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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 Form 10-Q
 (Mark One)
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended December 31, 2005
 OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the transition period fromto
 Commission file number: 0-27234
 PHOTON DYNAMICS, INC.
 (Exact name of registrant as specified in its charter)
 California
    
    94-3007502(State or other jurisdiction of
incorporation or organization)
    
    (I.R.S. Employer
Identification No.)
 5970 Optical Court
San Jose, California 95138-1400  (Address of principal executive offices including zip code)
 (408) 226-9900  (Registrants telephone number, including area code)
 þ o
  o þ o
 þ o
 o þ




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INDEX
 PagePART I FINANCIAL INFORMATIONItem 1
    
    Financial Statements (unaudited)Condensed Consolidated Balance Sheets as of December 31, 2005 and September 30, 2005
    
    
    3Condensed Consolidated Statements of Operations for the Three  Months Ended December 31, 2005 and 2004
    
    
    4Condensed Consolidated Statements of Cash Flows for the Three Months Ended December 31, 2005 and 2004
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    21Item 3
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    41Item 4
    
    Controls and Procedures
    
    
    41PART II OTHER INFORMATIONItem 1
    
    Legal Proceedings
    
    
    42Item 1A
    
    Risk Factors
    
    
    42Item 2
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    43Item 3
    
    Defaults Upon Senior Securities
    
    
    43Item 4
    
    Submission of Matters to a Vote of Security Holders
    
    
    43Item 5
    
    Other Information
    
    
    43Item 6
    
    Exhibits
    
    
    43Signatures
    
    
    
    
    44EXHIBIT 3.3EXHIBIT 10.43EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1
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PART I. FINANCIAL INFORMATION
 
 ITEM 1. Financial Statements
 PHOTON DYNAMICS, INC.
 
 CONDENSED CONSOLIDATED BALANCE SHEETS*
 December 31,
    
    
    September 30,2005
    
    
    2005(in thousands)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    20,376
    
    
    $
    20,288Short-term investments
    
    
    72,347
    
    
    
    72,738Accounts receivable, net of allowance for doubtful accounts of $153 in each period
    
    
    28,361
    
    
    
    27,067Inventories
    
    
    31,392
    
    
    
    32,545Other current assets
    
    
    3,252
    
    
    
    3,932Total current assets
    
    
    155,728
    
    
    
    156,570Land, property and equipment, net
    
    
    18,116
    
    
    
    19,366Other assets
    
    
    5,172
    
    
    
    4,390Intangible assets, net
    
    
    2,833
    
    
    
    3,205Goodwill
    
    
    153
    
    
    
    153Total assets
    
    $
    182,002
    
    
    $
    183,684LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    9,413
    
    
    $
    13,005Warranty
    
    
    3,898
    
    
    
    5,346Other current liabilities
    
    
    14,093
    
    
    
    8,618Deferred gross margin
    
    
    6,251
    
    
    
    13,113Total current liabilities
    
    
    33,655
    
    
    
    40,082Other non-current liabilities
    
    
    973
    
    
    
    1,008Commitments and contingenciesShareholders equity:Common stock, no par value
    
    
    289,153
    
    
    
    287,765Accumulated deficit
    
    
    (142,126
    )
    
    
    (145,489
    )Accumulated other comprehensive income
    
    
    347
    
    
    
    318Total shareholders equity
    
    
    147,374
    
    
    
    142,594Total liabilities and shareholders equity
    
    $
    182,002
    
    
    $
    183,684
 *
    
    Amounts as of December 31, 2005 are unaudited. Amounts as of September 30, 2005 are derived from the September 30, 2005 audited financial statments.
  3




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PHOTON DYNAMICS, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 Three Months EndedDecember 31,2005
    
    
    2004(unaudited)(in thousands, except per share data)Revenue
    
    $
    41,633
    
    
    $
    36,639Cost of revenue
    
    
    22,382
    
    
    
    22,781Gross margin
    
    
    19,251
    
    
    
    13,858Operating expenses:Research and development
    
    
    8,071
    
    
    
    9,470Selling, general and administrative
    
    
    6,845
    
    
    
    4,684Restructuring charge
    
    
    62
    
    
    
    Loss on sale of property and equipment
    
    
    6
    
    
    
    Amortization of intangible assets
    
    
    372
    
    
    
    397Total operating expenses
    
    
    15,356
    
    
    
    14,551Income (loss) from operations
    
    
    3,895
    
    
    
    (693
    )Interest income and other, net
    
    
    500
    
    
    
    1,255Income from continuing operations before income taxes and discontinued operations
    
    
    4,395
    
    
    
    562Provision for income taxes
    
    
    352
    
    
    
    39Income from continuing operations before discontinued operations
    
    
    4,043
    
    
    
    523Loss from discontinued operations
    
    
    (680
    )
    
    
    (6
    )Net income
    
    $
    3,363
    
    
    $
    517Income per share from continuing operations:Basic
    
    $
    0.24
    
    
    $
    0.03Diluted
    
    $
    0.24
    
    
    $
    0.03Loss per share from discontinued operations:Basic
    
    $
    (0.04
    )
    
