---

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

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FORM 10-Q

|ý | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------

For the quarterly period ended June 30, 2002

OR

|o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------

Commission file number: 0-27234

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

California(State or other jurisdiction of
incorporation or organization)

94-3007502(I.R.S. Employer
Identification No.)17 Great Oaks Boulevard
San Jose, California 95119(Address of principal executive offices including zip code) (408) 360-3550(Registrant's telephone number, including area code)
6325 San Ignacio Avenue
San Jose, California 95119(Former address of principal executive offices)


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

As
of July 31, 2002, there were 17,136,096 shares outstanding of the Registrant's Common Stock, no par value.

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INDEX

|           |  |                                                                                                                   |  | Page
|---------- |  | ----------------------------------------------------------------------------------------------------------------- |  | ----
|PART I     |  | FINANCIAL INFORMATION                                                                                             |  |     
|Item 1.    |  | Financial Statements (unaudited)                                                                                  |  |     
|           |  | Condensed Consolidated Balance Sheets as of June 30, 2002 and September 30, 2001                                  |  | 3   
|           |  | Condensed Consolidated Statements of Operations for the Three and Nine Month Periods Ended June 30, 2002 and 2001 |  | 4   
|           |  | Condensed Consolidated Statements of Cash Flows for the Nine Month Periods Ended June 30, 2002 and 2001           |  | 5   
|           |  | Notes to Condensed Consolidated Financial Statements                                                              |  | 6   
|Item 2.    |  | Management's Discussion and Analysis of Financial Condition and Results of Operations                             |  | 14  
|Item 3.    |  | Quantitative and Qualitative Disclosures About Market Risk                                                        |  | 27  
|PART II    |  | OTHER INFORMATION                                                                                                 |  |     
|Item 1.    |  | Legal Proceedings                                                                                                 |  | 28  
|Item 2.    |  | Changes in Securities and Use of Proceeds                                                                         |  | 28  
|Item 3.    |  | Defaults Upon Senior Securities                                                                                   |  | 28  
|Item 4.    |  | Submission of Matters to a Vote of Security Holders                                                               |  | 28  
|Item 5.    |  | Other Information                                                                                                 |  | 28  
|Item 6.    |  | Exhibits and Reports on Form 8-K                                                                                  |  | 29  
|Signatures |  | 30                                                                                                               

2

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PART I. FINANCIAL INFORMATION

Item 1.Financial Statements

PHOTON DYNAMICS, INC.  CONDENSED CONSOLIDATED BALANCE SHEETS  (Unaudited)

|                                     |                                        | June 30, 2002                              |        | September 30, 2001 |        
|------------------------------------ | -------------------------------------- | ------------------------------------------ | ------ | ------------------ | -------
|
|ASSETS                               |                                        |                                            |        |                    |        
|Current assets:                      |                                        |                                            |        |                    |        
|                                     | Cash and cash equivalents              |                                            | $      | 44,718             |        
|                                     | Short-term investments                 |                                            |        | 138,781            |        
|                                     | Accounts receivable, net               |                                            |        | 19,454             |        
|                                     | Inventories                            |                                            |        | 12,905             |        
|                                     | Other current assets                   |                                            |        | 5,425              |        
|                                     |                                        |                                            |        |                    |        
|                                     |                                        | Total current assets                       |        |                    | 221,283
|Land, property and equipment, net    |                                        |                                            | 13,265 |                    |        
|Other assets                         |                                        |                                            | 2,287  |                    |        
|Intangible assets, net               |                                        |                                            | 3,641  |                    |        
|Goodwill                             |                                        |                                            | 22,724 |                    |        
|                                     |                                        |                                            |        |                    |        
|                                     |                                        | Total assets                               |        | $                  | 263,200
|                                     |                                        |                                            |        |                    |        
|LIABILITIES AND SHAREHOLDERS' EQUITY |                                        |                                            |        |                    |        
|Current liabilities:                 |                                        |                                            |        |                    |        
|                                     | Accounts payable                       |                                            | $      | 4,702              |        
|                                     | Other current liabilities              |                                            |        | 7,302              |        
|                                     | Deferred revenue                       |                                            |        | 614                |        
|                                     |                                        |                                            |        |                    |        
|                                     |                                        | Total current liabilities                  |        |                    | 12,618 
|Other liabilities                    |                                        |                                            | 338    |                    |        
|Commitments and contingencies        |                                        |                                            |        |                    |        
|Shareholders' equity:                |                                        |                                            |        |                    |        
|                                     | Common stock, no par value             |                                            |        | 296,498            |        
|                                     | Accumulated deficit                    |                                            |        | (46,557            | )      
|                                     | Accumulated other comprehensive income |                                            |        | 303                |        
|                                     |                                        |                                            |        |                    |        
|                                     |                                        | Total shareholders' equity                 |        |                    | 250,244
|                                     |                                        |                                            |        |                    |        
|                                     |                                        | Total liabilities and shareholders' equity |        | $                  | 263,200
|                                     |                                        |                                            |        |                    |        

See
accompanying notes to condensed consolidated financial statements.

3

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PHOTON DYNAMICS, INC.  CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS  (Unaudited)

|                                                                                                |                                     | Three months ended June 30, |        | Nine months ended June 30, |      
|----------------------------------------------------------------------------------------------- | ----------------------------------- | --------------------------- | ------ | -------------------------- | -----
|
|
|
|Revenue                                                                                         |                                     | $                           | 19,320 |                            | $    
|Cost of revenue                                                                                 |                                     |                             | 10,952 |                            |      
|                                                                                                |                                     |                             |        |                            |      
|Gross margin                                                                                    |                                     |                             | 8,368  |                            |      
|Operating expenses:                                                                             |                                     |                             |        |                            |      
|                                                                                                | Research and development            |                             |        | 4,803                      |      
|                                                                                                | Selling, general and administrative |                             |        | 4,064                      |      
|                                                                                                | Non-recurring acquisition charges   |                             |        |                           |      
|                                                                                                | Amortization of intangible assets   |                             |        | 287                        |      
|                                                                                                |                                     |                             |        |                            |      
|                                                                                                |                                     | Total operating expenses    |        |                            | 9,154
|Loss from operations                                                                            |                                     |                             | (786   | )                          |      
|Interest income and other, net                                                                  |                                     |                             | 903    |                            |      
|                                                                                                |                                     |                             |        |                            |      
|Income (loss) before income taxes and cumulative effect of change in accounting principle       |                                     |                             | 117    |                            |      
|Provision (benefit) for income taxes                                                            |                                     |                             |       |                            |      
|                                                                                                |                                     |                             |        |                            |      
|Income (loss) before cumulative effect of change in accounting principle                        |                                     |                             | 117    |                            |      
|Cumulative effect of change in accounting principle                                             |                                     |                             |       |                            |      
|                                                                                                |                                     |                             |        |                            |      
|Net income (loss)                                                                               |                                     | $                           | 117    |                            | $    
|                                                                                                |                                     |                             |        |                            |      
|Net income (loss) per share before cumulative effect of change in accounting principle:         |                                     |                             |        |                            |      
|Basic                                                                                           |                                     | $                           | 0.01   |                            | $    
|                                                                                                |                                     |                             |        |                            |      
|Diluted                                                                                         |                                     | $                           | 0.01   |                            | $    
|                                                                                                |                                     |                             |        |                            |      
|Loss per share from the cumulative effect of change in accounting principle, net of tax benefit |                                     |                             |        |                            |      
|Basic                                                                                           |                                     | $                           |       |                            | $    
|                                                                                                |                                     |                             |        |                            |      
|Diluted                                                                                         |                                     | $                           |       |                            | $    
|                                                                                                |                                     |                             |        |                            |      
|Net income (loss) per share                                                                     |                                     |                             |        |                            |      
|Basic                                                                                           |                                     | $                           | 0.01   |                            | $    
|                                                                                                |                                     |                             |        |                            |      
|Diluted                                                                                         |                                     | $                           | 0.01   |                            | $    
|                                                                                                |                                     |                             |        |                            |      
|Weighted average number of shares:                                                              |                                     |                             |        |                            |      
|Basic                                                                                           |                                     |                             | 17,031 |                            |      
|Diluted                                                                                         |                                     |                             | 17,999 |                            |      

See
accompanying notes to condensed consolidated financial statements.

