile electronicdevices such as cellular phones, personal digital assistants andportable video games. Our test and repair systems are used bymanufacturers to collect data, analyze product quality andidentify and repair product defects at critical steps in themanufacturing process.
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     We sell our products to manufacturers in the flat panel displayindustries. Our flat panel display customers are located inKorea, Taiwan and Japan, where flat panel display production isconcentrated, and in China. We derive most of our revenue from asmall number of customers, and we expect this to continue forthe foreseeable future.     Our products are primarily manufactured in San Jose,California. Our manufacturing activities consist primarily offinal assembly and test of components and subassemblies, whichare purchased from third party vendors. We schedule productionbased upon customer purchase orders and anticipated ordersduring the planning cycle. We generally expect to be able toaccept a customer order, build the required machinery and shipto the customer within 26 to 39 weeks.     The success of our business depends upon numerous factors,including, but not limited to: •     The level of capital expenditures of flat panel display    manufacturers, which in turn depends on the current and    anticipated market demand for products utilizing flat panel    displays, and  •     The relative competitiveness of our products and services.     We do not consider our business to be seasonal in nature, but itis cyclical with respect to the capital equipment procurementpractices of flat panel display manufacturers and is impacted bythe investment patterns of these manufacturers in differentglobal markets. A substantial percentage of our revenue isderived from the sale of a small number of yield managementsystems ranging in price from approximately $300,000 to$3.4 million. Therefore, the timing of the sale of a singlesystem could have a significant impact on our quarterly results.***Focus on Flat Panel Display Industry***     We have not always focused solely on the flat panel displayindustry. Previously, we also produced printed circuit boardassembly inspection products and cathode ray tube display andhigh quality glass inspection products. However, we determinedto exit these markets as we believed that they did not have thepotential to be profitable for us. Consequently, in January2003, we implemented a plan to exit the printed circuit boardassembly inspection business, and in June 2003, we implemented aplan to exit the cathode ray tube display and high quality glassinspection business. Accordingly, the operating results of theseformer businesses are reclassified as discontinued operationsfor all periods presented.     In view of continued deterioration in market opportunities thatbegan in the fourth quarter of fiscal 2003, we suspendedoperations in the low temperature poly-silicon(“LTPS”) technology and inverter markets in the firstquarter of fiscal 2004. Although we did not actively pursue newLTPS business opportunities, we continued to support LTPSsystems in the field with parts and service throughMarch 31, 2005. Having completed substantially all ourcustomer commitments, we wrote off the remaining assetsassociated with the LTPS technology of approximately $382,000 inthe three months ended March 31, 2005. We currently are notactively pursuing new business for systems, upgrades orenhancements for the foreseeable future. In our third quarter offiscal 2004, we sold all assets related to the inverter business.     Our transition to the singular focus on our core business ofdeveloping yield management solutions for the flat panel displayindustry has given us a clear strategy and direction. As aresult of this strategic shift in fiscal 2004, we achievedseveral quarters of profitability, successfully acquired two keysuppliers, moved into a new facility that doubled ourmanufacturing capacity and introduced our new automated cell andmodule inspection systems.     In fiscal 2005 our emphasis is to strengthen our marketposition, our product focus, our operations and our fiscalperformance. Our management team is focused on severalimperatives to support these objectives: • *Product Focus:* We continue to improve our product    performance in defect detection, repair success, cost of    ownership, ease of use and throughput for each of our product    generations. We seek to couple this improved system performance    with our expert applications engineering services to provide the    best possible business solutions to our customers.
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 • *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***     We have redefined our strategic vision to be the leader in yieldmanagement for the flat panel display industry. In order toimplement this vision, we have taken certain actions related tonon-related businesses. For example, in the first quarter offiscal 2004, we suspended operations in the LTPS technology andinverter markets. In fiscal 2003, we exited the printed circuitboard assembly inspection and cathode ray tube and high qualityglass inspection businesses. As a result, some or all of thetechnologies acquired in connection with some of our prioracquisitions, have been sold or abandoned.     We recorded impairment charges of approximately $665,000 ofgoodwill and $2.1 million of acquired core technology andacquired developed technology associated with these reportingunits in the six months ended March 31, 2004.***Industry***     Continuous innovations in microelectronics and materials sciencehave enabled manufacturers, including our customers, to produceflat panel displays with sharper resolution, brighter pixels andfaster imaging in varying sizes for differing applications.Growth in the mobile electronic devices market, the desktopcomputer market and the television market have driven the demandfor flat panel displays, which offer reduced footprint, weight,power consumption and heat emission and better picture qualityas compared to cathode ray tube displays, the current standardtechnology for televisions.     Active matrix liquid crystal display (“AMLCD”) is themost prevalent and one of the highest performance flat paneldisplays available today. The manufacture of active matrixliquid crystal displays is an extremely complex process, whichhas been developed and refined for different substrate glasspanel sizes. Each progressive increase in initial substratepanel size is referred to by its “generation.”Manufacturing an active matrix liquid crystal display involves aseries of three principal phases — the Array Phase,the Cell Phase and the Module Assembly Phase. At various pointsin the manufacturing process, the flat panel displaymanufacturer uses test and inspection equipment to identifydefects to permit repair and to avoid wasting costly materialson continued manufacturing of a defective product. Our yieldmanagement products include our test and repair equipment thatare used primarily in the Array phase of production, and ourinspection equipment that is used primarily in the Cell andModule Assembly phases of production.     The flat panel display market growth during the first half ofcalendar 2004 was reflected in the 80% increase in flat paneldisplay capital equipment spending between 2003 and 2004. In thelast half of calendar year 2004, there was uncertainty in theflat panel display market as supply exceeded demand. Thisover-supply was driven primarily by decreasing demand due torecord high panel prices and increasing supply as a result ofnumerous generation 5 factories coming on line in Korea andTaiwan. This over-supply has been moderated by longer factoryramp times due to yield issues, and a shortage of key componentssuch as glass substrates and color filters. Demand is forecastedto exceed supply some time in the latter half of calendar 2005.Current market indicators show that demand is rising as a resultof significantly reduced panel prices in the latter half ofcalendar 2004.     Growth in the AMLCD television market is expected to continue tofuel the overall growth in the flat panel display market. WhileAMLCD television demand lagged during the first half of calendaryear 2004, it
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picked up momentum during the second half of the year andfinished slightly above market analyst expectations. AMLCDtelevision demand is essentially on track due to successfulgeneration 6 factories at Sharp and LG Philips LCD and theresultant pricing efficiencies offered from these factories.This represents an encouraging indicator of the future asgeneration 7 factories are scheduled to come on line duringcalendar 2005. However, there are many factors that will dictatehow successful AMLCD manufacturers are in penetrating thetelevision market, including display performance, pricereduction and the ability to maintain profitability.     Demand for our Generation 5 and 6 test and repair equipmentremains high and our Generation 7 test system installation andacceptance is underway. In addition, we continue to see agrowing interest in our automated cell and module inspectionsystems.     We believe continued growth in demand for AMLCD products willfuel investments in Generation 6 and 7 factories to keep paceand that inspection, test and repair systems will continue torepresent a significant percentage of our customers’capital spending, driving increased demand for our products andservices.***Backlog***     Our backlog for unshipped system orders as of March 31,2005, was approximately $76.5 million. Our backlog consistsof orders for which we have accepted purchase orders andassigned shipment dates within twelve months from March 31,2005 and which are reasonably expected to be filled within thattime frame. All orders are subject to delay or cancellation withlimited penalty or no penalty to the customer. Because ofpossible changes in product delivery schedules and cancellationof product orders, cyclical nature of customers’ capitalequipment procurement practices, among other factors, ourbacklog may vary significantly and, at any particular date, isnot necessarily indicative of actual sales for any succeedingperiod.**Critical Accounting Policies and Estimates**     Our discussion and analysis of our financial condition andresults of operations are based upon our condensed consolidatedfinancial statements, which have been prepared in accordancewith generally accepted accounting principles in the UnitedStates. The preparation of our financial statements and therelated disclosures requires our management to make judgments,assumptions and estimates that affect the reported amounts ofassets, liabilities, revenue and expenses, and relateddisclosure of contingent assets and liabilities. Note 1 of“Notes to Condensed Consolidated Financial Statements”describes significant accounting policies used in thepreparation of our condensed consolidated financial statements.Some of these significant accounting policies are considered tobe critical accounting policies.     A critical accounting policy is defined as one that is bothmaterial to the presentation of our financial statements andrequires management to make difficult, subjective or complexjudgments that could have a material effect on our financialcondition and results of operations.     Estimates and assumptions about future events and their effectscannot be determined with certainty. We base our estimates onhistorical experience and on various other assumptions that arebelieved to be applicable and reasonable under thecircumstances. These estimates may change as new events occur,as additional information is obtained and as our operatingenvironment changes. In addition, management is periodicallyfaced with uncertainties, the outcomes of which are not withinits control and will not be known for prolonged periods of time.These uncertainties are discussed in the section below entitled“Factors Affecting Operating Results.”     We believe the following critical accounting policies affect ourmore significant judgments and estimates used in the preparationof our consolidated financial statements.     *Revenue Recognition.* Note 1 of our “Notes toCondensed Consolidated Financial Statements” provides adescription of our revenue recognition policy. For eacharrangement, we recognize revenue when persuasive evidence of anarrangement exists, delivery has occurred or the services havebeen rendered, the selling price is fixed or determinable andcollectability is reasonably assured, the latter of which issubject to judgment. If we
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determine that any of these criteria are not met, we deferrevenue recognition until such time as we determine that all ofthe criteria are met.     In addition, for arrangements with multiple deliverables, wemake additional judgments as to whether each item has value tothe customer on a stand-alone basis, the amounts of revenue foreach element that are not subject to refund, all definedcustomer acceptance experience levels have been met and the fairvalues of any undelivered items have been reliably determined.     We have a policy to record a provision for estimated salesreturns in the same period as the related revenue is recorded,which is netted against revenue. These estimates are based onhistorical sales returns and other known factors which have notvaried widely in the past and we do not reasonably expect thesefactors to significantly change in the foreseeable future. Ifthe historical data we use to calculate these estimates does notproperly reflect future returns, additional provisions may berequired. Historically, we have not experienced the return ofany of our flat panel display systems and do not expect this tochange in the foreseeable future. However, due to the relativelyhigh prices of our systems, the return of one of these systemswould have a material adverse effect on our results ofoperations.     *Allowance for Doubtful Accounts.* Our trade receivablesare derived from sales to flat panel display manufacturerslocated in Korea, Taiwan, Japan and China. In order to monitorpotential credit losses, we perform periodic evaluations of ourcustomer’s financial condition. We maintain an allowancefor doubtful accounts for the potential inability of ourcustomers to make required payments based upon our assessment ofthe expected collectability of all accounts receivable. Inestimating the provision, we consider (i) historicalexperience, (ii) the length of time the receivables arepast due, (iii) any circumstances of which we are awareregarding a customer’s inability to meet its financialobligations, and (iv) other known factors. We review thisprovision periodically to assess the adequacy of the provision.     Our allowance for doubtful accounts was approximately $171,000and $497,000 at March 31, 2005 and September 30, 2004.These balances each represent less than 2% of fiscal 2004revenues. Our reserve at March 31, 2005 decreased from theSeptember 30, 2004 balance due to the collection of certainreceivable balances that were previously reserved. Historically,losses due to customer bad debts in our flat panel displaybusiness have been immaterial, and we expect that this will notchange in the foreseeable future. However, if a single customerwas unable to make payments, additional allowances may berequired. Accordingly, the inability of a single customer tomake required payments could have a material adverse effect onour results of operations.     *Inventories.* The valuation of inventory requires us toestimate obsolete or excess inventory and inventory that is notsaleable. The determination of obsolete or excess inventoryrequires us to estimate the future demand for our productswithin specific time horizons, generally twelve months or less.If our demand forecast for specific products is greater thanactual demand and we fail to reduce manufacturing outputaccordingly, we could be required to record additional inventorywrite-offs, which would have a negative impact on our grossmargin.     We review the adequacy of our inventory valuation on a quarterlybasis. For production inventory, our methodology involvesmatching our on-hand inventory with our demand forecast over thenext twelve months on a part-by-part basis. We then evaluate theparts found to be in excess of the twelve-month demand and takeappropriate write-downs to reflect the risk of obsolescence.This methodology is significantly affected by the demandforecast assumption. Using a longer time period of estimateddemand could result in reduced inventory adjustmentrequirements. Based on our past experience, we believe thetwelve-month time period to best reflect the reasonable andrelative obsolescence risks. If actual demand or usage were tobe substantially lower than estimated, additional inventoryadjustments for excess or obsolete inventory may be required.     *Warranty.* Our warranty policy generally states that wewill provide warranty coverage for a period of one year fromfinal acceptance. We record the estimated cost of warrantycoverage, primarily material and labor to repair and service theequipment when the related revenue is recognized. Our warrantyobligation is affected by product failure rates, consumption offield service parts and the efficiency by which the productfailure is corrected. We estimate our warranty cost based onhistorical data related to these factors.
