##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 Form 10-Q
 (Mark One)
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
 For the quarterly period ended December 31, 2006
 OR
 o
    
    TRANSITION REPORT PURSUANT TO
SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the transition period from  to
 Commission file number: 0-27234
 PHOTON DYNAMICS, INC.
 (Exact name of registrant as specified in its charter)
 California
    
    94-3007502(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)
 5970 Optical Court
San Jose, California 95138-1400  (Address of principal executive offices including zip code)
 (408) 226-9900  (Registrants telephone number, including area code)
 þ o
  o þ o
 o þ




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##### 



INDEX
 PagePART I FINANCIAL INFORMATIONItem 1
    
    Financial Statements (unaudited)
    
    3Condensed Consolidated Balance Sheets as of December 31, 2006 and September 30, 2006
    
    3Condensed Consolidated Statements of Operations for the Three Months Ended December 31, 2006 and 2005
    
    4Condensed Consolidated Statements of Cash Flows for Three Months Ended December 31, 2006 and 2005
    
    5Notes to Condensed Consolidated Financial Statements
    
    6Item 2
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    21Item 3
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    35Item 4
    
    Controls and Procedures
    
    36PART II OTHER INFORMATIONItem 1
    
    Legal Proceedings
    

    37Item 1A
    
    Risk Factors
    
    37Item 2
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    46Item 3
    
    Defaults Upon Senior Securities
    
    46Item 4
    
    Submission of Matters to a Vote of Security Holders
    
    46Item 5
    
    Other Information
    
    47Item 6
    
    Exhibits
    
    47Signatures
    
    
    
    48EXHIBIT 10.41EXHIBIT 10.43EXHIBIT 10.44EXHIBIT 10.56EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1
  2




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##### Table of Contents



PART I. FINANCIAL INFORMATION
 
 ITEM 1. Financial Statements
 PHOTON DYNAMICS, INC.
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
 December 31,
    
    
    September 30,2006
    
    
    2006(in thousands)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    19,085
    
    
    $
    47,935Short-term investments
    
    
    78,009
    
    
    
    54,834Accounts receivable, net of allowance for doubtful accounts of $261
and $406 at December 31, 2006 and September 30, 2006, respectively
    
    
    18,055
    
    
    
    29,341Inventories
    
    
    24,938
    
    
    
    18,442Other current assets
    
    
    3,902
    
    
    
    3,972Total current assets
    
    
    143,989
    
    
    
    154,524Long-term investments
    
    
    
    
    
    
    787Land, property and equipment, net
    
    
    15,054
    
    
    
    15,891Other assets
    
    
    6,063
    
    
    
    4,542Intangible assets, net
    
    
    1,343
    
    
    
    1,716Goodwill
    
    
    153
    
    
    
    153Total assets
    
    $
    166,602
    
    
    $
    177,613LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    7,199
    
    
    $
    7,657Warranty
    
    
    7,858
    
    
    
    8,058Other current liabilities
    
    
    10,276
    
    
    
    9,944Deferred gross margin
    
    
    2,841
    
    
    
    7,454Total current liabilities
    
    
    28,174
    
    
    
    33,113Other non-current liabilities
    
    
    118
    
    
    
    119Commitments and contingenciesShareholders equity:Common stock, no par value
    
    
    286,681
    
    
    
    285,510Accumulated deficit
    
    
    (148,609
    )
    
    
    (141,409
    )Accumulated other comprehensive income
    
    
    238
    
    
    
    280Total shareholders equity
    
    
    138,310
    
    
    
    144,381Total liabilities and shareholders equity
    
    $
    166,602
    
    
    $
    177,613
  3




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PHOTON DYNAMICS, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
 Three Months EndedDecember 31,2006
    
    
    2005(in thousands, except per sharedata)Revenue
    
    $
    21,435
    
    
    $
    41,633Cost of revenue
    
    
    15,871
    
    
    
    22,382Gross margin
    
    
    5,564
    
    
    
    19,251Operating expenses:Research and development
    
    
    7,995
    
    
    
    8,071Selling, general and administrative
    
    
    4,930
    
    
    
    6,851Restructuring charge
    
    
    446
    
    
    
    62Amortization of intangible assets
    
    
    373
    
    
    
    372Total operating expenses
    
    
    13,744
    
    
    
    15,356Income (loss) from operations
    
    
    (8,180
    )
    