4

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PHOTON DYNAMICS, INC.  CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS  (Unaudited)

|                                                             |                                                                                           | Nine months ended June 30,         |                                                    
|------------------------------------------------------------ | ----------------------------------------------------------------------------------------- | ---------------------------------- | ---------------------------------------------------
|
|
|
|Cash flows from operating activities:                        |                                                                                           |                                    |                                                    
|                                                             | Net loss                                                                                  |                                    | $                                                  
|                                                             | Adjustments to reconcile net loss to net cash provided by (used in) operating activities: |                                    |                                                    
|                                                             |                                                                                           | Depreciation and amortization      |                                                    
|                                                             |                                                                                           | Amortization of intangibles        |                                                    
|                                                             |                                                                                           | Loss on disposal of equipment      |                                                    
|                                                             |                                                                                           | Stock based compensation expense   |                                                    
|                                                             |                                                                                           | Changes in assets and liabilities: |                                                    
|                                                             |                                                                                           |                                    | Accounts receivable                                
|                                                             |                                                                                           |                                    | Inventories                                        
|                                                             |                                                                                           |                                    | Other current assets                               
|                                                             |                                                                                           |                                    | Other assets                                       
|                                                             |                                                                                           |                                    | Accounts payable                                   
|                                                             |                                                                                           |                                    | Other current liabilities                          
|                                                             |                                                                                           |                                    | Deferred revenue                                   
|                                                             |                                                                                           |                                    |                                                    
|                                                             |                                                                                           |                                    | Net cash provided by (used in) operating activities
|                                                             |                                                                                           |                                    |                                                    
|Cash flows from investing activities:                        |                                                                                           |                                    |                                                    
|                                                             | Purchase of property and equipment                                                        |                                    |                                                    
|                                                             | Purchase of short-term investments                                                        |                                    |                                                    
|                                                             | Redemption of short-term investments                                                      |                                    |                                                    
|                                                             |                                                                                           |                                    |                                                    
|                                                             |                                                                                           |                                    | Net cash used in investing activities              
|                                                             |                                                                                           |                                    |                                                    
|Cash flows from financing activities:                        |                                                                                           |                                    |                                                    
|                                                             | Issuance of common stock, net                                                             |                                    |                                                    
|                                                             | Repayment of lease obligations                                                            |                                    |                                                    
|                                                             |                                                                                           |                                    |                                                    
|                                                             |                                                                                           |                                    | Net cash provided by financing activities          
|                                                             |                                                                                           |                                    |                                                    
|Effect of exchange rate changes on cash and cash equivalents |                                                                                           |                                    | (91                                                
|                                                             |                                                                                           |                                    |                                                    
|Net increase in cash and cash equivalents                    |                                                                                           |                                    | 28,190                                             
|Cash and cash equivalents at beginning of period             |                                                                                           |                                    | 16,528                                             
|                                                             |                                                                                           |                                    |                                                    
|Cash and cash equivalents at end of period                   |                                                                                           | $                                  | 44,718                                             
|                                                             |                                                                                           |                                    |                                                    

See
accompanying notes to condensed consolidated financial statements.

5

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PHOTON DYNAMICS, INC.  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Unaudited)

NOTE 1Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the
United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include
all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments
(consisting only of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine month periods ended June 30, 2002 are
not necessarily indicative of the results that may be expected for the year ending September 30, 2002. This financial information should be read in conjunction with the financial statements and
the notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended September 30, 2001.

The
condensed consolidated balance sheet as of September 30, 2001 is derived from the Company's audited consolidated financial statements as of September 30, 2001, included
in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission, but does not include all of the information and footnotes required by generally
accepted accounting principles for complete financial statements.



The Company changed its revenue recognition policy effective October 1, 2000 based on guidance provided in SEC Staff Accounting Bulletin No. 101,
Revenue Recognition in Financial Statements ("SAB 101"). The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the
selling price is fixed or determinable and collectibility is reasonably assured.

The
Company accounts for certain of its product sales in its flat panel display ("FPD") products and cathode ray tube ("CRT") display and high quality glass inspection product segments
as multiple-element arrangements. If the Company has met defined customer acceptance experience levels with the specific type of equipment, the Company recognizes revenue for a portion of the total
contract price due and billable upon shipment, with the remainder recognized when it becomes due (generally upon acceptance). The Company recognizes all other product sales with the customer
acceptance provisions upon customer acceptance. The Company generally recognizes revenue from the sale of its surface mount technology products upon shipment, as such product sales are not subject to
customer acceptance holdbacks. The Company recognizes revenue from the sale of spare parts upon shipment.

In
accordance with guidance provided in SAB 101, the Company recorded a non-cash charge of $6.6 million, or $0.50 per share, to reflect the cumulative effect of the
accounting change as of October 1, 2000 and, accordingly, has restated the condensed consolidated statement of operations for the three and nine month periods ended June 30, 2001 and
cash flows for the nine months ended June 30, 2001, presented herein.

The
deferred revenue balance as of October 1, 2000 was $8.4 million. This amount is comprised of final holdback amounts comprised of certain portions of the total sales
prices that became due on final acceptances, which had not occurred as of October 1, 2000. Of this amount, the Company recognized as revenue $705,000 and $1.3 million, which increased
net income by $504,000 and $1.1 million in the three month periods ended June 30, 2002 and June 30, 2001, respectively. The Company recognized as

6

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revenue $3.3 million and $2.8 million, which increased net income by $2.5 million and $2.2 million in the nine month periods ended June 30, 2002 and June 30,
2001, respectively.

Prior
to fiscal year 2001 and the adoption of SAB 101, the Company's revenue recognition policy was to recognize revenue when the customer took title to the equipment, generally at the
time of shipment, which generally preceded installation and final customer acceptance.

NOTE 2Inventories

Inventories are stated at the lower of cost (on a first-in, first-out basis) or market. The components of inventories were as follows:

June 30, 2002

September 30, 2001(in thousands)Raw materials

$
3,681

$
9,686Work-in-process


5,657


3,493Finished goods


3,567


2,828Total

$
12,905

$
16,007


NOTE 3Other Current Liabilities

The components of other current liabilities were as follows:

June 30, 2002

September 30, 2001(in thousands)Warranty

$
2,229

$
2,760Compensation


3,066


3,160Commissions


1,086


694Acquisition charges





451Income taxes


494


494Other accrued expenses


427


802Total

$
7,302

$
8,361


NOTE 4Earnings Per Share

Basic earnings per share is calculated using the weighted average number of shares of common stock outstanding. Diluted earnings per share is computed in the same
manner and also gives effect to all dilutive common equivalent shares outstanding during the period. Common equivalent shares consist

7

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of stock options issued to employees under employee stock option plans and warrants. The following table sets forth the computation of basic and diluted net income (loss) per share:

|                                                            |  | Three months ended June 30, |        | Nine months ended June 30, |  
|----------------------------------------------------------- |  | --------------------------- | ------ | -------------------------- | -
|
|
|Numerator:                                                  |  |                             |        |                            |  
|Net income (loss) for basic and diluted earnings per share: |  | $                           | 117    |                            | $
|                                                            |  |                             |        |                            |  
|Denominator:                                                |  |                             |        |                            |  
|Weighted average shares for basic earnings per share        |  |                             | 17,031 |                            |  
|Effect of dilutive securities:                              |  |                             |        |                            |  
|Employee stock options                                      |  |                             | 968    |                            |  
|Warrants                                                    |  |                             |       |                            |  
|                                                            |  |                             |        |                            |  
|Weighted average shares for diluted earnings per share      |  |                             | 17,999 |                            |  
|                                                            |  |                             |        |                            |  
|Basic net income (loss) per share                           |  | $                           | 0.01   |                            | $
|                                                            |  |                             |        |                            |  
|Diluted net income (loss) per share                         |  | $                           | 0.01   |                            | $
|                                                            |  |                             |        |                            |  

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NOTE 5Operations by Industry Segment

The Company conducts business in three operating segments: flat panel display ("FPD") products; printed circuit board ("PCB") assembly and advanced semiconductor
packaging inspection products (collectively, "surface mount technology products"); and cathode ray tube ("CRT") display and glass inspection products. The Company's FPD products include test, repair
and inspection equipment. The Company's FPD test and inspection equipment identifies and characterizes defects at early stages of the manufacturing process so that the panels may be repaired before
the next stage, or, if necessary, discarded, minimizing the loss of time and materials. The Company's FPD products gather comprehensive data that enable FPD manufacturers to control and refine their
manufacturing processes. The Company's surface mount technology products enable PCB assembly and advanced semiconductor packaging manufacturers to detect and identify defects, thereby increasing
yields and quality and reducing costs. The Company's CRT display and glass inspection products allow CRT
display manufacturers to locate and characterize defects and glass manufacturers to detect and identify defects such as scratches, pits, bubbles, stones, inclusions and distortions, thereby increasing
yields and quality and reducing costs.