    $
    (0.00
    )Diluted
    
    $
    (0.04
    )
    
    $
    (0.00
    )Net income per share:Basic
    
    $
    0.20
    
    
    $
    0.03Diluted
    
    $
    0.20
    
    
    $
    0.03Weighted average number of shares:Basic
    
    
    16,946
    
    
    
    16,872Diluted
    
    
    17,047
    
    
    
    17,009
  4




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PHOTON DYNAMICS, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 Three Months EndedDecember 31,2005
    
    
    2004(unaudited)(in thousands)Cash flows from operating activities:Income from continuing operations
    
    $
    4,043
    
    
    $
    523Adjustments to reconcile income from continuing operations to net cash provided
by (used in) operating activities from continuing operations:Depreciation
    
    
    1,439
    
    
    
    1,024Amortization of intangible assets
    
    
    372
    
    
    
    397Non-cash stock-based compensation
    
    
    985
    
    
    
    Loss on sale of property and equipment
    
    
    6
    
    
    
    Non-employee stock ownership expense
    
    
    6
    
    
    
    35Accretion of non-interest bearing notes payable
    
    
    9
    
    
    
    19Changes in assets and liabilities:Accounts receivable
    
    
    (1,294
    )
    
    
    22,515Inventories
    
    
    1,188
    
    
    
    (1,990
    )Other current assets
    
    
    505
    
    
    
    268Other assets
    
    
    (541
    )
    
    
    (601
    )Accounts payable
    
    
    (3,513
    )
    
    
    (6,526
    )Other current liabilities
    
    
    3,611
    
    
    
    526Deferred gross margin
    
    
    (6,862
    )
    
    
    (509
    )Other liabilities
    
    
    (40
    )
    
    
    (16
    )Net cash provided by (used in) operating activities from continuing operations
    
    
    (86
    )
    
    
    15,665Net cash provided by (used in) operating activities from discontinued operations
    
    
    (413
    )
    
    
    50Net cash provided by (used in) operating activities
    
    
    (499
    )
    
    
    15,715Cash flows from investing activities:Purchase of property and equipment
    
    
    (195
    )
    
    
    (922
    )Purchase of short-term investments
    
    
    (16,323
    )
    
    
    (17,244
    )Maturities and sales of short-term investments
    
    
    16,788
    
    
    
    10,828Net cash provided by (used in) investing activities from continuing operations
    
    
    270
    
    
    
    (7,338
    )Cash flows from financing activities:Issuance of common stock
    
    
    362
    
    
    
    499Net cash provided by financing activities from continuing operations
    
    
    362
    
    
    
    499Effect of exchange rate changes on cash and cash equivalents
    
    
    (45
    )
    
    
    128Net increase in cash and cash equivalents from continuing operations
    
    
    501
    
    
    
    8,954Net increase (decrease) in cash and cash equivalents from discontinued operations
    
    
    (413
    )
    
    
    50Net increase in cash and cash equivalents
    
    
    88
    
    
    
    9,004Cash and cash equivalents at beginning of period
    
    
    20,288
    
    
    
    25,483Cash and cash equivalents at end of period
    
    $
    20,376
    
    
    $
    34,487
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PHOTON DYNAMICS, INC.
 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 NOTE 1  Basis of Presentation and Summary of Significant Accounting Policies
 Basis of Presentation.
   Description of Operations and Principles of Consolidation.
  Management Estimates.
 Fair Value of Financial Instruments.
 6




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Inventories.
 Concentration of Credit and Other Risk.
    Revenue Recognition.
   Shipping Costs.
 Research and Development Cost.
 7




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Interest Income.
 Variable Interest Entity
 Recent Accounting Pronouncements.
     8




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NOTE 2  Financial Statement Components
 December 31,
    
    
    September 30,2005
    
    
    2005(in thousands)Inventories:Raw materials
    
    $
    13,770
    
    
    $
    12,476Work-in-process
    
    
    12,748
    
    
    
    19,327Finished goods
    
    
    4,874
    
    
    
    742Total
    
    $
    31,392
    
    
    $
    32,545Other current liabilities:Compensation
    
    $
    4,357
    
    
    $
    3,838Commissions
    
    
    383
    
    
    
    295Vendor obligations
    
    
    677
    
    
    
    286Professional fees
    
    
    1,493
    
    
    
    1,314Employee notes payable
    
    
    490
    
    
    
    490Customer deposits
    
    
    3,760
    
    
    
    Other accrued expenses
    
    
    2,933
    
    
    
    2,395Total
    
    $
    14,093
    
    
    $
    8,618Deferred gross margin:Deferred system sales
    
    $
    15,955
    
    
    $
    25,481Deferred cost of revenue related to system sales
    
    
    (9,704
    )
    
    
    (12,368
    )Total
    
    $
    6,251
    
    
    $
    13,113Accumulated other comprehensive income:Foreign currency translation adjustments
    
    $
    598
    
    
    $
    643Unrealized losses on available for sale securities
    
    
    (251
    )
    
    
    (325
    )Total
    
    $
    347
    
    
    $
    318
 NOTE 3  Discontinued Operations
 Printed Circuit Board Assembly Inspection Business
  9