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     Our liability for warranty coverage was approximately$6.2 million at both March 31, 2005 andSeptember 30, 2004. Should actual product failure rates,material usage or labor efficiencies differ from our estimates,revisions to the estimated warranty liability would be required.     *Goodwill and Intangible Assets.* We have accounted forgoodwill and other intangible assets resulting from ouracquisitions in accordance with FAS 142, which prohibitsthe amortization of goodwill and intangible assets withindefinite useful lives and requires that these assets bereviewed for impairment at least annually, and more frequentlyif there are indicators of impairment. The process forevaluating the potential impairment of goodwill is highlysubjective and requires significant judgment at many pointsduring the analysis. Should actual results differ from ourestimates, revisions to the recorded amount of goodwill could bereported.     We amortize intangible assets with finite lives and otherlong-lived assets over their estimated useful lives and alsosubject them to evaluation for impairment. We review long-livedassets including intangible assets with finite lives forimpairment whenever events or changes in business circumstancesindicate that the carrying amount of the assets may not be fullyrecoverable, such as a significant industry downturn,significant decline in the market value of the company, orsignificant reductions in projected future cash flows. We wouldrecognize an impairment loss when estimated undiscounted futurecash flows expected to result from the use of the asset and itseventual disposition is less than its carrying amount. Wedetermine impairment, if any, using discounted cash flows. Inassessing the recoverability of long-lived assets, includingintangible assets, we must make assumptions regarding estimatedfuture cash flows and other factors to determine the fair valueof the respective assets. If these estimates or their relatedassumptions change in the future, we may be required to recordadditional impairment charges for these assets.     As described in “Acquisitions and Dispositions” above,we recorded both goodwill and intangible asset impairmentcharges as part of our transition to a singular focus on ourcore business of developing yield management solutions for theflat panel display industry. During fiscal quarter endedDecember 31, 2003, we recorded a goodwill impairment chargeof approximately $365,000 and an intangible asset impairmentcharge of $2.1 million associated with our Akcron reportingunit and the remaining intangible assets associated with our RTPand Akcron reporting units. These charges were reflected in ourresults of operations for the six months ended March 31,2004. In October 2003, $1.7 million of the$2.0 million escrow related to the purchase of certainassets relating to the RTP Assets was settled in our favor, and$300,000 was settled in favor of Intevac, resulting in anadditional goodwill impairment charge of $300,000 also reflectedin our results of operations in the six months endedMarch 31, 2004.     *Contingencies and Litigation.* We make an assessment ofthe probability of an adverse judgment resulting from currentand threatened litigation. We accrue the cost of an adversejudgment if, in our estimation and based on the advice of legalcounsel, the adverse settlement is probable and we canreasonably estimate the ultimate cost of such a judgment. We areengaged in one significant litigation matter as ofMarch 31, 2005 — Amtower v. Photon Dynamics,Inc. — in which the plaintiffs are seeking damages ofapproximately $17.7 million, plus unspecified emotionaldistress and punitive damages. We settled our lawsuit withSanmina SCI in the second quarter of fiscal 2005. These mattersare as described in Note 9 to the Condensed ConsolidatedFinancial Statements in this Form 10-Q. We have made ourrequisite assessments and accruals, as warranted, as ofMarch 31, 2005. We believe that an adverse judgment in theAmtower litigation could have a material adverse effect on ourfinancial condition, results of operations or cash flows.
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**Results of Operations*****Selected Financial Data***     The percentage of net revenue represented by certain line itemsin our condensed consolidated statement of operations for theperiods indicated, are set forth in the table below.                     **Three Months Ended** **Six Months Ended**  **March 31,** **March 31,**       **2005** **2004** **2005** **2004**             **(Restated)**   **(Restated)**    Revenue  100.0%  100.0%  100.0%  100.0%    Cost of revenue  74.1   54.2   67.1   54.6                  Gross margin  25.9   45.8   32.9   45.4                  Operating expenses:                     Research and development  38.8   23.5   31.1   23.7      Selling, general and administrative  24.1   15.2   17.4   16.9      Amortization of intangible assets  1.6   0.2   1.3   0.5      Gain on sale of fixed assets  —   (0.1)  —   —      Impairment of goodwill  —   —   —   1.3      Impairment of purchased intangibles  —   —   —   4.1      Impairment of property and equipment  1.5   —   0.6   0.5                    Total operating expenses  66.0   38.8   50.4   47.0                  Income (loss) from operations  (40.1)  7.0   (17.5)  (1.6)    Interest income and other, net  0.6   1.3   2.3   8.1                  Income (loss) from continuing operations before income taxes and    discontinued operations  (39.5)  8.3   (15.2)  6.5     Provision for income taxes  1.4   0.2   0.6   0.8                  Income (loss) from continuing operations  (40.9)  8.1   (15.8)  5.7     Income (loss) from discontinued operations  0.0   (4.9)  0.0   (2.4)                 Net income (loss)  (40.9)%  3.2%  (15.8)%  3.3%             ***Revenue***                           **Three Months Ended** **Six Months Ended**  **March 31,** **March 31,**       **2005** **Change** **2004** **2005** **Change** **2004**                   **(Restated)**     **(Restated)**  **(Dollars in millions)**    Revenue $25.3   (3)% $26.2  $62.0   23% $50.6      The increase in revenue for the six months ended March 31,2005 over the same period of the prior year was primarily due tothe continued expansion of our customers’ manufacturingcapacity. Revenue declined 3% for the three months endedMarch 31, 2005 over the same period in the prior year anddeclined 31% sequentially, quarter over quarter as our customersabsorbed the higher capital invested over the previous fourquarters. Flat panel display manufacturers continue to increasecapacity to meet computer notebook, monitor and televisiondemand. Though over-supply in the flat panel display marketcaused revenue in the quarter ended March 31, 2005 todecrease from revenue of $36.6 million in the quarter endedDecember 31, 2004 and from $52.8 in the quarter endedSeptember 31, 2004, flat panel display manufacturerscontinued to invest to keep pace with forecasted AMLCD demand.