The
Company's management has determined the operating segments based upon the manner in which the business is managed and operated. There are no significant intersegment sales or
transfers, and the majority of the Company's long-lived assets are located in the U.S. The Company's principal customers are primarily Asian-based FPD and CRT display manufacturers.

8

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The
Company sells its products for the FPD industry directly to customers in Korea and Taiwan and through a value-added reseller, Ishikawajima-Harima Heavy Industries Co., Ltd.
("IHI"), in Japan. The Company sells its products for the CRT display and glass industries directly, except in Japan where a sales representative is used. The Company sells its products for the
surface mount technology industry primarily through sales representatives and distributors.

A
significant portion of the segments' expenses currently arise from shared services and infrastructure provided to the segments in order to realize economies of scale and to efficiently
use resources. These expenses include sales and marketing, field service, finance, human resource, information technology services and other corporate infrastructure costs. These expenses are
allocated to the segments and the allocations have been determined on a basis that the Company considers to be a reasonable reflection of the utilization of services provided to or benefits received
by the segments. The Company does not allocate interest and other income, interest and other expenses or taxes to operating segments. Accounting policies for segment reporting are the same as for the
Company as a whole.

The
Company's operating segments consisted of the following:

|                                 |                                              | Three months ended June 30, |        | Nine months ended June 30, |  
|-------------------------------- | -------------------------------------------- | --------------------------- | ------ | -------------------------- | -
|
|
|
|Net sales to external customers: |                                              |                             |        |                            |  
|                                 | FPD products                                 |                             | $      | 14,965                     |  
|                                 | Surface mount technology products            |                             |        | 2,768                      |  
|                                 | CRT display and glass inspection products    |                             |        | 1,587                      |  
|                                 |                                              |                             |        |                            |  
|Net sales to external customers  |                                              | $                           | 19,320 |                            | $
|                                 |                                              |                             |        |                            |  
|Operating income (loss):         |                                              |                             |        |                            |  
|                                 | FPD products                                 |                             | $      | 1,993                      |  
|                                 | Surface mount technology products            |                             |        | (2,032                     | )
|                                 | CRT display and glass inspection products(1) |                             |        | (747                       | )
|                                 |                                              |                             |        |                            |  
|Loss from operations             |                                              | $                           | (786   | )                          | $
|                                 |                                              |                             |        |                            |  

---

The
following table is a summary of sales to individual unaffiliated customers in excess of 10% of total revenue. All of the customers listed are customers of the Company's flat panel
display products.

|                                   |  | Three months ended June 30, |   | Nine months ended June 30, |  
|---------------------------------- |  | --------------------------- | - | -------------------------- | -
|
|
|
|Quanta Display Inc.                |  | 2                           | % |                           |  
|LG Philips LCD Co., Ltd.           |  | 37                          | % | 26                         | %
|IHI                                |  | 2                           | % | 8                          | %
|Chi Mei                            |  | 6                           | % | 14                         | %
|Samsung America, Inc.              |  | 14                          | % |                           |  
|Unipac Optoelectronics Corporation |  | 3                           | % | 11                         | %

9

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The
following is a summary of revenue by geographic area based on location where the product was shipped:

|         |               | Three months ended June 30, |   | Nine months ended June 30,
|-------- | ------------- | --------------------------- | - | --------------------------
|
|
|
|Revenue: |               |                             |   |                           
|         | Taiwan        |                             | $ | 5,345                     
|         | United States |                             |   | 2,432                     
|         | Korea         |                             |   | 9,327                     
|         | Japan         |                             |   | 482                       
|         | China         |                             |   | 689                       
|         | Europe        |                             |   | 411                       
|         | Canada        |                             |   | 391                       
|         | Other         |                             |   | 243                       
|         |               |                             |   |                           
|         |               | Total                       |   | $                         
|         |               |                             |   |                           

NOTE 6Comprehensive Income

The components of comprehensive income were as follows:

|                                   |                                          | Three months ended June 30, |                                   | Nine months ended June 30, |    
|---------------------------------- | ---------------------------------------- | --------------------------- | --------------------------------- | -------------------------- | ---
|
|
|
|Net income (loss)                  |                                          | $                           | 117                               |                            | $  
|Other comprehensive income (loss): |                                          |                             |                                   |                            |    
|                                   | Change in unrealized gain on investments |                             |                                   | 1                          |    
|                                   | Currency translation adjustments         |                             |                                   | (52                        | )  
|                                   |                                          |                             |                                   |                            |    
|                                   |                                          | Other comprehensive loss    |                                   |                            | (51
|                                   |                                          |                             |                                   |                            |    
|                                   |                                          |                             | Total comprehensive income (loss) |                            | $  
|                                   |                                          |                             |                                   |                            |    

Accumulated
other comprehensive income is comprised of an unrealized loss of $5,000 and a foreign exchange translation gain of $308,000 at June 30, 2002, and an unrealized gain of
$108,000 and a foreign exchange translation gain of $398,000 at September 30, 2001.

NOTE 7Outsourced Manufacturing Arrangement

In December 2001, the Company entered into a Manufacturing Services Agreement with Sanmina-SCI Corporation ("Sanmina-SCI"),
pursuant to which Sanmina-SCI agreed to provide a significant portion of the manufacturing, assembly and test operations for the Company's flat panel display and surface mount technology
optical products. Under the terms of the three year agreement and related agreements, Sanmina-SCI agreed to lease a portion of the Company's San Jose facility, lease and operate the
equipment required to manufacture a substantial portion of the Company's flat panel display products, expand the Company's San Jose clean room facility and purchase a portion of the Company's existing
flat panel display and surface mount technology raw material inventory. At June 30, 2002 the company has outstanding purchase obligations of approximately $15.0 million with
Sanmina-SCI.

10

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NOTE 8Restructuring

During the fourth quarter of fiscal year 2001, the Company implemented a restructuring plan (the "Restructuring Plan") to control spending and reduced its
workforce. Prior to September 30, 2001, management approved and implemented the Restructuring Plan and determined the benefits that would be offered to the employees being terminated. The
benefits package was explained in sufficient detail such that each affected employee was able to determine the type and amount of benefits he or she was entitled to receive. The reductions occurred
primarily in manufacturing and operational locations in North America. The Company recorded a restructuring charge in the fourth quarter of fiscal year 2001 of $1.2 million for employee-related
costs and other expenses. As of June 30, 2002, the remaining liability associated with the Restructuring Plan is approximately $500,000. There have been no adjustments to the liability and
management expects to settle all liabilities under the Restructuring Plan by the end of the fourth quarter of fiscal 2002.

NOTE 9Line of Credit

In March 2002, the Company extended its existing bank line of credit until May 2002. In April 2002, the Company entered into a new bank line
of credit, replacing the then existing facility, expiring in April 2003, that provides a borrowing capacity of $4.0 million. The line of credit is secured by substantially all of the
Company's assets and contains financial and other covenants. As of June 30, 2002, no amounts were outstanding under the line of credit.

NOTE 10Income Taxes

The provision for income taxes was $0 for both the three and nine month periods ended June 30, 2002, and $468,000 for the nine month period ended
June 30, 2001. For the three month period ended June 30, 2001, the company recorded a tax benefit of $241,000. The effective tax rate for the nine month period ended June 30, 2001
was 13%, before non-recurring acquisition expenses and cumulative effect of change in accounting principle, and was lower than the statutory U.S. tax rate of 35% due to realization of net
operating loss carry forwards.

NOTE 11Shareholders' Equity

On July 21, 2002, the Company's Board of Directors approved an increase of 250,000 shares reserved for issuance under the Company's 2001 Equity Incentive
Plan from 400,000 shares to 650,000 shares.

On
April 1, 2002, the remaining 51,951 exchangeable shares of IPS that were not owned by the Company or its affiliates were automatically exchanged for shares of the Company's
common stock. In connection with the exchange of the remaining exchangeable shares of IPS, the one share of the Company's Series A Preferred Stock issued to Computershare Trust Company of
Canada as trustee for the exchangeable shares was cancelled.

On
February 6, 2002, the Company completed an underwritten public offering of shares of its common stock. The offering related to 2,500,000 shares of common stock at a price of
$40.14 per share, all of which were sold by the Company. Additionally, the underwriters exercised their option to purchase an additional 375,000 shares to cover over-allotments. The net
proceeds to the Company, after the underwriters' discount and expenses of the offering, aggregated approximately $107.0 million.