    
    3,895Interest income and other, net
    
    
    1,081
    
    
    
    500Income (loss) from continuing operations before income taxes and discontinued operations
    
    
    (7,099
    )
    
    
    4,395Provision for income taxes
    
    
    101
    
    
    
    352Income (loss) from continuing operations before discontinued operations
    
    
    (7,200
    )
    
    
    4,043Loss from discontinued operations
    
    
    
    
    
    
    (680
    )Net income (loss)
    
    $
    (7,200
    )
    
    $
    3,363Income (loss) per share from continuing operations:Basic
    
    $
    (0.43
    )
    
    $
    0.24Diluted
    
    $
    (0.43
    )
    
    $
    0.24Loss per share from discontinued operations:Basic
    
    $
    
    
    
    $
    (0.04
    )Diluted
    
    $
    
    
    
    $
    (0.04
    )Net income (loss) per share:Basic
    
    $
    (0.43
    )
    
    $
    0.20Diluted
    
    $
    (0.43
    )
    
    $
    0.20Weighted average number of shares:Basic
    
    
    16,590
    
    
    
    16,946Diluted
    
    
    16,590
    
    
    
    17,047
  4




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##### Table of Contents



PHOTON DYNAMICS, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 Three Months EndedDecember 31,2006
    
    
    2005(in thousands)Cash flows from operating activities:Income (loss) from continuing operations
    
    $
    (7,200
    )
    
    $
    4,043Adjustments to reconcile income (loss) from continuing operations to net cash
used in operating activities from continuing operations:Depreciation
    
    
    1,217
    
    
    
    1,439Amortization of intangible assets
    
    
    373
    
    
    
    372Non-cash stock-based compensation
    
    
    400
    
    
    
    985Loss on sale of property and equipment
    
    
    
    
    
    
    6Non-employee stock ownership expense
    
    
    
    
    
    
    6Restructuring charge
    
    
    273
    
    
    
    Accretion of non-interest bearing notes payable
    
    
    8
    
    
    
    9Changes in operating assets and liabilities:Accounts receivable
    
    
    11,286
    
    
    
    (1,294
    )Inventories
    
    
    (6,435
    )
    
    
    1,188Other current assets
    
    
    132
    
    
    
    505Other assets
    
    
    (1,521
    )
    
    
    (541
    )Accounts payable
    
    
    (458
    )
    
    
    (3,513
    )Other current liabilities
    
    
    139
    
    
    
    3,611Deferred gross margin
    
    
    (4,613
    )
    
    
    (6,862
    )Other liabilities
    
    
    (1
    )
    
    
    (40
    )Net cash used in operating activities from continuing operations
    
    
    (6,400
    )
    
    
    (86
    )Net cash used in operating activities from discontinued operations
    
    
    (56
    )
    
    
    (413
    )Net cash used in operating activities
    
    
    (6,456
    )
    
    
    (499
    )Cash flows from investing activities:Purchase of property and equipment
    
    
    (687
    )
    
    
    (195
    )Purchase of short-term investments
    
    
    (41,795
    )
    
    
    (16,323
    )Maturities and sales of short-term investments
    
    
    19,373
    
    
    
    16,788Net cash provided by (used in) investing activities from continuing operations.
    
    
    (23,109
    )
    
    
    270Cash flows from financing activities:Issuance of common stock
    
    
    710
    
    
    
    362Capital Lease repayments
    
    
    (21
    )
    
    
    Net cash provided by financing activities from continuing operations
    
    
    689
    
    
    
    362Effect of exchange rate changes on cash and cash equivalents
    
    
    26
    
    
    
    (45
    )Net increase (decrease) in cash and cash equivalents from continuing operations
    
    
    (28,794
    )
    
    
    501Net decrease in cash and cash equivalents from discontinued operations
    
    
    (56
    )
    
    
    (413
    )Net increase (decrease) in cash and cash equivalents
    
    
    (28,850
    )
    
    
    88Cash and cash equivalents at beginning of period
    
    
    47,935
    
    
    
    20,288Cash and cash equivalents at end of period
    
    $
    19,085
    
    
    $
    20,376
  5




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##### Table of Contents



PHOTON DYNAMICS, INC.
 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 NOTE 1  Basis of Presentation and Summary of Significant Accounting Policies
 Basis of Presentation.
   Description of Operations and Principles of Consolidation.
  Management Estimates and Assumptions.
 6