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     We generate revenue from the sales of ourArrayCheckertmandArraySavertmtest and repair equipment, ourPanelMastertminspection equipment, and the sales of spare parts.     OurArrayCheckertmandArraySavertmtest and repair equipment operate in the Array phase of AMLCDproduction and are built to handle the different generationsizes of substrate glass. Total revenue from our Generation 5and earlier generation test and repair products representedapproximately 43% and 65% of revenue in the three month periodsended March 31, 2005 and 2004, respectively, andapproximately 36% and 57% of revenue in the six month periodsended March 31, 2005 and 2004, respectively. Theperiod-over-period decrease in both the three and six monthperiods was due primarily to the increase in revenue from ourGeneration 6 products as flat panel display manufacturers moveto a larger size glass substrate in the manufacturing process.Revenue from our Generation 6 products represented approximately40% and 28% of revenue in the three month periods endedMarch 31, 2005 and 2004, respectively, and approximately53% and 36% of revenue in the six month periods endedMarch 31, 2005 and 2004, respectively. Our products in eachnew generation contain new performance and control featuresdesigned specifically to enhance yield improvement and processcontrol. As a result, historically we generally have experiencedincreases in our average selling prices of between 20% and 50%in each new generation product. As with prior generationproducts, our Generation 6ArrayCheckertmproducts have greater average selling prices than previousgenerations. However, the average selling prices of ourGeneration 6ArraySavertmproducts were relatively flat as compared to the priorgenerations due primarily to a more competitive environment inthe Array Repair market. There is no assurance that we will besuccessful at achieving or sustaining average selling priceincreases on our Generation 6 and future generation products.     OurPanelMastertminspection equipment operates in the Cell and Module Assemblyphases of AMLCD production, inspecting glass that has been cutdown to the size of the needed application. As such, ourPanelMastertmproduct is not dependent on the initial glass substrate size andcan function on either Generation 6 or Generation 7 fabricationlines. Consequently, we do not classify it by generations.     Revenue from ourArrayCheckertmproducts represented approximately 48% and 83% of our totalrevenue for the three months ended March 31, 2005 and 2004,respectively, and approximately 58% and 81% of our total revenuefor the six months ended March 31, 2005 and 2004,respectively. Revenue from our test products decreased inabsolute dollars primarily due to the level of capitalexpenditures of our customers as they invest in manufacturingcapacity. Revenue from our test products decreased as apercentage of revenue due primarily to the increase in revenuefrom our repair products.     Revenue from ourArraySavertmproducts represented approximately 35% and 10% of our totalrevenue for the three months ended March 31, 2005 and 2004,respectively, and approximately 31% and 12% of our total revenuefor the six months ended March 31, 2005 and 2004,respectively. Revenue from our repair products has increased inboth absolute dollars and as a percentage of total revenuepartly in response to the larger glass size processed infactories that use Generation 6 and due to expansion of customermanufacturing facilities. The cost of yield loss associated withlarge panels is driving flat panel display manufacturers toincrease the number of repair systems used in the manufacturingprocess in an effort to maximize yields.     Revenue from ourPanelMastertmproducts represented approximately 1% and 0.4% of total revenuefor the three and six month periods ended March 31, 2005,with no corresponding revenue in the same periods in the priorfiscal year. Our inspection equipment was introduced in fiscal2004 and the first production units were shipped in our fourthquarter of fiscal 2004. Because this is a new product line wehave deferred 100% of the revenue until we received customerfinal acceptance, which demonstrates that the product meets thecustomers’ specifications at the customers’ factorysite. The revenue recognized in the quarter ended March 31,2005 represents revenue on an older, pre-production machine forwhich we received final acceptance.     Revenue from ourArrayCheckertm,ArraySavertmandPanelMastertmproducts includes revenue recognized upon final customeracceptance. Our sales terms are typically 80% to 90% of thesales price due upon shipment with the remaining amount dueafter installation and upon final customer acceptance. Revenuefor both the three and six month periods ended March 31,2005 includes a lower absolute dollar value of revenue relatedto the receipt of final customer acceptances following completedinstallation of our products compared with the same periods inthe prior fiscal year.
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     Revenue from spare part sales represented approximately 16% and7% of our total revenue in the three month periods endedMarch 31, 2005 and 2004, respectively, and approximately11% and 7% of our total revenue in the six month periods endedMarch 31, 2005 and 2004, respectively. The increase is duein part to the increased installed base of tools at ourcustomer’s facilities.     Revenue by region for the periods indicated were as follows:                           **Three Months Ended** **Six Months Ended**  **March 31,** **March 31,**       **2005** **Change** **2004** **2005** **Change** **2004**                   **(Restated)**     **(Restated)**  **(Dollars in millions)**    Korea $4.7   (63)% $12.6  $11.0   (54)% $23.9     Taiwan  14.2   13%  12.6   22.6   14%  19.8     Japan  3.5   250%  1.0   15.1   118%  6.9     China  2.9   —   —   13.3   —   —                      $25.3   3% $26.2  $62.0   23% $50.6                         The changes in revenue in the current fiscal year as compared tothe same periods in the prior year are a result of theinvestment patterns of flat panel display manufacturers, whichin turn depends on the current and anticipated market demand forproducts utilizing flat panel displays.     In the three and six months ended March 31, 2005,approximately $6.1 million and $17.6 million of oursales were made in currencies other than U.S. dollars,primarily Japanese yen. In the three and six month periods endedMarch 31, 2004, approximately $2.5 million and$7.0 million of our sales were made in currencies otherthan U.S. dollars, primarily Japanese yen. The increase insales in Japanese yen is due to the termination of our agreementwith our value-added reseller in the second quarter of fiscal2004. Sales to our former reseller, who had exclusive rights tosell our products in Japan, were primarily in U.S. dollars.Our direct sales to our customers in Japan are denominated inyen.***Gross Margin***                           **Three Months Ended** **Six Months Ended**  **March 31,** **March 31,**       **2005** **Change** **2004** **2005** **Change** **2004**                   **(Restated)**     **(Restated)**    Gross Margin  26%  (43)%  46%  33%  (27)%  45%     Gross margins decreased in both the three and six month periodsended March 31, 2005 as compared to the same periods in theprior fiscal year. Gross margins in the current periods wereimpacted by: •     A more heavily weighted mix of our lower margin    ArraySavertm    systems compared to our higher margin    ArrayCheckertm    products;  •     A lower level of revenue recognized after installation and final    customer acceptance, which typically has a higher margin than    revenue billed on the associated items that were previously    delivered; and  •     The under-utilization of our San Jose facilities.     Key factors that may impact our future gross margin include: •     Our revenue mix between higher margin    ArrayCheckertm    systems and lower margin    ArraySavertm    and    PanelMastertm    systems;  •     The costs of increasing customer service staff to support the    increased demands of our customers;  •     The additional costs in connection with inefficiencies of    manufacturing newly-introduced products;  •     Competitive pricing pressures, particularly in the array repair    market;
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 •     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** **Six Months Ended**  **March 31,** **March 31,**       **2005** **Change** **2004** **2005** **Change** **2004**               **(Dollars in millions)**    Expense $9.8   60% $6.1  $19.3   61% $12.0     Percent of Revenue  39%      24%  31%      24%     Our research and development expenses consisted primarily ofsalaries, related personnel costs, depreciation, prototypematerials and fees paid to consultants and outside serviceproviders, all of which relate to the design, development,testing, pre-manufacturing and improvement of our products. Weincreased our overall research and development spending in thethree and six months ended March 31, 2005 in both absolutedollars and as a percentage of revenue over the same periods ofthe prior fiscal year due to more engineering programs inprocess to support simultaneous development of Generation 6 and7 test, repair and inspection products. The increased costsrelated primarily to higher spending on prototype materials andengineering headcount.     We will continue to invest in research and development tomaintain technology leadership in our products. Our customersmust continually improve their display quality performance andproduction costs in order to be successful in the displaymarket. To meet our customers’ needs, we must improve ourproduct performance in defect detection, repair success, cost ofownership, ease of use and throughput for each of our productgenerations.***Selling, General and Administrative***                           **Three Months Ended** **Six Months Ended**  **March 31,** **March 31,**       **2005** **Change** **2004** **2005** **Change** **2004**               **(Dollars in millions)**    Expense $6.1   54% $4.0  $10.8   26% $8.6     Percent of Revenue  24%      15%  17%      17%     Our selling, general and administrative expenses consistedprimarily of salaries and related expenses for marketing, sales,finance, administration and human resources personnel,accounting, commissions, insurance, legal and other corporateexpenses. Selling, general and administrative expenses werehigher in both the three and six month periods endedMarch 31, 2005 in absolute dollars compared to the sameperiods in the prior fiscal year due primarily to additionalinvestments in the marketing area and to amounts spent oncompliance with Section 404 of the Sarbanes-Oxley Act of2002.***Amortization of Intangibles***                           **Three Months Ended** **Six Months Ended**  **March 31,** **March 31,**       **2005** **Change** **2004** **2005** **Change** **2004**                 Expense $398,000   563% $60,000  $795,000   205% $261,000     Percent of Revenue  1.6%      0.2%  1.3%      0.5%     The increase in amortization expense for both the three and sixmonths ended March 31, 2005 compared to the same periods inthe prior fiscal year is due primarily to the addition ofintangible assets related to the purchase of assets from TucsonOptical Research Corporation in August 2004 and to the purchaseof assets from Quantum Composers in June 2004.