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Three MonthsEndedDecember 31,2005
    
    
    2004(in thousands)Operating expenses:Selling, general and administrative
    
    $
    697
    
    
    $
    4Total operating expenses
    
    
    697
    
    
    
    4Loss from discontinued operations
    
    $
    (697
    )
    
    $
    (4
    )
   December 31,
    
    
    September 30,2005
    
    
    2005(in thousands)ASSETSCurrent assets:Other current assets
    
    $
    
    
    
    $
    175Total current assets
    
    
    
    
    
    
    175Other assets:Other non-current assets
    
    
    1,258
    
    
    
    1,016Total assets
    
    $
    1,258
    
    
    $
    1,191LIABILITIESCurrent liabilities:Other current liabilities
    
    $
    968
    
    
    $
    579Total current liabilities
    
    
    968
    
    
    
    579Other liabilities:Other non-current liabilities
    
    
    
    
    
    
    42Total liabilities
    
    $
    968
    
    
    $
    621
    10




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One-TimeTerminationBenefits
    
    
    Other Costs
    
    
    Total(in thousands)Inception of liability
    
    $
    696
    
    
    $
    1,326
    
    
    $
    2,022Cash payments
    
    
    (614
    )
    
    
    (652
    )
    
    
    (1,266
    )Adjustments to the liability
    
    
    (82
    )
    
    
    (474
    )
    
    
    (556
    )Balance at September 30, 2005
    
    
    
    
    
    
    200
    
    
    
    200Cash payments
    
    
    
    
    
    
    
    
    
    
    Adjustments to the liability
    
    
    
    
    
    
    
    
    
    
    Balance at December 31, 2005
    
    $
    
    
    
    $
    200
    
    
    $
    200
  Cathode Ray Tube Display and High Quality Glass Inspection Business
   Three MonthsEndedDecember 31,(in thousands)2005
    
    
    2004Cost of revenue
    
    $
    (17
    )
    
    $
    Gross margin
    
    
    17
    
    
    
    Operating expenses:Selling, general and administrative
    
    
    
    
    
    
    2Total operating expenses
    
    
    
    
    
    
    2Income (loss) from discontinued operations
    
    $
    17
    
    
    $
    (2
    )
   December 31,
    
    
    September 30,2005
    
    
    2005(in thousands)LIABILITIESOther current liabilities:
    
    $
    53
    
    
    $
    74
   11




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One-Time
    
    
    ContractTermination
    
    
    TerminationBenefits
    
    
    Costs
    
    
    Other Costs
    
    
    Total(in thousands)Inception of liability
    
    $
    1,116
    
    
    $
    771
    
    
    $
    11
    
    
    $
    1,898Cash payments
    
    
    (1,116
    )
    
    
    (393
    )
    
    
    (61
    )
    
    
    (1,570
    )Adjustments to the liability
    
    
    
    
    
    
    (304
    )
    
    
    50
    
    
    
    (254
    )Balance at September 30, 2005
    
    
    
    
    
    
    74
    
    
    
    
    
    
    
    74Cash payments
    
    
    
    
    
    
    (21
    )
    
    
    
    
    
    
    (21
    )Adjustments to the liability
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Balance at December 31, 2005
    
    $
    
    
    
    $
    53
    
    
    $
    
    
    
    $
    53
  NOTE 4  Goodwill and Other Purchased Intangible Assets
 Goodwill
   Intangible Assets
  NonDeveloped
    
    
    Core
    
    
    License
    
    
    CompeteTechnology
    
    
    Technology
    
    
    Agreement
    
    
    Contract
    
    
    Total(in thousands)Gross carrying amount at December 31, 2005
    
    $
    1,006
    
    
    $
    2,408
    
    
    $
    1,138
    
    
    $
    968
    
    
    $
    5,520Accumulated amortization
    
    
    (389
    )
    
    
    (1,052
    )
    
    
    (663
    )
    
    
    (583
    )
    
    
    (2,687
    )Net carrying amount at December 31, 2005
    
    $
    617
    
    
    $
    1,356
    
    
    $
    475
    
    
    $
    385
    
    
    $
    2,833
  NonDeveloped
    
    
    Core
    
    
    License
    
    
    CompeteTechnology
    
    
    Technology
    
    
    Agreement
    
    
    Contract
    
    
    Total(in thousands)Gross carrying amount at September 30, 2005
    
    $
    1,006
    
    
    $
    2,408
    
    
    $
    1,138
    
    
    $
    968
    
    
    $
    5,520Accumulated amortization
    
    
    (326
    )
    
    
    (902
    )
    
    
    (568
    )
    
    
    (519
    )
    
    
    (2,315
    )Net carrying amount at September 30, 2005
    
    $
    680
    
    
    $
    1,506
    
    
    $
    570
    
    
    $
    449
    
    
    $
    3,205
  Net
    
    
    Net
    
    
    Net
    
    
    Net NonDeveloped
    
    
    Core
    
    
    License
    
    
    CompeteTechnology
    
    
    Technology
    
    
    Agreement
    
    
    Contract
    
    
    Total(in thousands)Net carrying amount at September 30, 2005
    
    $
    680
    
    
    $
    1,506
    
    
    $
    570
    
    
    $
    449
    
    
    $
    3,205Amortization during the period
    
    
    (63
    )
    