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##### Table of Contents



Fair Value of Financial Instruments.
 Inventories.
 Concentrations and Other Risk
    Revenue Recognition.
   7




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##### Table of Contents



Shipping Costs.
 Research and Development Cost.
 Interest Income.
 Stock-Based Compensation.
 Variable Interest Entity
 Recent Accounting Pronouncements. .
  8




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##### Table of Contents



NOTE 2  Financial Statement Components
 December 31,
    
    
    September 30,2006
    
    
    2006(in thousands)Inventories:Raw materials
    
    $
    13,450
    
    
    $
    10,740Work-in-process
    
    
    11,311
    
    
    
    7,036Finished goods
    
    
    177
    
    
    
    666Total
    
    $
    24,938
    
    
    $
    18,442Other current liabilities:Compensation
    
    $
    3,781
    
    
    $
    3,460Vendor obligations
    
    
    812
    
    
    
    942Professional fees
    
    
    738
    
    
    
    891Employee notes payable
    
    
    985
    
    
    
    977Customer deposits
    
    
    
    
    
    
    1,500Other accrued expenses
    
    
    3,960
    
    
    
    2,174Total
    
    $
    10,276
    
    
    $
    9,944Deferred gross margin:Deferred system sales
    
    $
    3,049
    
    
    $
    12,217Deferred cost of revenue related to system sales
    
    
    (208
    )
    
    
    (4,763
    )Total
    
    $
    2,841
    
    
    $
    7,454Accumulated other comprehensive income:Foreign currency translation adjustments
    
    $
    323
    
    
    $
    332Unrealized losses on available for sale securities
    
    
    (85
    )
    
    
    (52
    )Total
    
    $
    238
    
    
    $
    280
 NOTE 3  Discontinued Operations
 Printed Circuit Board Assembly Inspection Business
    9




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##### Table of Contents



Cathode Ray Tube Display and High Quality Glass Inspection Business
    NOTE 4  Goodwill and Other Purchased Intangible Assets
 Goodwill
   Intangible Assets
  NonDeveloped
    
    
    Core
    
    
    License
    
    
    CompeteTechnology
    
    
    Technology
    
    
    Agreement
    
    
    Contract
    
    
    Total(in thousands)Gross carrying amount at December 31, 2006
    
    $
    1,006
    
    
    $
    2,408
    
    
    $
    1,138
    
    
    $
    968
    
    
    $
    5,520Accumulated amortization
    
    
    (641
    )
    
    
    (1,655
    )
    
    
    (1,043
    )
    
    
    (838
    )
    
    
    (4,177
    )Net carrying amount at December 31, 2006
    
    $
    365
    
    
    $
    753
    
    
    $
    95
    
    
    $
    130
    
    
    $
    1,343
 10




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##### Table of Contents



NonDeveloped
    
    
    Core
    
    
    License
    
    
    CompeteTechnology
    
    
    Technology
    
    
    Agreement
    
    
    Contract
    
    
    Total(in thousands)Gross carrying amount at September 30, 2006
    
    $
    1,006
    
    
    $
    2,408
    
    
    $
    1,138
    
    
    $
    968
    
    
    $
    5,520Accumulated amortization
    
    
    (578
    )
    
    
    (1,504
    )
    
    
    (948
    )
    
    
    (774
    )
    
    
    (3,804
    )Net carrying amount at September 30, 2006
    
    $
    428
    
    
    $
    904
    
    
    $
    190
    
    
    $
    194
    
    
    $
    1,716
  NonDeveloped
    
    
    Core
    
    
    License
    
    
    CompeteTechnology
    
    
    Technology
    
    
    Agreement
    
    
    Contract
    
    
    Total(in thousands)Net carrying amount at September 30, 2006
    
    $
    428
    
    
    $
    904
    
    
    $
    190
    
    
    $
    194
    
    
    $
    1,716Amortization during the period
    
    
    (63
    )
    
    
    (151
    )
    
    
    (95
    )
    
    
    (64
    )
    
    
    (373
    )Net carrying amount at December 31, 2006
    
    $
    365
    
    
    $
    753
    
    
    $
    95
    
    
    $
    130
    
    
    $
    1,343
   NOTE 5  Restructuring Charges
 PanelMaster Product Discontinuation
 TM TM
 TM
   One-TimeTermination
    