On
January 21, 2002, the Company held its Annual Meeting of Shareholders. At that meeting, the Company's shareholders approved an amendment to the Company's Articles of
Incorporation to increase the authorized number of shares of Common Stock from 20,000,000 shares to 30,000,000 shares. The Company's shareholders also approved at that meeting an increase of 400,000
shares reserved for grant under the Company's 1995 Stock Option Plan from a total of 2,190,943 shares to

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2,590,943 shares and an increase of 250,000 shares authorized for issuance under the Company's 1995 Employee Stock Purchase Plan from a total of 750,000 shares to 1,000,000 shares.

On
December 17, 1999, in connection with services rendered in a private placement offering, Photon Dynamics Canada Inc., formerly known as Image Processing
Systems Inc. ("IPS"), issued special warrants to the placement agent for the right to purchase IPS common shares. Upon acquisition of IPS by the
Company, the warrants issued to the placement agent were converted into a replacement warrant to purchase 21,285 exchangeable shares of IPS at an exercise price of $26.40 (Canadian dollars) each,
which were exchangeable for the Company's common stock on a one to one ratio. This replacement warrant was fully exercised in December 2001.

NOTE 12Legal Proceedings

The Company has been named as defendant in a lawsuit captioned Thomason v. Photon Dynamics, Inc., No. 02CC03568, filed on February 28, 2002
in the Superior Court of the State of California, County of Orange. The plaintiff in this action has purported to assert that he was wrongly not allowed to exercise certain stock options and is
seeking damages of approximately $900,000. On March 29, 2002 the Company responded to the lawsuit and filed a counterclaim against the plaintiff for breach of a general release agreement. While
the Company intends to vigorously contest the action, it cannot predict the outcome of this litigation. The Company believes that an adverse determination in this litigation would not have a material
adverse effect on its financial condition or results of operations.

The
Company and certain of its directors and officers have been named as defendants in a lawsuit captioned Amtower v. Photon Dynamics, Inc., No. CV797876, filed on
April 30, 2001 in the Superior Court of the State of California, County of Santa Clara. The plaintiff in this action has asserted several causes of action under state law arising out of alleged
misrepresentation and enforcement of the Company's insider trading policy and is seeking damages of approximately $17.7 million, plus undetermined damages resulting from emotional distress and
punitive damages. On December 6, 2001, the court dismissed the complaint for failure to allege facts sufficient to state a cause of action, with leave to amend. On January 17, 2002, the
plaintiff filed an amended complaint and the Company answered such complaint. On June 27, 2002, the court issued an order granting in part and denying in part the Company's motion. While the
Company intends to vigorously contest this action, the Company cannot predict the outcome of this litigation. The Company believes that an adverse determination in this litigation would not have a
material adverse effect on the Company's financial condition or results of operations.

NOTE 13Subsequent Events

On July 12, 2002, the Company completed the purchase of certain assets from Advanced Research Technologies Inc., a corporation incorporated under
the laws of the Province of Quebec, Canada, ("ART") pursuant to an Asset Purchase Agreement between the Company and ART (the "Purchase Agreement"). Under the terms of the Purchase Agreement and
related agreements, the Company paid $5,500,000 in cash for certain assets and assumed certain liabilities related to ART's Infrared Screening and Inspection Solutions ("ISIS") Division. The funds
used to purchase the assets of ART came directly out of the Company's working capital. The ART assets acquired, including the personnel, technology and inventory, were used by ART in the design,
manufacture and sale of the ISIS infrared verification systems.

New Accounting Pronouncements

In July 2002, the FASB issued Statement of Financial Accounting Standards No. 146 "Accounting for Costs Associated with Exit or Disposal Activities"
(SFAS 146). SFAS 146 addresses financial

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accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits
and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." (EITF 94-3). The principal difference between SFAS 146 and EITF 94-3 relates
to the timing of the recognition of a liability for a cost associated with an exit or disposal activity. SFAS 146 requires that a liability for a cost associated with an exit or disposal
activity be recognized when the liability is incurred. Under EITF 94-3 a liability for an exit cost as generally defined in EITF 94-3 is to be recognized at the date of an
entity's commitment to an exit plan. SFAS 146 is effective for exit or disposal activities that are initiated after December 31, 2002, and as a result, adoption of SFAS 146 would
not have a material impact on the Company's current financial position or results of operations.

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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 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," and elsewhere in this Form 10-Q.
Generally, the words "anticipate", "expect", "intend", "believe" and similar expressions identify forward-looking statements. The information included in this Form 10-Q is as of the
filing date with the Securities and Exchange Commission and future events or circumstances could differ significantly from the forward-looking statements included here.

The
following discussion should be read in conjunction with the condensed consolidated financial statements and notes thereto included in Item 1 above and with our financial statements
and notes thereto for the year ended September 30, 2001 contained in our Annual Report on Form 10-K filed with the Securities and Exchange Commission.

Overview

We are a leading provider of yield management solutions to the flat panel display industry. Our flat panel display systems are designed to collect data, analyze
product quality and identify and repair product defects at critical steps in the flat panel display manufacturing process. We also offer yield management solutions for the printed circuit board
assembly and advanced semiconductor packaging industry (collectively referred to as our surface mount technology products) and the cathode ray tube display and high quality glass industries. Our
optical and X-ray inspection systems are used to detect and identify defects on printed circuit board assemblies with advanced semiconductor packages mounted on the surfaces of these
assemblies. Our optical inspection systems use high-resolution cameras and proprietary software to locate and characterize defects in cathode ray tube displays, cathode ray tube glass and
automotive glass panels. Our systems are designed to help manufacturers maximize factory output with reduced material input and error, a practice know as yield management.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States for interim financial information. The preparation of these financial statements requires us to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates,
including those related to accounts receivable, inventories, purchase order commitments, warranty obligations, intangible assets and contingencies and litigation. We base our estimates on historical
experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We
believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

We changed our revenue recognition policy effective October 1, 2000 based on guidance provided in The Securities and Exchange Commission Staff Accounting
Bulletin No. 101, Revenue Recognition in Financial Statements, or SAB 101. We recognize revenue when persuasive evidence of an

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arrangement exists, delivery has occurred or services have been rendered, the selling price is fixed or determinable and collectibility is reasonably assured.

We
account for certain product sales in the FPD and CRT display and high quality glass inspection product segments as multiple-element arrangements. If we have met defined customer
acceptance experience levels with the specific type of equipment, we recognize revenue for a portion of the total contract price due and billable upon shipment, with the remainder recognized when it
becomes due (generally upon acceptance). We recognize all other product sales with the customer acceptance provisions upon customer acceptance. We generally recognize revenue from the sale of our
surface mount technology products upon shipment, as such product sales are not subject to customer acceptance holdbacks. We recognize revenue from the sale of spare parts upon shipment.

Accounts Receivable

We maintain an allowance for estimated losses resulting from product returns, allowances or the inability of our customers to make required payments. If a single
customer was unable or unwilling to make payments, additional allowances may be required as certain of our products have selling prices in excess of $1.5 million per unit. Accordingly, a single
customer could have a material adverse effect on our results of operations.

Inventories

We assess the recoverability of all inventory, including raw materials, work-in-process, finished goods, spare parts and purchase
commitments to determine whether adjustments for impairment are required. Inventory which is obsolete or in excess of the forecasted usage is written down to its estimated market value based on
assumptions about future demand and market conditions. If actual demand is lower than our forecast, additional inventory write-downs may be required.

Warranty Obligations

Our warranty policy generally states that we will provide warranty coverage for a period of one year from final acceptance. We record the estimated cost of
warranty coverage, primarily material and labor to repair and service the equipment, upon product shipment. Our warranty obligation is affected by product failure rates, material usage rates and the
efficiency by which the product failure is corrected. Should actual product failure rates, material usage and labor efficiencies differ from our estimates, revisions to the estimated warranty
liability would be required.

Goodwill and Intangible Assets

We have goodwill and other intangible assets resulting from an acquisition accounted for under the purchase method of accounting. The purchase price was allocated
based on available information with respect to the fair value of the assets acquired and liabilities assumed. The intangible assets are being amortized over a three to five year life. Goodwill is not
being amortized, but we perform an impairment test on an annual basis and between annual tests in certain circumstances. In response to changes in the industry and market conditions, we may
strategically realign our resources and consider restructuring, disposing of, or otherwise exiting businesses, which could result in an impairment of goodwill or a revision to the value or estimated
life of intangible assets.