    
    (150
    )
    
    
    (95
    )
    
    
    (64
    )
    
    
    (372
    )Net carrying mount at December 31, 2005
    
    $
    617
    
    
    $
    1,356
    
    
    $
    475
    
    
    $
    385
    
    
    $
    2,833
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NOTE 5  Restructuring Charges
 TM
    One-Time
    
    
    ContractTermination
    
    
    TerminationBenefits
    
    
    Costs
    
    
    Total(in thousands)Inception of liability
    
    $
    430
    
    
    $
    246
    
    
    $
    676Cash payments
    
    
    (526
    )
    
    
    (21
    )
    
    
    (547
    )Costs incurred and charged to expense
    
    
    521
    
    
    
    
    
    
    
    521Adjustments to the liability
    
    
    24
    
    
    
    (166
    )
    
    
    (142
    )Balance at September 30, 2005
    
    
    449
    
    
    
    59
    
    
    
    508Cash payments
    
    
    (114
    )
    
    
    (3
    )
    
    
    (117
    )Costs incurred and charged to expense
    
    
    62
    
    
    
    
    
    
    
    62Adjustments to the liability
    
    
    (1
    )
    
    
    (1
    )
    
    
    (2
    )Balance at December 31, 2005
    
    $
    396
    
    
    $
    55
    
    
    $
    451
   13




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NOTE 6  Comprehensive Income
  Three Months EndedDecember 31,2005
    
    
    2004(in thousands)Net income
    
    $
    3,363
    
    
    $
    517Other comprehensive loss:Net change in unrealized losses on investments
    
    
    75
    
    
    
    (156
    )Change in foreign currency translation
    
    
    (46
    )
    
    
    128Other comprehensive income (loss)
    
    
    29
    
    
    
    (28
    )Total comprehensive income
    
    $
    3,392
    
    
    $
    489
 NOTE 7  Stock-Based Compensation
   Prior to the Adoption of SFAS No. 123R.
  Three Months EndedDecember 31, 2004(in thousands, except pershare data)Net income  as reported
    
    $
    517Less: total stock-based employee compensation
expense determined under fair value based
method for all awards
    
    
    (2,017
    )Net loss  pro forma
    
    $
    (1,500
    )Basic net income per share  as reported
    
    $
    0.03Diluted net income per share  as reported
    
    $
    0.03Basic net loss per share  pro forma
    
    $
    (0.09
    )Diluted net loss per share  pro forma
    
    $
    (0.09
    )
 Impact of the adoption of SFAS No. 123R
 14




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Three Months EndedDecember 31, 2005(in thousands, exceptper share data)Stock-based compensation expense by type of award:Employee stock options
    
    $
    925Employee stock purchase plan
    
    
    94Amounts capitalized as inventory and deferred gross margin
    
    
    (35
    )Total stock-based compensation
    
    
    985Tax effect on stock-based compensation
    
    
    Net effect on net income
    
    $
    985Effect on net income per share:Basic
    
    $
    0.06Diluted
    
    $
    0.06
  Equity Incentive Program
  Number of SecuritiesRemaining Available forFuture Issuance UnderNumber of Securities
    
    
    
    
    
    
    Equityto be Issued upon
    
    
    Weighted-Average
    
    
    Compensation PlansExercise of
    
    
    Exercise Price of
    
    
    (Excluding SecuritiesOutstanding Options
    
    
    Outstanding Options
    
    
    Reflected in Column (a))Plan Category
    
    (a)
    
    
    (b)
    
    
    (c)Equity compensation plans approved by security holders
    
    
    1,910,521
    
    
    $
    24.18
    
    
    
    1,022,597Equity compensation plans not approved by security holders
    
    
    625
    
    
    $
    16.88
    
    
    
    Total
    
    
    1,911,146
    
    
    $
    24.18
    
    
    
    1,022,597
  15




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Three Months EndedDecember 31,2005
    
    
    2004Stock option plan:Expected volatility
    
    
    44
    %
    
    
    72
    %Risk free rate
    
    
    4.20
    %
    
    
    2.89
    %Expected term (in years)
    
    
    3.9
    
    
    
    5.5
   Weighted-
    
    
    Weighted- Average
    
    
    AggregateAvailable
    
    
    Options
    
    
    Average
    
    
    Remaining Contract
    
    
    Intrinsic Valuefor Grant
    
    
    Outstanding
    
    
    Exercise Price
    
    
    Term (in years)
    
    
    (in thousands)Balances at September 30, 2005
    
    
    1,663,308
    
    
    
    1,946,274
    
    
    $
    24.64Plan shares expired
    
    
    (649,252
    )
    
    
    
    
    
    
    Options granted
    
    
    (84,500
    )
    
    
    84,500
    
    
    
    17.01Options canceled/expired
    
    
    93,041
    
    
    
    (93,041
    )
    
    
    29.98Options exercised
    
    
    