    
    OtherBenefits
    
    
    Costs
    
    
    Total(in thousands)Inception of liability
    
    $
    173
    
    
    $
    273
    
    
    $
    446Cash payments
    
    
    (91
    )
    
    
    
    
    
    
    (91
    )Impairment of manufacturing assets
    
    
    
    
    
    
    (222
    )
    
    
    (222
    )Balance at December 31, 2006
    
    $
    82
    
    
    $
    51
    
    
    $
    133
 11




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##### Table of Contents



TM
 Markham, Canada Closure
 TM
    One-Time
    
    
    ContractTermination
    
    
    TerminationBenefits
    
    
    Costs
    
    
    Total(in thousands)Inception of liability
    
    $
    430
    
    
    $
    246
    
    
    $
    676Cash payments
    
    
    (1,018
    )
    
    
    (37
    )
    
    
    (1,055
    )Costs incurred and charged to expense
    
    
    635
    
    
    
    
    
    
    
    635Adjustments to the liability
    
    
    (47
    )
    
    
    (171
    )
    
    
    (218
    )Balance at September 30, 2006
    
    
    
    
    
    
    38
    
    
    
    38Cash payments
    
    
    
    
    
    
    (2
    )
    
    
    (2
    )Costs incurred and charged to expense
    
    
    
    
    
    
    
    
    
    
    Adjustments to the liability
    
    
    
    
    
    
    (1
    )
    
    
    (1
    )Balance at December 31, 2006
    
    $
    
    
    
    $
    35
    
    
    $
    35
  12




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##### Table of Contents



NOTE 6  Comprehensive Income
  Three Months EndedDecember 31,2006
    
    
    2005(in thousands)Net income (loss)
    
    $
    (7,200
    )
    
    $
    3,363Other comprehensive income (loss):Net change in unrealized gain (loss) on investments
    
    
    (33
    )
    
    
    75Change in foreign currency translation
    
    
    (9
    )
    
    
    (46
    )Other comprehensive income (loss)
    
    
    (42
    )
    
    
    29Total comprehensive income (loss)
    
    $
    (7,242
    )
    
    $
    3,392
 NOTE 7  Shareholders Equity
 Stock Ownership Expense.
 NOTE 8  Stock-Based Compensation
   Three Months EndedDecember 312006
    
    
    2005(in thousands, except per share data)Stock-based compensation expense included in continuing
operations: :Cost of revenue
    
    $
    20
    
    
    $
    27Research and development
    
    
    89
    
    
    
    139Selling, general and administrative
    
    
    291
    
    
    
    819Total stock-based compensation expense after income taxes (1)
    
    $
    400
    
    
    $
    985Stock-based compensation expense by type of award: :Employee stock options
    
    $
    353
    
    
    $
    925Employee stock purchase plan
    
    
    104
    
    
    
    95Restricted stock awards
    
    
    5
    
    
    
    Amounts capitalized as inventory and deferred gross margin
    
    
    (61
    )
    
    
    (35
    )Net effect on net income (1)
    
    $
    400
    
    
    $
    985Effect on net income per share:Basic
    
    $
    0.02
    
    
    $
    0.06Diluted
    
    $
    0.02
    
    
    $
    0.06
 
 (1)
    
    The income tax benefit on stock-based compensation for all periods presented was not
material. 13




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##### Table of Contents



Equity Incentive Program
   Number of SecuritiesRemaining Available forFuture Issuance UnderNumber of Securities
    
    
    
    
    
    
    Equityto be Issued upon
    
    
    Weighted-Average
    
    
    Compensation PlansExercise of
    
    
    Exercise Price of
    
    
    (Excluding SecuritiesOutstanding Options (1)
    
    
    Outstanding Options
    
    
    Reflected in Column (a))Plan Category
    
    (a)
    
    
    (b)
    
    
    (c)Equity compensation plans approved by security holders
    
    
    2,113,810
    
    
    $
    21.75
    
    
    
    537,678Equity compensation plans not approved by security holders
    
    
    625
    
    
    $
    16.88
    
    
    
    Total
    
    
    2,114,435
    
    
    $
    21.75
    
    
    
    537,678
 
 (1)
    