Contingencies and Litigation

We make an assessment of the probability of an adverse judgment resulting from current and threatened litigation. We would accrue the cost of an adverse judgment
if, in our estimation, the adverse settlement is probable and we can reasonably estimate the ultimate cost of such litigation. We have made no such accruals at June 30, 2002.

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Results of Operations

Revenue.Revenue for the three months ended June 30, 2002 was $19.3 million compared to $13.4 million in
the same period of the prior fiscal year, representing an increase of $5.9 million, or 44%. The increase is due to an increase of $8.0 million of revenue from our flat panel display
products resulting from current period customer expansion of manufacturing capacity in the flat panel display segment versus the prior year in which the general economic slowdown impacted all of our
product segments. This increase was offset in part by decreases in our surface mount technology and cathode ray tube display and high quality glass products, which continue to be impacted by the
general economic slowdown. Sales of flat panel display products represented $15.0 million and $7.0 million, or 78% and 52%, of revenue in the three month periods ended June 30,
2002 and 2001, respectively. Sales of surface mount technology products represented $2.8 million and $3.4 million, or 14% and 26%, of revenue in the three month periods ended
June 30, 2002 and 2001, respectively. Sales of cathode ray tube display and high quality glass products represented $1.6 million and $3.0 million, or 8% and 22%, of revenue in the
three month periods ended June 30, 2002 and 2001, respectively.

Revenue
for the nine months ended June 30, 2002 was $50.8 million compared with $60.7 million for the nine months ended June 30, 2001, representing a decrease
of $9.9 million, or 16%. For the nine month periods ended June 30, 2002 and 2001, sales of flat panel display products represented $36.4 million and $35.1 million, or 71%
and 58%, of revenue, respectively. Sales of surface mount technology products represented $9.0 million and $14.0 million, or 18% and 23%, of revenue in the nine month periods ended
June 30, 2002 and 2001, respectively. Sales of cathode ray tube display and high quality glass products represented $5.5 million and $11.6 million, or 11% and 19%, of revenue in
the nine month periods ended June 30, 2002 and 2001, respectively. The revenue decrease in the surface mount technology products is the result of the continued general economic slowdown. The
decrease in cathode ray tube display products is the result of flat panel displays continuing to replace cathode ray tube displays in the overall display market.

Gross Margin.Gross margin increased to 43% in the three month period ended June 30, 2002 from 40% in the three month
period ended June 30, 2001. The overall increase in gross margin for the most
recent quarter is the result of increased manufacturing efficiencies attributable to higher sales volumes of flat panel display products and favorable product mix, offset in part by lower gross
margins in the other two segments due to manufacturing inefficiencies resulting from decreased revenue and lower manufacturing volumes, combined with lower average selling prices for surface mount
technology products. For the nine month period ended June 30, 2002 the gross margin was 41% as compared to 42% for the same period of the prior fiscal year. The overall decrease in gross margin
for the nine months ended June 30, 2002 is primarily due to manufacturing inefficiencies resulting from decreased revenue and lower manufacturing volumes in the surface mount technology
products segments, combined with lower average selling prices for surface mount technology products, offset in part by increased manufacturing efficiencies attributable to higher sales volumes of flat
panel display products and favorable product mix. Gross margin from flat panel display products was 50% and 32% in the three month periods ended June 30, 2002 and 2001 and 46% and 43% in the
nine month periods ended June 30, 2002 and 2001, respectively. The increase in FPD gross margin for the most recent quarter and for the nine month period is the result of increased
manufacturing efficiencies attributable to higher sales volumes of flat panel display products and favorable product mix. Gross margin from surface mount technology products was 18% and 44% in the
three month periods ended June 30, 2002 and 2001 and 18% and 44% for the nine month periods ended June 30, 2002 and 2001, respectively. The decrease in surface mount technology gross
margin is the result of lower sales and manufacturing volumes, resulting in under-absorption of manufacturing overhead, combined with lower average selling prices. Gross margin from cathode ray tube
display and high quality glass products was 29% and 52% in the three month periods ended June 30, 2002 and 2001, respectively. The decrease in cathode ray tube display and high quality glass
products gross margin is the result of lower sales and manufacturing

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volumes, resulting in under-absorption of manufacturing overhead. Gross margin from cathode ray tube display and high quality glass products was 39% and 36% for the nine month periods ended
June 30, 2002 and 2001, respectively. The higher gross margins in the nine month period ended June 30, 2002 is the result of a more favorable product mix, combined with lower
manufacturing overhead resulting from the restructuring in the fourth quarter of fiscal 2001.

Research and Development.Research and development expenses were $4.8 million and $3.8 million, or 25% and 28%,
of revenue in the three month periods ended June 30, 2002 and 2001, respectively. The increase in research and development expenses in absolute dollars for the three months ended
June 30, 2002 as compared to June 30, 2001 is primarily attributable to salaries and related expenses incurred after our acquisition of Intelligent Reasoning Systems, Inc. in
July 2001, combined with higher spending on prototype materials for the three months ended June 30, 2002. For the nine month periods ended June 30, 2002 and 2001, research and
development expenses were $12.9 million and $12.9 million, or 25% and 21%, of revenue, respectively. As a percentage of revenue, research and development expenses are greater in the
fiscal year 2002 nine month period than the fiscal 2001 nine month period primarily as a result of lower revenue.

Selling, General and Administrative.Selling, general and administrative expenses were $4.1 million and
$3.9 million, or 21% and 29% of revenue, in the three month periods ended June 30, 2002 and 2001, respectively. For the nine month periods ended June 30, 2002 and 2001, selling,
general and administrative expenses were $13.7 million and $13.3 million, or 27% and 22% of revenue, respectively. Selling, general and administrative expenses for the three and nine
month periods ended June 30, 2002 are higher than the selling, general and administrative expenses for the comparable periods ending June 30, 2001, primarily due to additional headcount
and other expenses related to our acquisition of
Intelligent Reasoning Systems, Inc. in July 2001. Such expenses were partially offset by reduced headcount and other expenses resulting from the restructuring in the fourth quarter of
fiscal 2001.

Non-Recurring Acquisition Charges.In December 2000, we acquired Image Processing Systems in exchange for
approximately 1,139,000 shares of our common stock. This acquisition was accounted for as a pooling of interests. We incurred $2.3 million in professional fees consisting of legal, accounting
and integration costs in connection with the acquisition, reflected in the nine month period ended June 30, 2001.

Interest Income and Other, Net.Interest income and other, net was $903,000 and $1.1 million for the three month
periods ended June 30, 2002 and 2001 and $2.1 million and $4.3 million for the nine month periods ended June 30, 2002 and 2001, respectively. The decrease in the three and
nine month periods ended June 30, 2002 was primarily attributable to lower overall yields on investments as compared to the three and nine month periods ended June 30, 2001. The effect
of the lower yields more than offset the impact of higher cash balances in the fiscal 2002 periods, resulting from the underwritten public offering of common stock in February 2002,

Provision for Income Taxes.The provision for income taxes was $0 for both the three and nine month periods ended
June 30, 2002, and $468,000 for the nine month period ended June 30, 2001. For the three month period ended June 30, 2001, the company recorded a tax benefit of $241,000. The
effective tax rate for the nine month period ended June 30, 2001 was 13%, before non-recurring acquisition expenses and cumulative effect of change in accounting principle, and was
lower than the statutory U.S. tax rate of 35% due to realization of net operating loss carry forwards.

Liquidity and Capital Resources

We have financed our operations primarily through a combination of cash flows from operations, public stock offerings, lines of credit and loans. Working capital
was $208.7 million as of June 30, 2002 compared to $99.7 million as of September 30, 2001. Cash, cash equivalents and short-term investments

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of $183.5 million at June 30, 2002 and $84.1 million at September 30, 2001, represent the largest components of working capital in both periods.

The
increase in cash, cash equivalents and short term investments and working capital resulted from our underwritten public offering of common stock in February 2002. We sold in
the offering 2,500,000 shares of our common stock at a price of $40.14 per share. Additionally, the underwriters exercised their option to purchase an additional 375,000 shares to cover
over-allotments. Our gross proceeds, after the underwriters' discount and expenses of the offering, aggregated approximately $107.0 million.