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***Impairment of Goodwill, Purchased Intangibles and Property    and Equipment***     As discussed in the overview and critical accounting policiesabove, we have exited all business lines other than the flatpanel display products market and have suspended operations inthe LTPS and inverter markets. As a result, in the three monthsended December 31, 2003, we took impairment charges for theremaining goodwill of $665,000 and purchased intangible assetsof $2.1 million related to these prior acquisitions andlong-lived assets of $234,000. In the three months endedMarch 31, 2005, we wrote off approximately $382,000,representing the remaining production assets related to our LTPSproduct line, as substantially all our customer commitments werefulfilled.     At March 31, 2005, the remaining balance for goodwill of$153,000 relates to our acquisition of assets from SummitImaging and the balance for purchased intangible assets of$4.0 million relates to our acquisition of assets fromSummit Imaging, Quantum Composers and Tucson Optical ResearchCorporation and the license agreement with Ishikawajima-HarimaHeavy Industries Co., Ltd.***Interest Income and Other, Net***                           **Three Months Ended** **Six Months Ended**  **March 31,** **March 31,**       **2005** **Change** **2004** **2005** **Change** **2004**                 Income $164,000   (51)% $334,000  $1.4 million   (65)% $4.1 million     Percent of Revenue  1%      1%  2%      8%     Interest income and other, net consisted primarily of interestincome, foreign currency exchange gains and losses, changes inthe fair value of derivative financial instruments and othermiscellaneous income and expense. The lower level of interestincome and other, net, in the three month period endedMarch 31, 2005 as compared to the same period of fiscal2004, was primarily attributable to increased foreign currencytransaction losses. The lower level of interest income andother, net, in the six month period ended March 31, 2005 ascompared to the same period of fiscal 2004, was primarilyattributable to having received a one-time technology licensefee resulting from a litigation settlement in the first quarterof fiscal 2004.***Provision for Income Taxes***                           **Three Months Ended** **Six Months Ended**  **March 31,** **March 31,**       **2005** **Change** **2004** **2005** **Change** **2004**                 Expense $359,000   461% $64,000  $398,000   (7)% $426,000     Percent of Revenue  1%      0%  1%      1%     Our provision for income taxes for the six months endedMarch 31, 2004 included a foreign withholding tax relatedto the resolution of the technology license fee litigationsettlement. We had a provision for income taxes despite a netloss position in both the three and six month periods endedJune 30, 2005 due primarily to foreign income taxes.     Our future effective income tax rate depends on various factors,such as tax legislation, the geographic composition of ourpre-tax income, amount of and access to tax loss carryforwards,expenses incurred in connection with acquisitions that are notdeductible for tax purposes, amounts of tax-exempt interestincome and research and development credits as a percentage ofaggregate pre-tax income, and the effectiveness of our taxplanning strategies.***Discontinued Operations***                   **Three Months Ended** **Six Months Ended**  **March 31,** **March 31,**       **2005** **2004** **2005** **2004**             Loss $(4,000) $(1.3) million  $(10,000) $(1.2) million 
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     Discontinued operations consist of our former printed circuitboard assembly inspection business and our former cathode raytube display and high quality glass inspection business. Incomefrom discontinued operations for the three and six months endedMarch 31, 2005 included approximately $132,000 reversal ofa liability related to the settlement of vendor obligations andapproximately $113,000 of additional legal accruals related toour lawsuit with a former executive officer; both related to theprinted circuit board assembly inspection business. The lossfrom discontinued operations for the three and six months endedMarch 31, 2004 included approximately $1.2 million inlitigation costs for settlement of prior inventory purchasecommitments and for settlement of a lawsuit brought by a formeremployee, both related to the disposition of the printed circuitboard assembly inspection business. We do not expect losses fromthese businesses to be material in the foreseeable future;however, an adverse judgment in our litigation with a formerexecutive officer could have a material adverse effect on theresults of operations from discontinued operations.**Liquidity and Capital Resources**     We have financed our growth primarily by a combination of cashflows from operations and public stock offerings. Workingcapital was $123.6 million as of March 31, 2005,compared to $132.3 million as of September 30, 2004. Amajor component of working capital is $101.0 million ofcash, cash equivalents and short-term investments as ofMarch 31, 2005, compared to $84.1 million as ofSeptember 30, 2004. Our cash, cash equivalents andshort-term investments represent 54% and 40% of total assets atMarch 31, 2005 and September 31, 2004, respectively.***Operating Activities of Continuing Operations***     Cash provided by operating activities from continuing operationswas $20.3 million in the first six months of fiscal 2005.In the six months ending March 31, 2005, cash was providedby decreases in working capital offset by our net loss, adjustedfor non-cash related items. We generated $26.0 million ofcash by reducing our investment in working capital, the primarysource being a decrease of approximately $40.7 million inour net accounts receivable, resulting primarily from:(a) collections on the September 30, 2004 balance,(b) sales decreasing quarter over quarter fromapproximately $52.8 million in the fourth quarter of fiscal2004 to approximately $36.6 million in our first quarter offiscal 2005 to approximately $25.3 million in our secondquarter of fiscal 2005, and (c) the timing of shipments inour second quarter. This decrease in accounts receivable wasprimarily offset by a $10.3 million decrease in accountspayable primarily related to inventory purchases.***Investing Activities of Continuing Operations***     Cash used in investing activities from continuing operations was$22.6 million in the first six months of fiscal 2005. Cashused in investing activities was primarily the result ofapproximately $18.5 million of net purchases of short-terminvestments and capital expenditures of $4.1 million.***Financing Activities of Continuing Operations***     Cash provided by financing activities from continuing operationswas $1.4 million in the first six months of fiscal 2005resulting from approximately $1.6 million in sales of ourcommon stock under our employee equity compensation plans,offset by approximately $192,000 in repayments of short termdebt obligations.     The timing of and amounts received from employee stock optionexercises are dependent upon the decisions of the respectiveoption holders, and are not controlled by us. Therefore, fundsraised from the issuance of common stock upon the exercise ofemployee stock options should not be considered an indication ofadditional funds to be received in future periods.     In March 2000, we entered into a bank line of credit which hadan initial term of one year. We have renegotiated the line ofcredit on an annual basis and currently have a $4.0 millionborrowing capacity on the line of credit with an interest rateof floating prime, expiring in October 2005. The line of creditis secured by substantially all of our assets and containscertain financial and other covenants. At March 31, 2005, no
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amounts were outstanding under the line of credit and we are incompliance with all covenants. We currently expect that uponexpiration of the line of credit, we will seek to renew it.***Operating, Investing and Financing Activities of    Discontinued Operations***     Discontinued operations consist of our former printed circuitboard assembly inspection business and our former cathode raytube display and high quality glass inspection business. Netcash provided by (used in) discontinued operations, consistingprimarily of changes in working capital balances, during the sixmonth period ended March 31, 2005 and 2004 is as follows:            **Six Months Ended**  **March 31,**     **2005** **2004**       **(In thousands)**     Printed circuit board business $(407) $115      Cathode ray tube display and high quality glass inspection    business  (150)  (143)           Net cash used in discontinued operations $(557) $(28)       ***Contractual Obligations***     The following table summarizes the approximate contractualobligations that we have at March 31, 2005. Suchobligations include both non-cancelable obligations and otherobligations that are generally non-cancelable except undercertain limited conditions.                                **Payments Due by Fiscal Year**   **Contractual Obligations** **Total** **2005(1)** **2006** **2007** **2008** **2009** **Thereafter**                 **(In thousands)**    Notes payable $2,489  $1,058  $484  $947  $—  $ —  $—     Operating lease obligations  17,085   1,868   3,533   3,007   2,652   2,627   3,398     Purchase obligations  39,511   33,836   3,775   1,169   731   —   —                            Total $59,085  $36,762  $7,792  $5,123  $3,383  $2,627  $3,398                        (1)     Remaining 6 months     Notes payable consist primarily of promissory notes issued inconnection with the acquisition of Quantum Composers, Inc. andTucson Optical Research Corporation. These notes mature through2007.     Operating lease obligations consist primarily of our leaseagreement for our headquarters in San Jose, California,which is leased under a non-cancelable operating lease thatexpires in 2010, with two renewal options at fair market valuefor additional five year periods.     We maintain certain open inventory purchase commitments with oursuppliers to help provide a smooth and continuous supply chainfor key components. Our liability in these purchase commitmentsis generally restricted to purchase commitments over aforecasted time horizon as mutually agreed upon between theparties and is reflected in “purchase obligations” inthe table above. The majority of these purchase commitments arecovered by confirmed customer orders.***Working Capital***     We believe that cash generated from operations, together withthe liquidity provided by existing cash balances and borrowingcapability, will be sufficient to meet our operating and capitalrequirements and obligations for at least the next twelvemonths. However, this forward-looking statement is based uponour current plans and assumptions, which may change, and ourcapital requirements may increase in future periods. Inaddition, we believe that success in our industry requiressubstantial capital in order to maintain the flexibility to takeadvantage of opportunities as they may arise. We may, from timeto time, invest in or acquire
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complementary businesses, products or technologies and may seekadditional equity or debt financing to fund such activities.There can be no assurance that such funding will be available tous on commercially reasonable terms, if at all, and if we wereto proceed with acquisitions without this funding or withlimited funding it would decrease our capital resources. Thesale of additional equity or convertible debt securities couldresult in dilution to our existing shareholders.**Impact of Accounting Pronouncements**     In March 2005, the FASB published FASB InterpretationNo. 47, “Accounting for Conditional Asset RetirementObligations,” which clarifies that the term, conditionalasset retirement obligations, as used in SFAS No. 143,“Accounting for Asset Retirement Obligations,” refersto a legal obligation to perform an asset retirement activity inwhich the timing and (or) method of settlement areconditional on a future event that may or may not be within thecontrol of the entity. The uncertainty about the timing and(or) method of settlement of a conditional asset retirementobligation should be factored into the measurement of theliability when sufficient information exists. The interpretationalso clarifies when an entity would have sufficient informationto reasonably estimate the fair value of an asset retirementobligation. This interpretation is effective no later than theend of our fiscal 2006. The adoption of this Interpretation isnot expected to have a material effect on our consolidatedfinancial position or results of operations.     In March 2004, the Emerging Issues Task Force (“EITF”)reached a consensus on recognition and measurement guidancepreviously discussed under EITF Issue No. 03-01, “TheMeaning of Other-Than-Temporary Impairment and Its Applicationto Certain Investments.” (“EITF 03-01”). Theconsensus clarifies the meaning of other-than temporaryimpairment and its application to investments in debt and equitysecurities, in particular investments within the scope of FASBStatement No. 115, “Accounting for Certain Investmentsin Debt and Equity Securities,” and investments accountedfor under the cost method. In September 2004, the FinancialAccounting Standards Board approved the issuance of a FASB staffposition to delay the requirement to record impairment lossesunder EITF 03-01. The approved delay applies to allsecurities within the scope of EITF 03-01. We will evaluatethe impact of EITF 03-1 once the final guidance is issued.     