    
    
    
    (26,587
    )
    
    
    14.78Balances at December 31, 2005
    
    
    1,022,597
    
    
    
    1,911,146
    
    
    $
    24.18
    
    
    
    7.8
    
    
    $
    1,038Vested and
expected to vest at December 31, 2005
    
    
    
    
    
    
    1,814,578
    
    
    $
    24.44
    
    
    
    7.7
    
    
    $
    1,005Exercisable at December 31, 2005
    
    
    
    
    
    
    1,269,756
    
    
    $
    26.90
    
    
    
    7.1
    
    
    $
    809
     Employee Stock Purchase Plan.
 16




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##### Table of Contents



Three Months EndedDecember 31,2005
    
    
    2004Stock purchase plan:Expected volatility
    
    
    44
    %
    
    
    80
    %Risk free rate
    
    
    4.20
    %
    
    
    1.70
    %Expected term (in years)
    
    
    0.5
    
    
    
    1.6
   NOTE 8  Net Income Per Share
   Three Months EndedDecember 31,2005
    
    
    2004(in thousands, except per sharedata)Numerator:Net income from continuing operations
    
    $
    4,043
    
    
    $
    523Net loss from discontinued operations
    
    
    (680
    )
    
    
    (6
    )Net income
    
    $
    3,363
    
    
    $
    517Denominator:Weighted average shares for basic net income per share
    
    
    16,946
    
    
    
    16,872Effect of shares held in escrow
    
    
    57
    (1)
    
    
    Effect of dilutive securities: Employee stock options
    
    
    44
    
    
    
    137Weighted average shares for diluted net income per share
    
    
    17,047
    
    
    
    17,009Earnings per share:Basic net income (loss) per share:Net income from continuing operations
    
    $
    0.24
    
    
    $
    0.03Net loss from discontinued operations
    
    
    (0.04
    )
    
    
    (0.00
    )Net income per share
    
    $
    0.20
    
    
    $
    0.03Diluted net income (loss) per share:Net income from continuing operations
    
    $
    0.24
    
    
    $
    0.03Net loss from discontinued operations
    
    
    (0.04
    )
    
    
    (0.00
    )Net income per share
    
    $
    0.20
    
    
    $
    0.03
 
 (1)
    
    The Company has 57,195 shares company stock in an escrow account. These shares are
considered contingently issuable shares under Statement of Financial Accounting Standards No.
128, Earnings per Share, and were therefore excluded from the calculation of weighted
average shares for basic net income per share and were included in the calculation of weighted
average shares for diluted net income per share. 17




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##### Table of Contents



NOTE 9  Commitments and Contingencies
 Purchase Agreements
  Warranty Obligations
   Three Months EndedDecember 31,2005
    
    
    2004(in thousands)Beginning balance
    
    $
    5,346
    
    
    $
    6,194Estimated warranty cost of new shipments during the period
    
    
    1,073
    
    
    
    1,500Warranty costs during the period
    
    
    (554
    )
    
    
    (1,538
    )Changes in liability for pre-existing warranties, including expirations
    
    
    (1,967
    )
    
    
    75Ending balance
    
    $
    3,898
    
    
    $
    6,231
  Legal Proceedings
   18




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##### Table of Contents



NOTE 10  Geographic Information
   Three MonthsEndedDecember 31,2005
    
    
    2004(in thousands)Revenue:Korea
    
    $
    35,047
    
    
    $
    6,380Taiwan
    
    
    5,921
    
    
    
    8,339Japan
    
    
    538
    
    
    
    11,533China
    
    
    
    
    
    
    10,387Other
    
    
    127
    
    
    
    Total
    
    $
    41,633
    
    
    $
    36,639
  Three MonthsEndedDecember 31,2005
    
    
    2004Revenue:ArrayCheckerTM
    
    
    75
    %
    
    
    64
    %ArraySaverTM
    
    
    7
    %
    
    
    29
    %PanelMasterTM
    
    
    10
    %
    
    
    Customer spares and other
    
    
    8
    %
    
    
    7
    %Total
    
    
    100
    %
    
    
    100
    %
  Three MonthsEndedDecember 31,2005
    
    
    2004Customer A
    
    
    40
    %
    
    
    17
    %Customer B
    
    
    *
    
    
    
    29
    %Customer C
    
    
    *
    
    
    
    31
    %Customer D
    
    
    *
    
    
    
    18
    %Customer E
    
    
    44
    %
    
    
    *
 
 *
    
    Customer accounted for less than 10% of total revenue for the period  December 31,
    
    
    September 30,2005
    
    
    2005Customer A
    
    
    48
    %
    
    
    29
    %Customer B
    
    
    24
    %
    
    
    19
    %Customer C
    
    
    *
    
    
    
    19
    %Customer D
    
    
    *
    
    
    
    10
    %
 
 *
    
    Customer accounted for less than 10% of total gross accounts receivable for the period 19




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##### Table of Contents



December 31,
    
    
    September 30,2005
    
    
    2005(In thousands)United States
    
    $
    19,404
    
    
    $
    21,022Canada
    
    
    367
    
    
    