Operating Activities.Cash used in operating activities was $11.3 million for the nine month period ended
June 30, 2002 as compared to cash provided by operating activities of $9.1 million for the same period in the prior fiscal year. The cash used in operating activities in the nine month
period ended June 30, 2002 was primarily due to the net loss of $4.9 million, an increase in accounts receivable of $8.6 million, an increase in other current assets of
$2.0 million, a decrease in other current liabilities of $1.1 million, offset in part by a reduction in inventory of $2.7 million. Other significant components of cash used in
operating activities included the non-cash items of depreciation of $2.2 million, amortization of intangibles of $861,000 and a decrease in deferred revenue of $1.7 million.
For the nine months ended June 30, 2001 the primary components of cash provided by operating activities were a reduction of accounts receivable of $16.9 million, partially offset by the
net loss of $5.7 million. Other significant components in the cash provided by operating activities included a decrease in inventory of $3.3 million partially offset by a decrease in
accounts payable of $2.3 million.

Investing Activities.Cash used in investing activities was $72.4 million and $9.9 million for the nine month
periods ended June 30, 2002 and 2001, respectively. The primary component of cash used in investing activities in the nine months ended June 30, 2002 was the net purchase of short term
investments of $71.3 million. Additionally, capital expenditures for the nine months ended June 30, 2002 were $1.1 million. For the nine months ended June 30, 2001, cash
used in investing activities was due to capital expenditures of $10.9 million, partially offset by a net redemption of short-term investments of $1.0 million.

Financing Activities.Cash provided by financing activities was $112.0 million and $1.0 million for the nine
month periods ended June 30, 2002 and 2001, respectively. In the nine month period ended June 30, 2002, the primary component of cash provided by financing activities was approximately
$107.0 million from the public offering of our common stock in February 2002. Additionally, in the nine months ended June 30, 2002, employee stock purchases, warrant exercises and
employee stock options exercises provided approximately $4.6 million from financing activities.

In
March 2002, we extended our existing bank line of credit until May 2002. In April 2002, we entered into a new bank line of credit, expiring in April 2003,
that provides a borrowing capacity of $4.0 million. The line of credit is secured by substantially all of our assets and contains financial and other covenants. As of June 30, 2002, no
amounts were outstanding under the line of credit.

At
June 30, 2002, we had $44.7 million in cash and cash equivalents and $138.8 million in short term investments. We lease certain facilities under
non-cancelable operating leases with terms ranging from 27 to 57 months. The following table summarizes the approximate contractual obligations that we

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have at June 30, 2002. Such obligations include both non-cancelable obligations and other obligations that are generally non-cancelable except under certain limited
conditions.

|                            |  | Payments Due by Period
|--------------------------- |  | ----------------------
|
|
|Operating Lease Obligations |  | $                     
|Capital Lease Obligations   |  | $                     
|Purchase Obligations        |  | $                     

Subsequent
to June 30, 2002, on July 12, 2002, we completed the purchase of certain assets from Advanced Research Technologies Inc., a corporation incorporated under
the laws of the Province of Quebec, Canada, ("ART") pursuant to an Asset Purchase Agreement between ART and us (the "Purchase Agreement"). Under the terms of the Purchase Agreement and related
agreements, we paid $5,500,000 in cash for certain assets and assumed certain liabilities related to ART's Infrared Screening and Inspection Solutions ("ISIS") Division. The funds used to purchase the
assets of ART came directly out of our working capital.

We
believe that existing liquid capital resources and funds generated from operations combined with the ability, if necessary, to borrow up to $4.0 million under our bank line of
credit will be sufficient to meet our operating and capital requirements and obligations for at least the next twelve months. We believe that success in our industry requires substantial capital in
order to maintain the flexibility to take advantage of opportunities as they may arise. We may, from time to time, invest in or acquire complementary businesses, products or technologies and may seek
additional equity or debt financing to fund such activities. There can be no assurance that such funding will be available to us on commercially reasonable terms, and if we were to proceed with
acquisitions without this funding or with limited funding it would decrease our capital resources. The sale of additional equity or convertible debt securities could result in dilution to our
shareholders.

Factors Affecting Operating Results

We have recently sustained losses and we may not be able to return to profitability.

We reported decreases in revenues for the nine months ended June 30, 2002 and for the fiscal year ended September 30, 2001 as compared to prior year
comparable periods, losses for the nine months ended June 30, 2002 and for the fiscal year ended September 30, 2001. In the future, our revenue may decline, remain flat or grow at a rate
slower than expected, especially in light of the recent economic slowdown. Our ability to regain profitability on an annual basis is dependent in part on our customers' recovery from this slowdown and
the success of our efforts to reduce operating expenses as a percentage of revenue through our outsourcing strategy and ongoing cost-cutting measures in connection with our recent
restructuring. In addition, if we determine that the goodwill of one of the businesses we acquired has been impaired, then we would need to decrease the carrying value of the goodwill, which would
decrease our net income, or increase our net loss, during the period in which we determined that the asset was impaired. Our operating results are difficult to predict, as described below, and we
cannot assure you that we will be successful in achieving increased revenue, positive cash flows or profitability.

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

Our business depends in large part on capital expenditures by manufacturers of flat panel display products and other electronics products, which in turn depend on
the current and anticipated market demand for the end products in these industries. The markets for flat panel display products and other

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electronics products are highly cyclical and have experienced periods of oversupply resulting in significantly reduced demand for capital equipment. For example, the flat panel display industry
experienced a downturn in 1998, which led many flat panel display manufacturers to delay or cancel capital expenditures. Additionally, in 2001, due to the general deteriorating economic environment,
flat panel display and electronics manufacturers reduced capital expenditures resulting in a decrease in revenue for all segments of our business. In 2002, capital expenditures by manufacturers in the
electronics industry continue to remain low, which has resulted in decreased revenue for our electronics products as compared to the prior year. Although flat panel display revenues increased for the
nine months ended June 30, 2002 compared to the prior year, this was not enough to offset the decline in revenue from our other segments. Semiconductor manufacturers have been heavily impacted
by the recent economic environment, and have significantly curtailed their capital expenditures. We had no sales to these customers in fiscal 2001 or in the nine months ended June 30, 2002 and
do not expect sales to such customers in the quarter ended September 30, 2002. If the flat panel display and other markets in which we sell our products do not recover sufficiently or
experience further slowdowns in the future, it could cause our revenue to decrease significantly. In addition, the need to invest in the engineering, research and development, and marketing required
to penetrate targeted foreign markets
and maintain extensive service and support capabilities limits our ability to reduce expenses during these downturns.

We depend on sales to a few large customers in the flat panel display industry, and if we lose any of our large customers our revenue could decrease significantly.

The flat panel display industry is extremely concentrated with a small number of manufacturers producing the majority of the world's flat panel displays. If one
or more of our major customers ceased or significantly curtailed their purchases, our revenue could drop significantly. We may be unable to replace sales to these customers. Sales of flat panel
display products represented 78% of our revenue for the nine months ended June 30, 2002 and 54% and 68% of our revenue in fiscal 2001 and 2000, respectively. Sales of flat panel display
products to LG Phillips LCD Co., Ltd. represented 36% of our revenue for the nine months ended June 30, 2002. LG Phillips LCD Co., Ltd., Quanta Display Inc.,
Ishikawajima-Harima Heavy Industries Co., Ltd., or IHI, and Samsung America, Inc., all customers of our flat panel display products, collectively accounted for 50% of our total revenue,
in fiscal 2001 and collectively for substantially all of our revenue from sales of flat panel display products in fiscal 2001.

Our operating results are difficult to predict and may vary from investors' expectations, which could cause our stock price to drop.

We have experienced and expect to continue to experience significant fluctuations in our quarterly results. Consequently, past financial results may not be
indicative of future financial results. A substantial percentage of our revenue is derived from the sale of a small number of yield management systems ranging in price from $150,000 to
$1.85 million. Therefore, the timing of the sale of a single system could have a significant impact on our quarterly results. Moreover, customers may cancel or reschedule shipments, and
production difficulties could delay shipments. Therefore, our backlog at the beginning of each quarter does not necessarily determine actual sales for the quarter or any succeeding period.

Other
factors which may influence our operating results in a particular quarter include:



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If
we experience difficulties in any of these areas, our operating results could be significantly and adversely affected and our stock price could decline. In addition, it is possible
that in some future quarter our operating results may be below the expectations of public market analysts and investors, which could cause our stock price to fall.

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

We obtain some equipment for our systems from a single source or a limited group of suppliers. For example, we currently obtain materials handling platforms,
ultra high-resolution cameras and high-speed image processing systems for our flat panel display products from single source suppliers, one of which is experiencing financial
difficulties and may cease operations, in which case we could experience shipment delays and higher materials costs, which could last for several months, as we transition to a new supplier. We also
currently obtain X-ray equipment for our printed circuit board assembly and
advanced semiconductor packaging inspection products from limited source suppliers. Although we seek to reduce dependence on our sole and limited source suppliers, alternative sources of supply for
this equipment may not be available or may be available on unfavorable terms. The partial or complete loss of our sole and limited source suppliers could at least temporarily delay our shipments or
otherwise harm our results of operations and damage customer relationships. Further, a significant increase in the price of one or more of these pieces of equipment could harm our results of
operations.