In November 2004, the FASB issued SFAS No. 151,“Inventory Costs, an amendment of ARB No. 43,Chapter 4.” SFAS No. 151 clarifies thatabnormal inventory costs such as costs of idle facilities,excess freight and handling costs, and wasted materials(spoilage) are required to be recognized as current periodcharges. The provisions of SFAS No. 151 are effectivefor fiscal periods beginning after June 15, 2005. We do notexpect the adoption of SFAS No. 151 to have materialimpact on our consolidated results of operations, financialposition or cash flows.     In December 2004, the FASB issued SFAS No. 153,Exchanges of Nonmonetary Assets, an amendment of APB OpinionNo. 29. SFAS No. 153 addresses the measurement ofexchanges of nonmonetary assets and redefines the scope oftransactions that should be measured based on the fair value ofthe assets exchanged. SFAS No. 153 is effective for usfor nonmonetary asset exchanges beginning in the first quarterof fiscal 2006. We do not expect the adoption ofSFAS No. 153 to have a material effect on ourconsolidated financial position or results of operations.     In December 2004, the FASB issued FASB Staff PositionNo. FAS 109-2, Accounting and Disclosure Guidance forthe Foreign Earnings Repatriation Provision within the AmericanJobs Creation Act of 2004. The American Jobs Creation Actintroduces a special one-time dividends received deduction onthe repatriation of certain foreign earnings to aU.S. taxpayer (repatriation provision), provided certaincriteria are met. FSP FAS 109-2 provides accounting anddisclosure guidance for the repatriation provision. We have yetto complete its evaluation of the Foreign Earnings RepatriationProvision. However, at this time we do not anticipate that theProvision will result in a material impact on our effective taxrate.     In December 2004, the FASB issued SFAS 123 (revised 2004),“Share-Based Payment.” SFAS 123R requiresmeasurement of all employee stock-based compensation awardsusing a fair value method and the recording of such expense inthe consolidated financial statements. In addition, the adoptionof SFAS 123R will require additional accounting related tothe income tax effects and additional disclosure regarding the
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cash flow effects resulting from share-based paymentarrangements. SFAS 123R is effective beginning in our firstquarter of fiscal 2006. We are evaluating the requirements ofSFAS 123R and expect that the adoption of SFAS 123Rwill have a material impact on our results of operations andfinancial condition. We have not yet determined whether theadoption of SFAS 123R will result in stock-basedcompensation charges that are similar to the current pro formadisclosures under SFAS 123.**Factors Affecting Operating Results*****We have sustained losses and we may sustain losses in the    future.***     We reported net losses for each of the fiscal years endedSeptember 30, 2003 and 2002. Although we reported profitsin each of the four quarters of fiscal 2004 and in the firstquarter of fiscal 2005, we again reported net losses in thesecond quarter of fiscal 2005. In the future our revenue maydecline, remain flat or grow at a rate slower than expected. Ourability to maintain profitability is dependent in part on thesuccess of our efforts to increase revenues and to reduceoperating expenses as a percentage of revenue through ourongoing cost-cutting measures and our gross margin improvementprograms. However, we recently increased our manufacturingcapacity to meet greater demand for our products, and this hascaused us to experience increased operating expenses. Inaddition, we expect our selling, general and administrativeexpenses in fiscal 2005 to be higher in absolute dollars ascompared to fiscal 2004 due to investments we intend to make inthe marketing area and in compliance with section 404 ofthe Sarbanes-Oxley Act of 2002. If the increase in demand forour products is not sustained, or if we are not able to increaseour manufacturing capacity in a cost-efficient manner, thiswould impair our ability to again achieve profitability. For allof these reasons, there is no assurance that we will besuccessful in achieving or maintaining increased revenue,reduced operating expenses, positive cash flows or profitability.***Our operating results are difficult to predict and may    vary from investors’ expectations, which could cause our    stock price to fall.***     We have experienced, and expect to continue to experience,significant fluctuations in our quarterly results. Consequently,past financial results may not be indicative of future financialresults. A substantial percentage of our revenue is derived fromthe sale of a small number of yield management systems rangingin price from $300,000 to $3.4 million. Therefore, thetiming of the sale of a single system could have a significantimpact on our quarterly results. After we ship our products,customers may reject or delay acceptance, which would adverselyimpact our revenues. Moreover, customers may cancel orreschedule shipments, and production difficulties could delayshipments. For example, in the fourth quarter of 2004, weincurred additional costs such as expedite fees, premiums anddelivery penalties in an effort to meet customer deliveryschedules and quality related costs such as rework and higherwarranty.     Other factors which may influence our operating results in aparticular quarter include: •     the timing of the receipt of orders from major customers;  •     our product mix;  •     competitive pricing pressures;  •     our ability to obtain components from our single or limited    source suppliers in a timely manner;  •     global economic uncertainty;  •     changing international economic conditions;  •     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;
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 •     the delay between expenses to further develop marketing and    service capabilities and the realization of benefits from those    improved capabilities; and  •     the introduction of new products by our competitors.     Our operating results also could be affected by sudden changesin customer requirements, currency exchange rate fluctuationsand other economic conditions affecting customer demand and thecost of operations in the global markets in which we dobusiness. As a result of these or other factors, our operatingresults could be significantly and adversely affected and ourstock price could decline. In addition, it is possible that insome future quarter our operating results may be below theexpectations of public market analysts and investors, whichcould cause our stock price to fall.***If our products experience performance, reliability or    quality problems, our customers may reduce their orders.***     We believe that future orders of our products will depend inpart on our ability to satisfy the performance, reliability andquality standards required by our customers. Particularly ascustomers seek increased yields, greater throughput and higherquality end products, we must continually redesign our productsto meet the needs of our customers. As with the introduction ofany new product, our customers may experience yield loss. Forexample, with ourArraySavertm650,ArrayCheckertm3628 andArrayCheckertm3500, certain customers experienced yield loss higher thanexpected when the products were first introduced. If ourproducts have performance, reliability or quality problems, thenwe may experience: •     delays in collecting accounts receivable;  •     reduced orders;  •     additional service expenses; and  •     higher manufacturing costs.     If we are unable to meet the requirements of our customers, ourrevenue may decrease and our business could be harmed.     In addition, we typically provide a limited warranty on ourproducts for a period of one year from final acceptance bycustomers. Warranty claim expense may, at times, exceed theestimated cost of warranty coverage we record in our warrantyprovision. For example, in our fourth quarter of fiscal 2004, weincurred higher warranty costs and recorded incremental warrantyprovisions to cover certain identified quality problems. In thefuture, we may incur substantial warranty claim expenses on ourproducts and actual warranty claims may exceed recordedallowances, resulting in harm to our business.***Capital investment by manufacturers of flat panel display    products can be highly cyclical and may decline in the    future.***     Our business depends in large part on capital expenditures bymanufacturers of flat panel display products, which in turndepends on the current and anticipated market demand for the endproducts in that industry. The market for flat panel displayproducts is highly cyclical and has experienced periods ofoversupply resulting in significantly reduced demand for capitalequipment. For example, the flat panel display industryexperienced a downturn in 1998, which led many flat paneldisplay manufacturers to delay or cancel capital expenditures.Additionally, in 2001, due to the general deteriorating economicenvironment, flat panel display manufacturers reduced capitalexpenditures resulting in a decrease in our revenue. In fiscal2004, we saw AMLCD product supply exceed demand. Though thisoversupply has been moderated given the panel price decreases,it has resulted in a slowdown in capacity increases in fiscal2005, with flat panel display manufacturers pressing forwardwith carefully considered new capacity investments.     If the flat panel display markets in which we sell our productsexperience further slowdowns in the future, it could cause ourrevenue to decrease significantly. We do not control the timingor volume of orders placed by our customers. Whether and to whatextent our customers place orders for any specific products, aswell as
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the mix and quantities of products included in those orders, arefactors beyond our control. Insufficient orders, especially in adown cycle, will result in under-utilization of ourmanufacturing facilities and infrastructure and will negativelyaffect our operating results and financial condition. Inaddition, the need to invest in the engineering, research anddevelopment, and marketing required to penetrate targetedforeign markets and maintain extensive service and supportcapabilities limits our ability to reduce expenses during thesedownturns.***We depend on sales to a few large customers in the flat    panel display industry, and if we lose any of our large    customers our revenue could decrease significantly.***     The flat panel display industry is extremely concentrated with asmall number of manufacturers producing the majority of theworld’s flat panel displays. If one or more of our majorcustomers ceased or significantly curtailed their purchases, ourrevenue could drop significantly. We may be unable to replacesales to these customers. Sales to our greater than 10%customers in the first six months of fiscal 2005 and 2004 is asfollows: our top four customers accounted for 74% of our revenuein the first six months of fiscal 2005; and our top fivecustomers accounted for 84% of our revenue in the first sixmonths of fiscal 2004.***We rely upon sales of a limited range of products, and if    demand for one product decreases for any reason it could cause    our revenue to decline significantly.***     All of our revenue is expected to come from a limited range ofproducts for the flat panel display industry. As a result, weare solely reliant on the flat panel display industry. Anydecline in demand for, or failure to achieve continued marketacceptance of, our primary products or any new version of theseproducts could harm our business. Continued market acceptance ofour array test, array repair and cell and module inspectionproducts is critical to our success.***We may not be able to develop and introduce new products    that respond to evolving industry requirements in a timely    manner, which could reduce our ability to compete    effectively.***     The markets for our products are characterized by rapidlychanging technologies and frequent new product introductions.The failure to develop new products and introduce themsuccessfully and in a timely manner could harm our competitiveposition and results of operations. We believe that our futuresuccess will depend in part upon our ability to continue toenhance our existing products and to develop and manufacture newproducts. For example, the size of glass plates for flat paneldisplays and the resolution of flat panel displays have changedfrequently and may continue to change, requiring us to redesignor reconfigure our flat panel display products.     We expect to continue to incur significant research anddevelopment costs. There can be no assurance that we will besuccessful in the introduction, marketing and cost effectivemanufacture of any of our new products, that we will be able totimely develop and introduce new products and enhance ourexisting products and processes to satisfy customer needs orachieve market acceptance, or that the new markets for which weare developing new products or expect to sell current productswill develop sufficiently. For example, we experienced technicaldelays relating to the introduction of ourArrayCheckertm3500 system causing us to reschedule several shipments from thefirst quarter to the second quarter of fiscal 2003. In addition,beginning in the third quarter of fiscal 2004, initial shipmentsof the Generation7 ArrayCheckertm,Generation7 ArraySavertmandPanelMastertmsystems were shipped later than the customers requested deliverydates.     In addition, we depend on close relationships with our customersand the willingness of those customers to share information withus, and the failure to maintain these relationships could harmour product development efforts.