    Amounts shown are for options granted only. There were 50,000 shares of restricted stock
units issued under the 2005 Equity Incentive Plan as of December 31, 2006.  Expected Volatility
 Expected Term
 Risk-Free Interest Rate
 14




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##### Table of Contents



Expected Dividends
 Forfeitures
  Three Months EndedDecember 31,2006
    
    2005Stock option plan:Expected volatility
    
    
    44
    %
    
    
    44
    %Risk free rate
    
    
    4.6
    %
    
    
    4.2
    %Expected term (in years)
    
    
    3.4
    
    
    
    3.9
   Weighted-
    
    
    Weighted-Average
    
    
    AggregateAvailable
    
    
    Options
    
    
    Average
    
    
    Remaining Contract
    
    
    Intrinsic Valuefor Grant
    
    
    Outstanding
    
    
    Exercise Price
    
    
    Term (in years)
    
    
    (in thousands)Balances at September 30, 2006
    
    
    798,336
    
    
    
    1,950,695
    
    
    $
    23.28Plan shares expired (1)
    
    
    (46,421
    )
    
    
    
    
    
    
    Options granted
    
    
    (276,500
    )
    
    
    276,500
    
    
    
    11.17Restricted stock units granted
    
    
    (50,000
    )
    
    
    
    
    
    
    Options canceled/expired
    
    
    112,263
    
    
    
    (112,263
    )
    
    
    22.39Options exercised
    
    
    
    
    
    
    (497
    )
    
    
    4.69Balances at December 31, 2006
    
    
    537,678
    
    
    
    2,114,435
    
    
    $
    21.75
    
    
    
    6.8
    
    
    $
    353Vested and expected to vest at December 31, 2006
    
    
    
    
    
    
    1,863,513
    
    
    $
    22.58
    
    
    
    6.7
    
    
    $
    298Exercisable at December 31, 2006
    
    
    
    
    
    
    1,286,408
    
    
    $
    25.26
    
    
    
    6.4
    
    
    $
    209
 
 (1)
    
    The Companys 1995 Amended and Restated Stock Option Plan expired in November 2005. Shares
subject to outstanding options that were cancelled or expired during the period are no longer
available for grant.   15




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##### Table of Contents



Restricted Stock Units
  Weighted-AverageNumber
    
    Grant Dateof Shares
    
    Fair ValueUnvested restricted stock at September 30, 2006
    
    
    0
    
    
    $
    Granted
    
    
    50,000
    
    
    $
    10.93Vested
    
    
    0
    
    
    $
    Forfeited
    
    
    0
    
    
    $
    Unvested restricted stock at December 31, 2006
    
    
    50,000
    
    
    $
    10.93
  Employee Stock Purchase Plan
   Three Months EndedDecember 31,2006
    
    2005Stock purchase plan:Expected volatility
    
    
    44
    %
    
    
    44
    %Risk free rate
    
    
    4.7
    %
    
    
    4.2
    %Expected term (in years)
    
    
    0.6
    
    
    
    0.5
   16




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##### Table of Contents



NOTE 9  Net Income (Loss) Per Share
   Three Months EndedDecember 31,2006
    
    
    2005(in thousands, except per share data)Numerator:Net income (loss) from continuing operations
    
    $
    (7,200
    )
    
    $
    4,043Net loss from discontinued operations
    
    
    
    
    
    
    (680
    )Net income (loss)
    
    $
    (7,200
    )
    
    $
    3,363Denominator:Weighted average shares outstanding, excluding unvested restricted stock,
for basic net income per share
    
    
    16,590
    
    
    
    16,946Effect of shares held in escrow
    
    
    
    
    
    
    57
    (2)Effect of dilutive securities: Employee stock options and restricted stock
    
    
    
    (1)
    
    
    44Weighted average shares for diluted net income per share
    
    
    16,590
    
    
    
    17,047Earnings per share:Basic net income (loss) per share:Net income (loss) from continuing operations
    
    $
    (0.43
    )
    
    $
    0.24Net loss from discontinued operations
    
    
    
    
    
    
    (0.04
    )Net income (loss) per share
    
    $
    (0.43
    )
    
    $
    0.20Diluted net income (loss) per share:Net income (loss) from continuing operations
    
    $
    (0.43
    )
    
    $
    0.24Net loss from discontinued operations
    
    
    
    
    
    
    (0.04
    )Net income (loss) per share
    
    $
    (0.43
    )
    