A significant portion of our revenue is derived from sales to companies located outside the United States, which exposes us to risks that we do not experience with domestic
sales.

Sales to countries other than the United States accounted for 86% of revenue for the nine months ended June 30, 2002 and 79% and 82% of revenue in fiscal
2001 and 2000, respectively. We expect sales to foreign countries to continue to represent a significant percentage of our revenue. A number of factors may adversely affect our international sales and
operations, including:



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If
any of these factors occur, our operating results and revenues could be materially and adversely affected.

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.

A
substantial percentage of our revenue has come from a limited range of products for the flat panel display and printed circuit board assembly and advanced semiconductor packaging
industries. We expect that these products will continue to account for a substantial percentage of our revenue. Any decline in demand for, or failure to achieve continued market acceptance of, our
primary products or any new version of these products could harm our business. We currently market two primary products for the flat panel display industry, our array test and array repair equipment.
For the printed circuit board assembly and advanced semiconductor packaging industry, our primary products include our X-ray and optical inspection systems. Revenue from these four
products represented 80% of our revenue in the nine months ended June 30, 2002 and 73% of our total revenue in fiscal 2001. Continued market acceptance of these primary products is critical to
our success.

We may have difficulty integrating the businesses we recently acquired or other businesses or assets we may acquire in the future, and we may not realize the benefits that we
expect from these acquisitions.

We have recently acquired several companies, including Image Processing Systems in December 2000 and Intelligent Reasoning Systems in July 2001, as
well as certain assets from Advanced Research Technologies Inc. in July 2002, and may acquire other companies in the future. Integrating businesses can be a complex,
time-consuming and expensive process. If we are not able to do so effectively, we will not be able to realize the benefits that we expect to receive from acquisitions. For each
acquisition, we must integrate separate technologies, product lines, business cultures and practices, employees and systems. Acquisitions are subject to numerous risks, including:



Any
of these difficulties could increase our operating costs and harm our financial performance. Future acquisitions may also result in potentially dilutive issuances of equity
securities, incurrence of debt and contingent liabilities and amortization expenses related to acquired intangible assets, which could harm our profitability.

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We depend on our relationship with IHI to sell our flat panel display products in Japan, and if we are not able to maintain this relationship, we may not be able to access this
important market.

We believe that Japanese companies competing with us in sales to the flat panel display industry have a competitive advantage in Japan because of the preference
of some local customers for local equipment suppliers. Historically, foreign companies have found it difficult to penetrate the Japanese market and often depend upon local sales channels to sell their
products in Japan.

Since
June 1997, we have depended on IHI as our exclusive value-added reseller to sell our flat panel display products in Japan. We anticipate that this relationship will continue
in the future. In the nine months ended June 30, 2002, fiscal 2001 and fiscal 2000, 8%, 13% and 7% of our revenue came from sales to IHI, respectively. If IHI reduced the resources allocated to
the development, systems construction, customization, sale and support of our flat panel display products in Japan, our business would be harmed.

In
addition, IHI's rights to continue as our exclusive value-added reseller in Japan are currently unresolved. IHI may have the right to market some or all of our products in Japan on an
exclusive basis, even exclusive as to us. If so, we may not be able to compete effectively in Japan. Although IHI must purchase certain critical components from us, IHI may manufacture competing array
test systems based on our technology. If this occurs, our business could be harmed.

We
have granted IHI the non-exclusive right to manufacture and sell array test systems based on our technology, excluding technology incorporated into some critical
components, in Korea, Taiwan and several other countries. Although IHI has neither manufactured these products, nor sold these products in countries other than Japan, our business could be harmed if
IHI manufactures and sells array test systems in competition with our own in these countries.

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

If Sanmina-SCI Corporation or any other third party that we use to manufacture our products is unable to satisfy our quality requirements or provide
us with the products and services in a timely manner, our shipments of these products may be delayed, our customer relationships may be harmed and our results of operations may be adversely impacted.
In addition, we are in the process of transferring most of the manufacturing operations of our flat panel display and surface mount technology optical inspection and x-ray products to
Sanmina-SCI. During this transition period, we may encounter significant unforeseen expenses and difficulties due to reasons that may be beyond our control, including technology and
personnel incompatibility. These unforeseen expenses and difficulties could disrupt our ongoing business and distract management and employees. We cannot assure you that our relationship with
Sanmina-SCI or any other third party that we use to manufacture our products will result in a reduction of our expenses or enable us to satisfy our customers' quality requirements or to
deliver our products to our customers in a timely manner.

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

The markets for yield management systems in the flat panel display, printed circuit board assembly and advanced semiconductor packaging, cathode ray tube display,
cathode ray tube glass, and automotive glass industries are highly competitive. We face substantial competition from established competitors
that have greater financial, engineering and manufacturing resources than us and have larger service organizations and long-standing customer relationships. Our competitors can be expected
to continue to improve the design and performance of their products and to introduce new products with competitive price and performance characteristics. Competitive pressures may force price
reductions that could harm our results of operations. Our customers may also develop technology and

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equipment that may reduce or eliminate their need to purchase our products. Although we believe we have certain technological and other advantages over our competitors, maintaining and capitalizing
on these advantages will require us to continue a high level of investment in engineering, research and development, marketing and customer service support. There can be no assurance that we will have
sufficient resources to continue to make these investments or that we will be able to make the technological advances necessary to maintain our competitive advantages.

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

We
believe that future orders of our products will depend in part on our ability to satisfy the performance, reliability and quality standards required by our customers. Particularly as
customers seek increased yields, greater throughput and higher quality end products, we must continually redesign our products to meet the needs of our customers. If our products have performance,
reliability or quality problems, then we may experience:



If
we are unable to meet the requirements of our customers, our revenue may decrease and our business could be harmed.

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

While our technology is applicable to other flat panel display technologies, our experience has been focused on applications for active matrix liquid crystal
displays, the most prevalent and one of the highest performance flat panel displays available today. In the first nine months of fiscal 2002 and in fiscal 2001, we derived approximately 78% and 54% of
our revenue from sales of flat panel display products, substantially all of which were based on the active matrix liquid crystal display technology. An industry shift away from active matrix liquid
crystal display technology to existing or new competing technologies could reduce the demand for our existing products and require significant expenditures to develop new products, each of which could
harm our business.

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

The markets for our products are characterized by rapidly changing technologies and frequent new product introductions. The failure to develop new products and
introduce them successfully and in a timely manner could harm our competitive position and results of operations. We believe that our future success will depend in part upon our ability to continue to
enhance our existing products and to develop and manufacture new products. For example, the size of glass plates for flat panel displays and the resolution of flat panel displays have changed
frequently and may continue to change, requiring us to redesign or reconfigure our flat panel display products.

Similarly,
as the technologies for products in the printed circuit board assembly and advanced semiconductor packaging and cathode ray tube display and high quality glass industries
continue to become more complex, we will be forced to continually refine our product offerings. As a result, we expect to continue to incur significant research and development costs. There can be no
assurance that we will be successful in the introduction, marketing and cost effective manufacture of any of our new

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products, that we will be able to timely develop and introduce new products and enhance our existing products and processes to satisfy customer needs or achieve market acceptance, or that the new
markets for which we are developing new products or expect to sell current products will develop sufficiently. We depend on close relationships with our customers and the willingness of those
customers to share information with us, and the failure to do so could harm our development efforts.

We must attract and retain key employees to maintain and grow our business.

Our future success depends in part on our ability to retain key personnel, particularly senior management and engineers. We also need to attract additional
skilled personnel in significant areas of
our business to grow. There can be no assurance that we will be able to retain our existing personnel or attract additional qualified employees in the future. We generally do not have employment
contracts with our employees, other than with Kenneth Wawrew, our Vice President, Business Development, and do not maintain key person life insurance on any of our employees.