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***If we are not able to obtain critical components from our    single or limited source suppliers, we may experience    significant delays in producing our products, which could    decrease our revenue for an extended period of time.***     We obtain some equipment for our systems from a single source ora limited group of suppliers. For example, we currently obtainmaterials handling platforms from a single source supplier.Although we seek to reduce dependence on our sole and limitedsource suppliers, alternative sources of supply for thisequipment may not be available or may be available onunfavorable terms. The partial or complete loss of our sole andlimited source suppliers could significantly delay our shipmentsor otherwise harm our results of operations and damage customerrelationships. Further, a significant increase in the price ofone or more of these pieces of equipment could harm our resultsof operations.***All of our revenue is derived from sales to companies    located outside the United States, which exposes us to risks    that we would not experience with domestic sales.***     We expect sales to customers in foreign countries to continue torepresent 100% of our revenue in the foreseeable future. Anumber of factors may adversely affect our international salesand operations, including: •     political instability and the possibility of hostilities,    terrorist attacks, or war;  •     imposition of governmental controls;  •     fluctuations in interest and currency exchange rates;  •     export license requirements;  •     restrictions on the export of technology;  •     limited foreign protection of intellectual property rights;  •     trade restrictions;  •     periodic or local international downturns;  •     changes in tariffs; and  •     difficulties in staffing and managing international operations.     If any of these factors occur, our operating results and revenuecould be materially and adversely affected.***Compliance with new reporting requirements may strain our    resources and we may be unable to implement in a timely manner    additional finance and accounting systems, procedures and    controls in the future to satisfy new reporting requirements,    which could cause our stock price to fall.***     Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002,we will be required, beginning with our Annual Report onForm 10-K for our fiscal year 2005, to perform anevaluation of our internal control over financial reporting andhave our independent registered public accounting firm publiclyattest to such evaluation. We are executing an internal plan ofaction for compliance, which includes a timeline and scheduledactivities. However, we have limited time to complete theprocess and significant effort remains to be able to determinethat our internal control over financial reporting is effective,and to enable our independent registered public accounting firmto concur with our assessment. Preparation for and compliancewith these requirements has been, and we expect it will continueto be, expensive and time-consuming. This is especially truebecause we have had a number of material weaknesses, asdescribed in Item 4 of Part 1 of this report, that wehave been remediating, which has been expensive and timeconsuming. If we are unable to complete the required assessmentas to the adequacy of our internal control over financialreporting or if our independent registered public accountingfirm is unable to provide us with an unqualified report as tothe effectiveness of our internal control over financialreporting, we could be subject to regulatory scrutiny and afurther loss of public confidence in our internal control overfinancial reporting. In addition, any failure to implementrequired new or improved controls, or difficulties encounteredin their implementation, could harm
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our operating results or cause us to fail to meet our reportingobligation and result in a decline of our stock price.     We have recently disclosed material weaknesses in our internalcontrol over financial close process and sales order fulfillmentand revenue recognition process as discussed in Item 4“Controls and Procedures” of this Quarterly Report onForm 10-Q and Item 9A of our Annual Report onForm 10-K/ A, Amendment No. 3 filed with the SEC.Although we have committed significant resources to remediatethese weaknesses, there can be no assurances that we will nothave material weaknesses at the end of the fiscal year, or thatmaterial weaknesses will not occur in the future. Accordingly,to the extent these material weaknesses may occur in the futureor new material weaknesses may be found to exist, these materialweaknesses may have a material effect on our Company, or ourresults of operations, or result in a failure to meet ourreporting obligations.***We may have difficulty integrating the businesses or    assets we have acquired and may acquire in the future, and we    may not realize the benefits that we expect from these    acquisitions.***     In addition to our efforts to develop new technologies frominternal sources, we also may seek to acquire new technologiesfrom external sources. For example, in August 2004, we acquiredall of the assets relating to the design and manufacture ofpellicle products used in our modulators from Tucson OpticalResearch Corporation. In June 2004, we acquired from QuantumComposers, Inc. all of the assets related to the design andmanufacture of laser assembly products for our repair systems.In May 2003, we acquired all of the assets of Summit Imagingrelated to the design and manufacture of “cooled”cameras. All three of these acquisitions were to purchasetechnology that we use in our products so that we are notdependent on independent suppliers to provide the technology andrelated components. In the future, we may make additionalacquisitions of, or significant investments in, businesses withcomplementary products, services and/or technologies.Integrating businesses can be a complex, time-consuming andexpensive process. If we are not able to do so effectively, wewill not be able to realize the benefits that we expect toreceive from either our past or future acquisitions. For eachacquisition, we must integrate separate technologies, productlines, business cultures and practices, employees and systems.Acquisitions are subject to numerous risks, including: •     difficulty in the assimilation of the technologies and products    of the acquired company;  •     entering markets in which we have no or limited direct prior    experience;  •     loss of key customers of the acquired company;  •     diversion of management resources from the business of the    combined company;  •     incompatibility of business cultures or practices;  •     loss of key employees of the acquired company;  •     costs and delays in implementing common systems and procedures;  •     potential inefficiencies in delivering services to the customers    of the combined company; and  •     assumption of unknown or undisclosed liabilities.     Any of these difficulties could increase our operating costs orresult in impairment of purchased assets, which could harm ourfinancial performance.     In addition, we may also elect to change our strategic directionand may no longer have need for the acquired businesses ortechnologies. For example, in 2004 we determined not to pursuenew business for RTP Systems acquired from Intevac Corporationin November 2002. In 2003, we exited the printed circuit boardassembly inspection and high quality glass inspectionbusinesses. As a result, some or all of the technologiesacquired in connection with certain of our prior acquisitionshave been abandoned. In the third quarter of fiscal 2004, wesold all of our assets related to our TFT-LCD backlight inverterbusiness. Future acquisitions may also result in potentiallydilutive issuances of equity securities, incurrence of debt andcontingent liabilities and amortization expenses related toacquired intangible assets, which could harm our profitability.
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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.***     We use a wide range of materials in the production of ourproducts, including custom electronic and mechanical components,and we use numerous suppliers to supply these materials. If anythird party that we use to manufacture our products is unable tosatisfy our quality requirements or provide us with the productsand services in a timely manner, our shipments of these productsmay be delayed, our customer relationships may be harmed and ourresults of operations may be adversely impacted. There can be noassurance that our relationship with any third party that we useto manufacture our products will result in a reduction of ourexpenses or enable us to satisfy our customers’ qualityrequirements or to deliver our products to our customers in atimely manner.***If we do not compete effectively in our target markets, we    will lose market share.***     The markets for yield management systems in the flat paneldisplay industry are highly competitive. We face substantialcompetition from established competitors that have greaterfinancial, engineering and manufacturing resources than us andhave larger service organizations and long-standing customerrelationships. Our competitors can be expected to continue toimprove the design and performance of their products and tointroduce new products with competitive price and performancecharacteristics. Competitive pressures may force pricereductions that could harm our results of operations. Ourcustomers may also develop technology and equipment that mayreduce or eliminate their need to purchase our products.Although we believe we have certain technological and otheradvantages over our competitors, maintaining and capitalizing onthese advantages will require us to continue a high level ofinvestment in engineering, research and development, marketingand customer service support. There can be no assurance that wewill have sufficient resources to continue to make theseinvestments or that we will be able to make the technologicaladvances necessary to maintain our competitive advantages.***Our success depends in large part on the strength of the    active matrix liquid crystal display in the flat panel display    industry.***     While our technology is applicable to other flat panel displaytechnologies, our experience has been focused on applicationsfor active matrix liquid crystal displays, the most prevalentand one of the highest performance flat panel displays availabletoday. We derive 100% of our revenue from flat panel displayproducts, substantially all of which were based on the activematrix liquid crystal display technology. An industry shift awayfrom active matrix liquid crystal display technology to existingor new competing technologies could reduce the demand for ourexisting products and require significant expenditures todevelop new products, each of which could harm our business.***Our business could be harmed if we fail to properly    protect our intellectual property.***     Our success depends largely on our ability to protect ourintellectual property. While we attempt to protect ourintellectual property through patents, copyrights and tradesecrets in the United States and other countries, there can beno assurance that we will successfully protect our technology orthat competitors will not be able to develop similar technologyindependently. We cannot assure you that the claims allowed onany patents held by us will be sufficiently broad to protect ourtechnology against competition from third parties with similartechnologies or products. In addition, we cannot assure you thatany patents issued to us will not be challenged, invalidated orcircumvented or that the rights granted there under will providecompetitive advantages to us. Moreover, the laws of some foreigncountries do not protect intellectual property rights to thesame extent as the laws of the United States, and we couldexperience various obstacles and high costs in protecting ourintellectual property rights in foreign countries. If we areunable to obtain or maintain these protections, we may not beable to prevent third parties from using our intellectualproperty.     We also rely on trade secrets, proprietary know-how andcontinuing technological innovation to remain competitive. Wehave taken measures to protect our trade secrets and know-how,including the use of
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confidentiality agreements with our employees. It is possiblethat these agreements may be breached and that the availableremedies for any breach will not be sufficient to compensate usfor damages incurred.***Litigation may be necessary to enforce or defend against    claims of intellectual property infringement, which could be    expensive and, if we lose, could prevent us from selling our    products.***     Litigation may be necessary in the future to enforce our patentsand other intellectual property rights, to protect our tradesecrets or to determine the validity and scope of theproprietary rights of others. Any litigation, regardless of theoutcome, could be costly and require significant time andattention of key members of our management and technicalpersonnel.     Our domestic and international competitors, many of which havesubstantially greater resources and have made substantialinvestments in competing technologies, may have patents thatwill prevent, limit or interfere with our ability to manufactureand sell our products. We have not conducted an independentreview of patents issued to third parties. Third parties mayassert infringement claims, successful or otherwise, against us,and litigation may be necessary to defend against claims ofinfringement or invalidity. An adverse outcome in the defense ofa patent suit could subject us to significant liabilities tothird parties, require disputed rights to be licensed from thirdparties or require us to cease selling our products. Evensuccessful defenses of patent suits can be costly andtime-consuming.***We must attract and retain key employees and our    management team and employees must work effectively together to    maintain and grow our business.***     Our future success depends in part on our ability to retain keypersonnel, particularly senior management and engineers. We alsoneed to attract additional skilled personnel in significantareas of our business to grow. There can be no assurance that wewill be able to retain our existing personnel or attractadditional qualified employees in the future. We generally donot have employment contracts with our employees and do notmaintain key person life insurance on any of our employees.***Terrorism and international political instability may    negatively affect our operations.***     The threat of terrorism targeted at the regions of the world inwhich we do business increases the uncertainty in our marketsand may delay any recovery in the general economy, which couldthreaten our business.     Increased international political instability, particularlyresulting from the threat of terrorist attacks, and furtherenhanced security measures as a result of the threat ofterrorist attacks may hinder our ability to do business and mayincrease our costs of operations. Such continuing instabilitycould cause us to incur increased costs in transportation, makesuch transportation unreliable, increase our insurance costs andcause international markets to fluctuate. This instability couldhave the same effects on our suppliers and their ability totimely deliver their products to us. If this internationalpolitical instability continues or increases, our business andresults of operations could be harmed.***Our manufacturing facilities may be subject to disruption    from natural disasters.***     Operations at our manufacturing facilities are subject todisruption for a variety of reasons, including work stoppages,acts of war, terrorism, fire, earthquake, energy shortages,flooding or other natural disasters. Our corporate andmanufacturing facilities in California are located near majorearthquake faults, which have experienced earthquakes in thepast. Such disruption could cause delays in shipments ofproducts to our customers. We cannot ensure that alternateproduction capacity would be available if a major disruptionwere to occur or that, if it were available, it could beobtained on favorable terms. Such disruption could result incancellation of orders or loss of customers and could seriouslyharm our business. It could also significantly delay ourresearch and engineering efforts for the development of newproducts, most of which is conducted at our Californiafacilities.