    $
    0.20
 
 (1)
    
    The effect of potentially dilutive securities from employee stock options to purchase 17,696
shares of common stock and from restricted stock units for 50,000 shares of common stock for
the three month period ended December 31, 2006 were not included in the computation of diluted
net loss per share as the effect is anti-dilutive.(2)
    
    The Company had 57,195 shares of Photon Dynamics common stock in an escrow account related
to a lease that was part of the discontinued operations of the Printed Circuit Board Assembly
Inspection Business. These shares were considered to be contingently issuable shares under
Statement of Financial Accounting Standards No. 128, Earnings per Share, and were therefore
excluded from the calculation of weighted average shares for basic net income per share and
were included in the calculation of weighted average shares for diluted net income per share.  NOTE 10  Commitments and Contingencies
 Purchase Agreements
  17




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##### Table of Contents



Warranty Obligations
   Three Months EndedDecember 31,2006
    
    
    2005(in thousands)Beginning balance
    
    $
    8,058
    
    
    $
    5,346Estimated warranty cost of new shipments during the period
    
    
    995
    
    
    
    1,073Warranty costs during the period
    
    
    (1,539
    )
    
    
    (554
    )Changes in liability for pre-existing warranties, including expirations
    
    
    344
    
    
    
    (1,967
    )Ending balance
    
    $
    7,858
    
    
    $
    3,898
 TM
 Legal Proceedings
   NOTE 11  Geographic Information
  18




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##### Table of Contents



Three MonthsEndedDecember 31,2006
    
    
    2005(in thousands)Revenue:South Korea
    
    $
    6,021
    
    
    $
    35,047Taiwan
    
    
    6,162
    
    
    
    5,921Japan
    
    
    9,034
    
    
    
    665China
    
    
    218
    
    
    
    Total
    
    $
    21,435
    
    
    $
    41,633
  Three MonthsEndedDecember 31,2006
    
    2005Revenue:ArrayCheckerTM
    
    
    64
    %
    
    
    75
    %ArraySaverTM
    
    
    15
    %
    
    
    7
    %PanelMasterTM
    
    
    0
    %
    
    
    10
    %Customer spares and other
    
    
    21
    %
    
    
    8
    %Total
    
    
    100
    %
    
    
    100
    %
  Three MonthsEndedDecember 31,2006
    
    2005Customer A
    
    
    42
    %
    
    
    *Customer B
    
    
    22
    %
    
    
    40
    %Customer C
    
    
    14
    %
    
    
    *Customer D
    
    
    11
    %
    
    
    *Customer E
    
    
    *
    
    
    
    44
    %
 
 *
    
    Customer accounted for less than 10% of total revenue for the period.  December 31,
    
    September 30,2006
    
    2006Customer A
    
    
    18
    %
    
    
    37
    %Customer B
    
    
    19
    %
    
    
    21
    %Customer C
    
    
    31
    %
    
    
    16
    %Customer D
    
    
    14
    %
    
    
    16
    %
  December 31,
    
    
    September 30,2006
    
    
    2006(In thousands)United States
    
    $
    15,053
    
    
    $
    16,234South Korea
    
    
    1,221
    
    
    
    1,229Other
    
    
    276
    
    
    
    297Total
    
    $
    16,550
    
    
    $
    17,760
 19




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NOTE 12  Related Party Transactions
  NOTE 13  Provision for Income Taxes
  NOTE 14  Subsequent Event
    20