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

Our success depends largely on our ability to protect our intellectual property. While we attempt to protect our intellectual property through patents, copyrights
and trade secrets in the United States and other countries, there can be no assurance that we will successfully protect our technology or that competitors will not be able to develop similar
technology independently. We cannot assure you that the claims allowed on any patents held by us will be sufficiently broad to protect our technology against competition from third parties with
similar technologies or products. In addition, we cannot assure you that any patents issued to us will not be challenged, invalidated or circumvented or that the rights granted thereunder will provide
competitive advantages to us. Moreover, the laws of some foreign countries do not protect intellectual property rights to the same extent as the laws of the United States and we could experience
various obstacles and high costs in protecting our intellectual property rights in foreign countries. If we are unable to obtain or maintain these protections, we may not be able to prevent third
parties from using our intellectual property.

We
also rely on trade secrets, proprietary know-how and continuing technological innovation to remain competitive. We have taken measures to protect our trade secrets and
know-how, including the use of confidentiality agreements with our employees. It is possible that these agreements may be breached and that the available remedies for any breach will not
be sufficient to compensate us for damages incurred.

Litigation may be necessary to enforce or defend against claims of intellectual property infringement, which could be expensive and, if we lose, could prevent us from selling
our products.

Litigation may be necessary in the future to enforce our patents and other intellectual property rights, to protect our trade secrets or to determine the validity
and scope of the proprietary rights of others. Any litigation, regardless of the outcome, could be costly and require significant time and attention of key members of our management and technical
personnel.

Our
domestic and international competitors, many of which have substantially greater resources and have made substantial investments in competing technologies, may have patents that will
prevent, limit or interfere with our ability to manufacture and sell our products. We have not conducted an independent review of patents issued to third parties. Third parties may assert infringement
claims, successful or otherwise, against us, and litigation may be necessary to defend against claims of infringement or invalidity. An adverse outcome in the defense of a patent suit could subject us
to significant liabilities to third parties, require disputed rights to be licensed from third parties or require
us to cease selling our products. Even successful defenses of patent suits can be costly and time-consuming.

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Because we rely on our sales representatives and distributors, our business may be harmed if our sales representatives become unable or unwilling to sell our products.

We market and sell some of our products, such as our printed circuit board assembly and advanced semiconductor packaging products, domestically and
internationally primarily through sales representatives and distributors. If some or all of our sales representatives and distributors experience financial difficulties, or otherwise become unable or
unwilling to promote and sell our products, our business could be harmed. These sales representatives and distributors could reduce or discontinue sales of our products. They may not devote the
resources necessary to provide effective sales and marketing support to us. In addition, we depend upon the continued viability and financial resources of these representatives and distributors, many
of which are small organizations with limited working capital. These representatives and distributors, in turn, depend substantially on general economic conditions and other factors affecting the
markets for the products they sell. We believe that our success will continue to depend upon these sales representatives and distributors.

We may experience unanticipated warranty claims.

We typically provide a limited warranty on our products for a period of one year from final acceptance by customers. In addition, for some custom-designed
systems, we may need to comply with certain performance specifications for a specific application. We may incur substantial warranty claim expenses on our products or with respect to our obligations
to meet custom performance specifications. Actual warranty claims may exceed recorded allowances, resulting in harm to our business.

Earthquakes may damage our facilities.

Our corporate and manufacturing facilities in California are located near major earthquake faults which have experienced earthquakes in the past. In addition,
some of our customers in Asia are located near fault lines. In the event of a major earthquake or other disaster in or near the San Francisco Bay Area or Southern California, our facilities may
sustain significant damage and our operations could be harmed. Similarly, a major earthquake in Asia, like the one that occurred in Taiwan in September 1999, could disrupt our operations or the
operations of our customers, which could reduce demand for our products.

Our stock price may fluctuate significantly.

The market price of our common stock could fluctuate significantly in response to variations in quarterly operating results and other factors, such as:



In
addition, the stock market has in recent years experienced significant price fluctuations. These fluctuations often have been unrelated to the operating performance of the specific
companies whose stock is traded. Broad market fluctuations, general economic condition and specific conditions in the flat panel display, printed circuit board assembly and advanced semiconductor
packaging and cathode ray tube display and high quality glass industries may adversely affect the market price of our common stock.

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

Our Amended and Restated Articles of Incorporation authorize our board of directors to issue up to 5,000,000 shares of preferred stock. The board also has the
authority to determine the price, rights, preferences and privileges, including voting rights, of those shares without any further vote or action by the shareholders. The rights of our shareholders
will be subject to, and may be impaired by, the rights of the holders of any preferred stock that may be issued in the future. These and other provisions contained in our charter documents and
applicable provisions of California law could serve to depress our stock price or discourage a hostile bid in which shareholders could receive a premium for their shares. In addition, these provisions
could make it more difficult for a third party to acquire a majority of our outstanding voting stock or otherwise effect a change in control of us.

We do not anticipate paying cash dividends.

We have never declared or paid any cash dividends on our capital stock and do not anticipate paying cash dividends in the foreseeable future. We have also agreed
not to pay cash dividends under our current bank line of credit. Instead, we intend to apply any earnings to the expansion and development of our business.

Item 3.Quantitative and Qualitative Disclosures About Market Risk

Our market and currency risk disclosures set forth in Item 7A of our Annual Report on Form 10-K for the year ended September 30, 2001
have not changed significantly.

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PART II. OTHER INFORMATION

Item 1.Legal Proceedings

We
have been named as defendant in a lawsuit captioned Thomason v. Photon Dynamics, Inc., No. 02CC03568, filed on February 28, 2002 in the Superior Court of the
State of California, County of Orange. The plaintiff in this action has purported to assert that he was wrongly not allowed to exercise certain stock options and is seeking damages of approximately
$900,000. On March 29, 2002 we responded to the lawsuit and filed a counterclaim against the plaintiff for breach of a general release agreement. While we intend to vigorously contest the
action, we cannot predict the outcome of this litigation. We believe that an adverse determination in this litigation would not have a material adverse effect on our financial condition or results of
operations.

We
and certain of our directors and officers have been named as defendants in a lawsuit captioned Amtower v. Photon Dynamics, Inc., No. CV797876, filed on April 30, 2001 in
the Superior Court of the State of California, County of Santa Clara. The plaintiff in this action has asserted several causes of action under state law arising out of alleged misrepresentation and
enforcement of our insider trading policy and is seeking damages of approximately $17.7 million, plus undetermined damages resulting from emotional distress and punitive damages. On
December 6, 2001, the court dismissed the complaint for failure to allege facts sufficient to state a cause of action, with leave to amend. On January 17, 2002, the plaintiff filed an
amended complaint and we have answered such complaint. On June 27, 2002, the court issued an order granting in part and denying in part our motion. While we intend to vigorously contest this
action, we cannot predict the outcome of this litigation. We believe that an adverse determination in this litigation would not have a material adverse effect on our financial condition or results of
operation.

Item 2.Changes in Securities

None.

Item 3.Defaults Upon Senior Securities

None.

Item 4.Submission of Matters to a Vote of Security Holders

None.

Item 5.Other Information

None.

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Item 6.Exhibits and Reports on Form 8-K



|Number |     | Exhibit                                                                                                                                                                             
|------ | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|2.1    | (1) | Acquisition Agreement for Plan of Arrangement by and among the Registrant, Photon Dynamics Nova Scotia Company and Image Processing Systems Inc. dated September 27, 2000.          
|2.2    | (2) | Agreement and Plan of Merger by and among the Registrant, Iris Acquisition, LLC, Intelligent Reasoning Systems Inc. and Clinton Bybee, dated July 6, 2001, amended on July 12, 2001.
|2.3    | (3) | Asset Purchase Agreement between Photon Dynamics, Inc. and ART Advanced Research Technologies Inc., dated July 2, 2002.                                                             
|3.1    | (4) | Amended and Restated Articles of Incorporation of the Registrant                                                                                                                    
|3.2    | (4) | Certificate of Amendment to Articles of Incorporation of the Registrant                                                                                                             
|3.3    | (5) | Bylaws of the Registrant and amendments thereto.                                                                                                                                    
|4.1    |     | Reference is made to Exhibits 3.1, 3.2 and 3.3                                                                                                                                      
|10.5   | (6) | 1995 Stock Option Plan, as amended.                                                                                                                                                 
|10.6   | (6) | 1995 Employee Stock Purchase Plan, as amended.                                                                                                                                      
|10.24  | (7) | 2001 Equity Incentive Plan, as amended.                                                                                                                                             
|99.1   |     | Certification of Chief Executive Officer and Chief Financial Officer                                                                                                                

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Key
to Exhibits:



None.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.

|                       |  | PHOTON DYNAMICS, INC.
|---------------------- |  | ---------------------
|                       |  | By:                  
|                       |  | By:                  
|Dated: August 12, 2002 |  |                      

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