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     In addition, some of our customers in Asia are located nearfault lines. A major earthquake in Asia could disrupt ouroperations or the operations of our customers, which couldreduce demand for our products.***Our stock price may fluctuate significantly.***     The market price of our common stock could fluctuatesignificantly in response to variations in quarterly operatingresults and other factors, such as: •     announcements of technological innovations or new products by us    or by our competitors;  •     government regulations;  •     developments in patent or other property rights; and  •     developments in our relationships with our customers.     In addition, the stock market has in recent years experiencedsignificant price fluctuations. These fluctuations often havebeen unrelated to the operating performance of the specificcompanies whose stock is traded. Broad market fluctuations,general economic condition and specific conditions in the flatpanel display industry may adversely affect the market price ofour common stock.***Some anti-takeover provisions may affect the price of our    common stock.***     Our Amended and Restated Articles of Incorporation authorize ourboard of directors to issue up to 5,000,000 shares ofpreferred stock. The board also has the authority to determinethe price, rights, preferences and privileges, including votingrights, of those shares without any further vote or action bythe shareholders. The rights of our shareholders will be subjectto, and may be impaired by, the rights of the holders of anypreferred stock that may be issued in the future. These andother provisions contained in our charter documents andapplicable provisions of California law could serve to depressour stock price or discourage a hostile bid in whichshareholders could receive a premium for their shares. Inaddition, these provisions could make it more difficult for athird party to acquire a majority of our outstanding votingstock or otherwise effect a change in control of us.***We do not anticipate paying cash dividends.***     We have never declared or paid any cash dividends on our capitalstock and do not anticipate paying cash dividends in theforeseeable future. We have also agreed not to pay cashdividends under our current bank line of credit. Instead, weintend to apply any earnings to the expansion and development ofour business.***New regulations related to equity compensation will    negatively impact our financial statements and could adversely    affect our ability to attract and retain key personnel.***     Since our inception, we have used stock options and otherlong-term equity incentives as a fundamental component of ouremployee compensation packages. We believe that stock optionsand other long-term equity incentives directly motivate ouremployees to maximize long-term stockholder value and, throughthe use of vesting, encourage employees to remain with PhotonDynamics. The Financial Accounting Standards Board(FASB) has announced changes to U.S. generallyaccepted accounting principles that will require us to recordcharges to earnings for employee stock option grants. Theserules become effective in the first quarter of fiscal 2006. Webelieve this accounting standard will have a material impact onour consolidated financial statements as reported undergenerally accepted accounting principles. In addition, newregulations implemented by The NASDAQ National Market requiringshareholder approval for all stock option plans, as well as newregulations implemented by the New York Stock Exchangeprohibiting NYSE member organizations from giving a proxy tovote on equity-compensation plans unless the beneficial owner ofthe shares has given voting instructions, could make it moredifficult for us to grant options to employees in the future. Tothe extent that new regulations make it more difficult orexpensive to grant stock options to employees, we may incurincreased compensation costs, change our equity compensationstrategy or find it difficult to attract, retain and motivateemployees, each of which could materially and adversely affectour business.
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**ITEM 3.*****Quantitative and Qualitative Disclosures About Market    Risk*****Foreign Currency Exchange Rate Risk**     We are exposed to changes in foreign currency exchange ratesprimarily related to the operating results of our foreignaffiliates. Actual changes in foreign exchange rates couldadversely affect our operating results or financial condition.The potential impact depends upon the magnitude of the ratechange. In fiscal 2004, approximately $4.4 million of ourrevenue was denominated in currencies other thanU.S. dollars, primarily in Japanese yen, and, atSeptember 30, 2004, approximately $13.2 million of ouraccounts receivable was denominated in currencies other thanU.S. dollars, all of which was in Japanese yen. In thethree and six month periods ended March 31, 2005,approximately $6.1 million and $17.6 million of ourrevenue was denominated in currencies other thanU.S. dollars, primarily in Japanese yen. At March 31,2005, approximately $1.0 million of our accounts receivablewas denominated in currencies other than U.S. dollars,primarily in Japanese yen.     Our accounts receivable denominated in currencies other thanU.S. dollars are subject to exchange rate risk and canfluctuate with the changes in exchange rates. A hypothetical 10%immediate and uniform adverse move in all currency exchangerates affecting the accounts receivable from the rates atMarch 31, 2005 would have decreased the fair value of theaccounts receivable by approximately $91,000. A hypothetical 10%immediate and uniform adverse move in all currency exchangerates affecting the accounts receivable from the rates atSeptember 30, 2004 would have decreased the fair value ofthe accounts receivable by approximately $1.5 million.     Although a relatively considerable portion of our revenue andaccounts receivable for the six months ended March 31, 2005was denominated in currencies other than U.S. dollars, weexpect that our cash, accounts receivable and accounts payablegenerally will be denominated in U.S. dollars and,therefore, our exposure to changes in foreign currency exchangerates for our cash, accounts receivable and accounts payable islimited.**Market Risk**     Our market risk as described under the heading “MarketRisk” in Item 7A of our Annual Report onform 10-K for the fiscal year ended September 30,2004, has not changed significantly.**ITEM 4.*****Controls and Procedures***     *Evaluation of Disclosure Controls and Procedures.* Basedon our management’s evaluation (with the participation ofour chief executive officer and chief financial officer), as ofthe end of the period covered by this report, our chiefexecutive officer and chief financial officer have concludedthat our disclosure controls and procedures (as defined inSecurities Exchange Act Rules 13a-15(e) and 15d-15(e)) asof March 31, 2005 were not effective to provide reasonableassurance that the information required to be disclosed by us inreports that we file or submit under the Securities Exchange Actof 1934 is recorded, processed, summarized and reported withinthe time periods specified in Securities and Exchange Commissionrules and forms, for the reasons cited below.     *Efforts to Address Existing Material Weaknesses and OtherDeficiencies.* In our Annual Report on Form 10-K filedon December 14, 2004 for our fiscal year endedSeptember 30, 2004, as updated by our Annual Report onForm 10-K/ A, Amendment No. 3 (the “10-K/ AAmendment”), we disclosed that in connection with our yearend close and audit processes, a number of issues werediscovered, which resulted in adjustments in our financialstatements. Further analysis of the nature of the adjustmentsand the associated internal controls led management to concludethat these adjustments were the result of material weaknesses inour internal controls over the financial close process. Thematerial weaknesses consist of failures to ensure: •     an appropriate level of review of those significant financial    statement accounts requiring a higher degree of judgment and    estimates, in part due to the need for more personnel as well as    more highly skilled and trained personnel in certain positions;
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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.     In addition to the material weaknesses identified above,management also identified a number of internal controldeficiencies that management has concluded do not constitutematerial weaknesses.     In late March of 2005, management identified an error related tothe timing of a portion of revenue recognized in connection witha sales transaction for which revenue was recorded in the fourthquarter of fiscal 2004. The error related to commitments made toa customer for certain system parts and supply contracts with afair value amounting to approximately $859,000, that were notdelivered by September 30, 2004. These additionalcommitments were made in the course of negotiating a largersales arrangement with the customer, but were inadvertently notcommunicated by Photon Dynamics’ sales people to theaccounting department as required by Photon Dynamics’policy. These additional commitments were identified to theaccounting department in late March 2005 when the customernotified Photon Dynamics that it wanted to take delivery ofcertain of the additional committed items. Based on the fairvalue of the committed but undelivered parts and supplycontracts at September 30, 2004, revenue and net income forthe quarter ended September 30, 2004 were overstated by$859,000, and deferred revenue at September 30, 2004 wasunderstated by $859,000.     Management notified Photon Dynamics’ Audit Committee, theBoard of Directors and Photon Dynamics’ independentregistered public accounting firm of the existence of theundelivered elements in early April after internal confirmationof their discovery. The Audit Committee immediately undertook aninternal investigation to evaluate the impact on the timing ofrevenue recognized under the total arrangement, to assess why ithad occurred, and to determine whether any other suchtransactions might exist for which such an error had occurred.In connection with this investigation, the Audit Committeeengaged Photon Dynamics’ outside legal counsel, which thenengaged a third-party forensic accounting firm and an electronicdata recovery firm to assist them in its investigation. TheAudit Committee also had the full cooperation of management inthe process.     As part of its investigation, the Audit Committee, with theassistance of outside legal counsel, the forensic accountingfirm and the electronic data recovery firm, reviewed salestransactions for fiscal 2004, and for the first two quarters offiscal 2005. In addition to the error in the accounting for thetransaction described above identified by management, theensuing investigation revealed several other adjustments torevenue, all of which impact the timing, but not the eventualamount, of revenue recognizable under the related arrangements.We believe these failures were due in part to an additionalmaterial weakness related to our sales order fulfillment andrevenue recognition process as discussed in this 10-Q andin our 10-K/ A Amendment.     The Audit Committee’s investigation did not support theconclusion that any fraudulent or deceptive act had beencommitted, but rather that the errors were due to internalcontrol weaknesses as mentioned above.***Changes in Internal Control Over Financial Reporting in    the Second Quarter of Fiscal 2005***     We have taken a number of steps to remediate the materialweaknesses noted in our original Report on Form 10-K filedin December 2004 and the additional material weakness related toour sales order fulfillment and revenue recognition process asdiscussed above, and otherwise strengthen our disclosurecontrols and procedures and internal controls over financialreporting at March 31, 2005. During the first quarter offiscal 2005, we contracted with several independent consultantsto help manage the workload associated with the increasingdemands in preparation for our fiscal year 2005 compliance withSection 404 of the Sarbanes Oxley Act of 2002 and to helpwith the financial close process. These additional resources areintended to allow certain members of our financial staffadequate time to perform a more detailed level of review of thefinancial statements and supporting documentation, including amore comprehensive review process of the financial statementsand supporting schedules of our international subsidiaries.Although these resources were contracted for the first quarter,these resources made a significant contribution in our financialclose for the quarter ended March 31, 2005.