    519Other
    
    
    1,331
    
    
    
    1,183Total
    
    $
    21,102
    
    
    $
    22,724
 NOTE 11  Related Party Transactions
  NOTE 12  Provision for Income Taxes
  20




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##### Table of Contents



ITEM 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
 This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.
Actual results could differ materially from those projected in the forward-looking statements as a
result of a number of factors, risks and uncertainties, including the risk factors set forth in
this discussion, especially under the caption Factors Affecting Operating Results in this Form
10-Q. Financial projections for future periods are forward-looking statements, and generally other
statements using the words anticipate, expect, intend, believe and similar expressions
identify forward-looking statements. The forward-looking statements made in this Form 10-Q are made
as of the filing date with the Securities and Exchange Commission and future events or
circumstances could cause results that differ significantly from the forward-looking statements
included here. Accordingly, we caution readers not to place undue reliance on these statements. We
expressly disclaim any obligation to update or alter our forward-looking statements, whether as a
result of new information, future events or otherwise.
 The following discussion and analysis should be read in conjunction with the condensed
consolidated financial statements and notes thereto in Item 1 above and with our financial
statements and notes thereto for the year ended September 30, 2005, contained in our Annual Report
on Form 10-K filed with the SEC on December 14, 2005.
 Overview
 Our Company
     
    
    The level of capital expenditures of flat panel display manufacturers, which in turn
depends on the current and anticipated market demand for products utilizing flat panel
displays, and
    
    The relative competitiveness of our products and services.
  Focus on Flat Panel Display Industry
  21




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##### Table of Contents




    
    Product Focus:We continue to improve our product performance in defect detection,
repair success, cost of ownership, ease of use and throughput for each of our product
generations. We seek to couple this improved system performance with our expert applications
engineering services to provide the best possible business solutions to our customers.
    
    Quality Focus:We are continuing to implement processes to drive product quality
improvement and ease of use for our customers.
    
    Technology Leadership:We are continuing to emphasize our research and development to
maintain our technology leadership in our products. We have formed an advance technology
organization to focus on our 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 continue our efforts 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.
   
    
    Gross margin improvement;
    
    New product introduction execution; and
    
    Strengthening market leadership in our yield management portfolio of products.
 Industry
   22




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Backlog
  Critical Accounting Policies and Estimates
     23




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##### Table of Contents



Revenue Recognition.
   Allowance for Doubtful Accounts.
  Inventories
  Warranty.
  24




---



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Goodwill and Intangible Assets.
   Stock-Based Compensation
  Contingencies and Litigation
  25




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##### Table of Contents



Results of Operations
 Selected Financial Data
  Three Months EndedDecember 31,2005
    
    
    2004Revenue
    
    
    100.0
    %
    
    
    100.0
    %Cost of revenue
    
    
    53.8
    
    
    
    62.2Gross margin
    
    
    46.2
    
    
    
    37.8Operating expenses:Research and development
    
    
    19.4
    
    
    
    25.8Selling, general and administrative
    
    
    16.4
    
    
    
    12.8Restructure charge
    
    
    0.1
    
    
    
    Loss on sale of property and equipment
    
    
    0.0
    
    
    
    Amortization of intangible assets
    
    
    0.9
    
    
    
    1.1Total operating expenses
    
    
    36.8
    
    
    
    39.7Income (loss) from operations
    
    
    9.4
    
    
    
    (1.9
    )Interest income and other, net
    
    
    1.2
    
    
    
    3.4Income from continuing operations before income taxes and discontinued operations
    
    
    10.6
    
    
    
    1.5Provision for income taxes
    
    
    0.9
    
    
    
    0.1Income from continuing operations
    
    
    9.7
    
    
    
    1.4Loss from discontinued operations
    
    
    (1.6
    )
    
    
    0.0Net income
    
    
    8.1
    %
    
    
    1.4
    %
 Revenue
 Three Months EndedDecember 31,2005
    
    
    Change
    
    
    2004(dollars in millions)Revenue
    
    $
    41.6
    
    
    
    14
    %
    
    $
    36.6
  TM TM TM
 ArrayChecker TM and ArraySaver TM Product Revenue
 TM TM TM TM
 TM
 TM
 26




---



##### Table of Contents



TM TM
 PanelMaster TM Product Revenue
 TM TM
 TM
 Customer Support and Spare Parts Revenue
  International Revenue
  Three Months EndedDecember 31,2005
    
    
    Change
    
    
    2004(dollars in millions)Korea
    
    $
    35.0
    
    
    
    449
    %
    
    $
    6.5Taiwan
    
    
    5.9
    
    
    
    (29
    )%
    
    
    8.3Japan
    
    
    0.6
    
    
    
    (95
    )%
    
    
    11.5China
    
    
    
    
    
    
    (100
    )%
    
    
    10.4Other
    
    
    0.1
    
    
    
    100
    %
    
    
    Total Revenue
    
    $
    41.6
    
    
    
    14
    %
    
    $
    36.7
   Revenue Outlook
  27




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##### Table of Contents



Gross Margin
 Three Months EndedDecember 31,2005
    
    
    Change
    
    
    2004Gross Margin
    
    
    46
    %
    
    
    21
    %
    
    
    38
    %
  
    
    A high mix of higher-margin ArrayCheckerTM systems; and
    
    A favorable warranty adjustment related to the increased reliability and serviceability of our tools.
    
    
    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;
    
    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 EndedDecember 31,2005
    
    
    Change
    
    
    2004(dollars in millions)Expense
    
    $
    8.1
    
    
    
    (15
    )%
    
    $
    9.5Percent of Revenue
    
    
    19
    %
    
    
    
    
    
    
    26
    %
   
    
    Ramp up our automated inspection program to address mass production requirements;
    
    Increase our efforts on Generation 7 and 7.5 products and launch programs for Generation 8 products; and
    
    Invest funds in reliability and cost reduction initiatives.
  28




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##### Table of Contents



Selling, General and Administrative
 Three Months EndedDecember 31,2005
    
    
    Change
    
    
    2004(dollars in millions)Expense
    
    $
    6.8
    
    
    
    46
    %
    
    $
    4.7Percent of Revenue
    
    
    16
    %
    
    
    
    
    
    
    13
    %
   Stock-Based Compensation
       29




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##### Table of Contents



Restructuring Charge
 Three Months EndedDecember 31,2005
    
    
    Change
    
    
    2004Expense
    
    $
    62,000
    
    
    
    100
    %
    
    $
    Percent of Revenue
    
    
    0
    %
    
    
    
    
    
    
    0
    %
    Amortization of Intangibles
 Three Months EndedDecember 31,2005
    
    
    Change
    
    
    2004Expense
    
    $
    372,000
    
    
    
    (6
    )%
    
    $
    397,000Percent of Revenue
    
    
    1
    %
    
    
    
    
    
    
    1
    %
   Interest Income and Other, Net
 Three Months EndedDecember 31,2005
    
    
    Change
    
    
    2004Expense
    
    $
    500,000
    
    
    
    (60
    )%
    
    $1.3 millionPercent of Revenue
    
    
    1
    %
    
    
    
    
    
    
    3
    %
  30




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##### Table of Contents



Provision for Income Taxes
 Three Months EndedDecember 31,2005
    
    
    Change
    
    
    2004Expense
    
    $
    352,000
    
    
    
    802
    %
    
    $
    39,000Percent of Revenue
    
    
    1
    %
    
    
    
    
    
    
    0
    %
   Discontinued Operations
 Three Months EndedDecember 31,2005
    
    
    Change
    
    
    2004Loss
    
    $
    (680,000
    )
    
    
    (11,233
    )%
    
    $
    (6,000
    )
   Liquidity and Capital Resources
  Operating Activities of Continuing Operations
  Investing Activities of Continuing Operations
  31




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##### Table of Contents



Financing Activities of Continuing Operations
    Operating, Investing and Financing Activities of Discontinued Operations
  Three Months EndedDecember 31,2005
    
    
    2004(In thousands)Printed circuit board business
    
    $
    (410
    )
    
    $
    (94
    )Cathode ray tube display and high quality glass inspection business
    
    
    (3
    )
    
    
    144Net cash used in discontinued operations
    
    $
    (413
    )
    
    $
    50
 Contractual Obligations
  Payments Due by Fiscal YearContractual Obligations
    
    Total
    
    
    2006(1)
    
    
    2007
    
    
    2008
    
    
    2009
    
    
    2010
    
    
    Thereafter(In thousands)Notes payable
    
    $
    1,500
    
    
    $
    500
    
    
    $
    1,000
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Operating lease obligations
    
    
    13,908
    
    
    
    2,287
    
    
    
    2,936
    
    
    
    2,664
    
    
    
    2,624
    
    
    
    2,714
    
    
    
    683Purchase obligations
    
    
    36,367
    
    
    
    31,329
    
    
    
    4,979
    
    
    
    59
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    51,775
    
    
    $
    34,116
    
    
    $
    8,915
    
    
    $
    2,723
    
    
    $
    2,624
    
    
    $
    2,714
    
    
    $
    683
 
 (1)
    
    Remaining 9 months    Working Capital
  32




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Impact of Accounting Pronouncements
      33




---



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Factors Affecting Operating Results
 We have sustained losses and we may sustain losses in the future.
  Our operating results are difficult to predict and may vary from investors expectations, which
could cause our stock price to fall.
   
    
    the timing of the receipt of orders from major customers;
    
    our product mix;
    
    competitive pricing pressures;
    
    our ability to obtain components from our single or limited source suppliers in a timely manner;
    
    global economic uncertainty;
    
    changing international economic conditions;
    
    the outcome of our litigation with a former executive officer;
    
    worldwide political instability;
    
    our ability to design, manufacture and introduce new products on a cost-effective and timely basis;
    
    the delay between expenses to further develop marketing and service capabilities and the
realization of benefits from those improved capabilities; and
    
    the introduction of new products by our competitors.
  34




---



##### Table of Contents



If our products experience performance, reliability or quality problems, our customers may reduce
their orders.
 TM TM
 
    
    delays in collecting accounts receivable;
    
    reduced orders;
    
    additional service expenses; and
    
    higher manufacturing costs.
   Capital investment by manufacturers of flat panel display products can be highly cyclical and may
decline in the future.
   We depend on sales to a few large customers in the flat panel display industry, and if we lose any
of our large customers our revenue could decrease significantly.
  We rely upon sales of a limited range of products, and if demand for one product decreases for any
reason it could cause our revenue to decline significantly.
  We may not be able to develop and introduce new products that respond to evolving industry
requirements in a timely manner, which could reduce our ability to compete effectively.
 35