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     Also to address the material weaknesses noted in our originalReport on Form 10-K filed in December, 2004, in the secondquarter we expanded our domestic review of revenue transactionsin Japan, including instituting certain procedures for review ofrevenue in Japan that are consistent with those proceduresutilized for revenue review in the U.S.***Changes in Internal Control Over Financial Reporting    Subsequent to the Second Quarter of Fiscal 2005***     Subsequent to March 31, 2005, the following changesoccurred in our internal control over financial reporting, thathave materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting: •     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 andProcedures.* Our management, including the chief executiveofficer and chief financial officer, do not expect that ourdisclosure controls and procedures or internal control overfinancial reporting will prevent all error and all fraud. Acontrol system no matter how well designed and implemented, canprovide only reasonable, not absolute, assurance that thecontrol system’s objectives will be met. Further, thedesign of a control system must reflect the fact that there areresource constraints, and the benefits of controls must beconsidered relative to their costs. Because of the inherentlimitations in all control systems, no evaluation of controlscan provide absolute assurance that all control issues within acompany are detected. The inherent limitations include therealities that judgments in decision-making can be faulty, andthat breakdowns can occur because of simple error or mistakes.Controls can also be circumvented by the individual acts of somepersons, by collusion of two or more people or by managementoverride of the controls. Because of the inherent limitations ina cost-effective control system, misstatements due to error orfraud may occur and not be detected.**PART II. OTHER INFORMATION****ITEM 1.*****Legal Proceedings***     Photon Dynamics and certain of our directors and officers havebeen named as defendants in a lawsuit captioned Amtower v.Photon Dynamics, Inc., No. CV797876, filed on April 30,2001 in the Superior Court of the State of California, County ofSanta Clara. The plaintiff, who previously served as one ofour officers, has asserted several causes of action arising outof alleged misrepresentations made to plaintiff regarding the
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existence and enforcement of our insider trading policy. Theplaintiff is seeking damages of approximately $17.7 millionfor our alleged refusal to allow plaintiff to sell shares of ourstock in May of 2000, plus unspecified emotional distress andpunitive damages. On December 6, 2001, the court grantedour motion to dismiss the complaint for failure to allege factssufficient to state a cause of action, with leave to file anamended complaint. On January 17, 2002, plaintiff filed hisamended complaint and we again moved to dismiss the action. OnJune 27, 2002, the court issued an order granting in partand denying in part the motion and further granted plaintiff anopportunity to restate certain claims. On October 1, 2002,plaintiff filed his Second Amended Complaint, which was heard onApril 8, 2003, and we again moved to dismiss the action. OnApril 21, 2003, the court granted in part and denied inpart our motion. The pleadings have been finalized and certainclaims against us and the individual defendants will proceed.Defendants have filed a motion for summary judgment, which hasbeen continued to September 29, 2005, and a trial, ifnecessary, is scheduled to begin on November 7, 2005.Discovery is ongoing. We believe the plaintiff’s case iswithout merit and intend to defend this action vigorously.Although we cannot predict the outcome of this litigation, webelieve that any adverse judgment in this litigation could havea material adverse effect on our financial condition or resultsof operations. We believe that an adverse judgment in thislitigation could be material and could have an adverse effect onour financial condition, results of operations or cash flows.     We were named as a defendant in a lawsuit captioned Sanmina SCICorporation v. Photon Dynamics, Inc., No. CV013715, filed on February 3, 2004 in the Superior Court ofthe State of California, County of Santa Clara. Theplaintiff in this action, which previously was a third-partymanufacturer of Photon Dynamics, asserted several causes ofaction arising out of our alleged nonperformance of ourmanufacturing outsourcing agreement with the plaintiff andsought approximately $3.1 million in compensatory damagesand punitive damages in a unknown amount. We responded to thecomplaint on March 19, 2004, by filing an answer and crosscomplaint seeking damages of at least $135,000. We amended ourcross complaint on June 26, 2004. We settled this disputewith Sanmina SCI Corporation in March 2005, pursuant to which wepaid Sanmina SCI Corporation $1.4 million, and the courtdismissed the matter on April 1, 2005.     These two lawsuits were previously reported in our Annual Reporton Form 10-K for the fiscal year ended September 30,2004, and updated in our Quarterly Report on Form 10-Q forthe fiscal quarter ended March 31, 2005.     From time to time we are subject to other legal proceedings andclaims, either asserted or unasserted, which arise in theordinary course of business. While the outcome of these otherproceedings and claims cannot be predicted with certainty,management does not believe that the outcome of any of theselegal matters will have a material adverse effect on our resultsof operations or financial condition.**ITEM 2.*****Unregistered Sales of Equity Securities and Use of    Proceeds***     None.**ITEM 3.*****Defaults Upon Senior Securities***     None.
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**ITEM 4.*****Submission of Matters to a Vote of Security Holders***     The Annual Meeting of Shareholders of Photon Dynamics, Inc. washeld on March 7, 2005 at our offices in San Jose,California. At the Annual Meeting of Shareholders, ourshareholders approved the following five proposals:          1. Proposal to elect directors to serve for the ensuing    year and until their successors are elected. The results of the    votes for the directors standing for election were as follows:         **Name** **For** **Withheld**         Malcolm J. Thompson  12,352,753   2,815,914     E. Floyd Kvamme  11,561,009   3,607,658     Terry H. Carlitz  12,687,920   2,480,747     Curtis S Wozniak  12,688,336   2,480,331     Nicholas E. Brathwaite  10,484,347   4,684,320     Michael J. Kim  11,756,388   3,412,279     Jeffrey A. Hawthorne  12,556,063   2,612,604           2. Proposal to approve our 2005 Equity Incentive Plan.         For  6,420,247     Against  5,423,803     Abstain  9,327     Broker Non-Vote  3,315,290           3. Proposal to approve our 2005 Employee Stock Purchase    Plan.         For  8,466,185     Against  3,375,122     Abstain  12,070     Broker Non-Vote  3,315,290           4. Proposal to approve our 2005 Non-Employee    Directors’ Stock Option Plan.         For  6,208,261     Against  5,632,434     Abstain  12,682     Broker Non-Vote  3,315,290           5. Proposal to ratify the selection of Ernst &    Young LLP as Photon Dynamics’ Independent Registered Public    Accounting Firm for the fiscal year ending September 30,    2005.         For  15,056,605     Against  107,709     Abstain  4,353 **ITEM 5.*****Other Information***     None.**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.
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     **Number** **Exhibit**     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.  10.44(4)     Photon Dynamics, Inc. 2005 Equity Incentive Plan.  10.45(5)     Photon Dynamics, Inc. 2005 Employee Stock Purchase Plan.  10.46(6)     Photon Dynamics, Inc. 2005 Non-Employee Directors’ Stock    Option Plan.  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. (4)     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 March 9, 2005, and incorporated    herein by reference. (5)     Previously filed as Exhibit 10.5 to the Registrant’s    Current Report on Form 8-K as filed with the Securities and    Exchange Commission on March 9, 2005, and incorporated    herein by reference. (6)     Previously filed as Exhibit 10.6 to the Registrant’s    Current Report on Form 8-K as filed with the Securities and    Exchange Commission on March 9, 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.
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**SIGNATURES**     Pursuant to the requirements of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed onits behalf by the undersigned, thereunto duly authorized.     PHOTON DYNAMICS, INC. By:     /s/ Maureen L. Lamb   **Maureen L. Lamb** **Chief Financial Officer and Secretary** **(Duly authorized and principal financial officer)**Dated: August 9, 2005
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**Exhibit Index**     **Number** **Exhibit**    3.1(1)     Amended and Restated Articles of Incorporation of the Registrant.  3.2(1)     Certificate of Amendment to Articles of Incorporation of the    Registrant.  3.3(2)     Bylaws of the Registrant and amendments thereto.  4.1     Reference is made to Exhibits 3.1, 3.2 and 3.3.  10.4(3)     Letter Agreement Extending Consulting Contract with Malcolm    Thompson, dated April 8, 2005.  10.44(4)     Photon Dynamics, Inc. 2005 Equity Incentive Plan.  10.45(5)     Photon Dynamics, Inc. 2005 Employee Stock Purchase Plan.  10.46(6)     Photon Dynamics, Inc. 2005 Non-Employee Directors’ Stock    Option Plan.  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. (4)     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 March 9, 2005, and incorporated    herein by reference. (5)     Previously filed as Exhibit 10.5 to the Registrant’s    Current Report on Form 8-K as filed with the Securities and    Exchange Commission on March 9, 2005, and incorporated    herein by reference. (6)     Previously filed as Exhibit 10.6 to the Registrant’s    Current Report on Form 8-K as filed with the Securities and    Exchange Commission on March 9, 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.
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