---



##### Table of Contents



If we are not able to obtain critical components from our single or limited source suppliers, we
may experience significant delays in producing our products, which could decrease our revenue for
an extended period of time.
  All of our revenue is derived from sales to companies located outside the United States, which
exposes us to risks that we would not experience with domestic sales.
  
    
    political instability and the possibility of hostilities, terrorist attacks, or war;
    
    imposition of governmental controls;
    
    fluctuations in interest and currency exchange rates;
    
    export license requirements;
    
    restrictions on the export of technology;
    
    limited foreign protection of intellectual property rights;
    
    trade restrictions;
    
    periodic or local international downturns;
    
    decreases in productivity, temporary plant shutdowns or infrastructure service
disruptions resulting from widespread health alerts including SARS and warnings of an Avian
Flu pandemic;
    
    changes in tariffs; and
    
    difficulties in staffing and managing international operations.
  36




---



##### Table of Contents



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.
   We may have difficulty integrating the businesses or assets we have acquired and may acquire in
the future, and we may not realize the benefits that we expect from these acquisitions.
  
    
    difficulty in the assimilation of the technologies and products of the acquired company;
    
    entering markets in which we have no or limited direct prior experience;
    
    loss of key customers of the acquired company;
    
    diversion of management resources from the business of the combined company;
    
    incompatibility of business cultures or practices;
    
    loss of key employees of the acquired company;
    
    costs and delays in implementing common systems and procedures;
 37




---



##### Table of Contents




    
    potential inefficiencies in delivering services to the customers of the combined company; and
    
    assumption of unknown or undisclosed liabilities.
   Any failure of, or other problems at or with, our third party manufacturers could delay shipments
of our flat panel display products, harm our relationships with our customers or otherwise
negatively impact our business.
  If we do not compete effectively in our target markets, we will lose market share.
  Our success depends in large part on the strength of the active matrix liquid crystal display in
the flat panel display industry.
  Our business could be harmed if we fail to properly protect our intellectual property.
  38




---



##### Table of Contents



Litigation may be necessary to enforce or defend against claims of intellectual property
infringement, which could be expensive and, if we lose, could prevent us from selling our
products.
   We must attract and retain key employees and our management team and employees must work
effectively together to maintain and grow our business.
  Terrorism and international political instability may negatively affect our operations.
   Our manufacturing facilities may be subject to disruption from natural disasters.
  39




---



##### Table of Contents



Our stock price may fluctuate significantly.
  
    
    announcements of technological innovations or new products by us or by our competitors;
    
    government regulations;
    
    developments in patent or other property rights; and
    
    developments in our relationships with our customers.
  Some anti-takeover provisions may affect the price of our common stock.
  We do not anticipate paying cash dividends.
  New regulations related to equity compensation will negatively impact our financial statements and
could adversely affect our ability to attract and retain key personnel.
   40




---



##### Table of Contents



ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
 Foreign Currency Exchange Rate Risk
   Market Risk
  
 ITEM 4. Controls and Procedures
 Evaluation of Disclosure Controls and Procedures
    Changes in Control Over Financial Reporting in the First Quarter of Fiscal 2006
  41




---



##### Table of Contents



Inherent Limitations of Disclosure Controls and Procedures and Internal Control Over Financial
Reporting.
  
 PART II. OTHER INFORMATION
 
 ITEM 1. Legal Proceedings
    
 ITEM 1A. Risk Factors
  42




---



##### Table of Contents



ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds
  
 ITEM 3. Defaults Upon Senior Securities
  
 ITEM 4. Submission of Matters to a Vote of Security Holders
  
 ITEM 5. Other Information
  
 ITEM 6. Exhibits
 Exhibits
  43




---



##### Table of Contents



SIGNATURES
  PHOTON DYNAMICS, INC.By:
    
    /s/ Maureen L. LambMaureen L. LambChief Financial Officer and Secretary(Duly authorized and principal financial officer)
  44




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##### Table of Contents



Exhibit Index
 Number
    
    Exhibit3.1(1)
    
    Amended and Restated Articles of Incorporation of the Registrant.3.2(1)
    
    Certificate of Amendment to Articles of Incorporation of the Registrant.3.3
    
    Bylaws of the Registrant.4.1
    
    Reference is made to Exhibits 3.1, 3.2 and 3.3.10.43
    
    Form of Stock Option Agreement for use in the 2005 Equity Incentive Plan10.53(2)
    
    Photon Dynamics Management Incentive 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 an exhibit to the Registrants Current Report on Form 8-K (Commission
File No. 000-27234), filed with the SEC on January 24, 2006, 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.