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##### Table of Contents



ITEM 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
 This Quarterly Report on Form 10-Q contains certain 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. All statements included or incorporated by reference in this Quarterly Report on Form 10-Q
other than statements of historical fact may be forward-looking statements. You can identify these
and other forward-looking statements by the use of words such as may, will, could, would,
should, plans, anticipates, relies, expects, intends, believes, estimates,
predicts, potential, continue or the negative of such terms, or other comparable terminology.
Forward-looking statements also include the assumptions underlying or relating to any such
statements. These forward-looking statements are based on current expectations as of the filing
date of this Quarterly Report on Form 10-Q and involve a number of uncertainties and risks. These
uncertainties and risks include, but are not limited to: the adoption of new technology by our
existing and potential customers; the delay of investments by the Companys customers in response
to current economic factors, which could reduce their purchase of Photon Dynamics products until
the markets become more certain; the migration of our manufacturing operations offshore and the
changing customer investment climate, which could lead to impairments of assets; the current
economic conditions, which may cause an increase in competitive pricing pressures; the risk of the
introduction of competing products having technological and/or pricing advantages, which would
reduce the demand for our products; and failure to comply with a variety of United States and
foreign federal, state and local laws and regulations, which could lead to the Company incurring
additional expenses, interest and penalties.. As a result, our actual results and end user demand
may differ substantially from expectations.
 Our actual results could differ materially from those projected in the forward-looking
statements included herein as a result of a number of factors, risks and uncertainties, including
the risk factors set forth in Part II Item 1A. Risk Factors in this Quarterly Report on Form
10-Q. The information included in this Quarterly Report on 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 herein. Accordingly, we caution readers
not to place undue reliance on such statements and we expressly assume no obligation to update the
forward-looking statements included in this report after the date hereof except as required by law.
 The following discussion and analysis should be read in conjunction with the condensed
consolidated financial statements and notes thereto in Item 1 above and with our financial
statements and notes thereto for the year ended September 30, 2006, contained in our Annual Report
on Form 10-K filed with the Securities and Exchange Commission (the SEC) on December 14, 2006.
 Overview
 Our Company
  TM TM TM TM TM TM TM
  21




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##### Table of Contents



TM TM
  
    
    The level of capital expenditures of flat panel display manufacturers, which in turn
depends on the current and anticipated market demand for products utilizing flat panel
displays;
    
    The ability of our customers to sustain growth long term; and
    
    The relative competitiveness of our products and services.
   Focus on Flat Panel Display Industry
   
    
    Product Focus:We continue to improve our product performance in defect detection, repair
success, cost of ownership, ease of use and throughput for each of our product generations.
We seek to couple this improved system performance with our expert applications engineering
services to provide the best possible business solutions to our customers.
    
    Quality Focus:We continue to implement processes to drive product quality improvement and
ease of use for our customers.
    
    Technology Leadership:We continue to emphasize our research and development to maintain
our technology leadership in our products.
 22




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##### Table of Contents




    
    Financial Improvement:We continue our efforts to improve financial performance. To
achieve these goals, we will continue to look for vertical integration opportunities, source
certain raw materials and certain system integration in Asia, and expand sales and marketing
of our service product offerings.
  
    
    Continuing investment in research and development, with a focus on Generation 10 products
and new repair product applications;
    
    Growing our service and upgrade revenue as a percentage of overall revenue;
    
    Improving gross margin on existing products;
    
    Executing on effective new product introduction; and
    
    Reducing our overall operating expenses.
 Industry
      23




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##### Table of Contents



Backlog
  Critical Accounting Policies and Estimates
     24




---



##### Table of Contents



Revenue Recognition.
   Allowance for Doubtful Accounts.
  Inventories.
  Warranty.
 TM
 25




---



##### Table of Contents



Goodwill, Intangible and Other Long-Lived Assets.
     Stock-Based Compensation.
 Contingencies and Litigation.
 26




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##### Table of Contents



Results of Operations
 Selected Financial Data
  Three Months EndedDecember 31,2006
    
    2005Revenue
    
    
    100.0
    %
    
    
    100.0
    %Cost of revenue
    
    
    74.0
    
    
    
    53.8Gross margin
    
    
    26.0
    
    
    
    46.2Operating expenses:Research and development
    
    
    37.3
    
    
    
    19.4Selling, general and administrative
    
    
    23.0
    
    
    
    16.4Restructure charge
    
    
    2.1
    
    
    
    0.1Amortization of intangible assets
    
    
    1.7
    
    
    
    0.9Total operating expenses
    
    
    64.1
    
    
    
    36.8Income (loss) from operations
    
    
    (38.2
    )
    
    
    9.4Interest income and other, net
    
    
    5.0
    
    
    
    1.2Income (loss) from continuing operations before income taxes and discontinued operations
    
    
    (33.1
    )
    
    
    10.6Provision for income taxes
    
    
    0.5
    
    
    
    0.9Income (loss) from continuing operations
    
    
    (33.6
    )
    
    
    9.7Loss from discontinued operations
    
    
    
    
    
    
    (1.6
    )Net income (loss)
    
    
    (33.6
    )%
    
    
    8.1
    %
 Revenue
 Three Months EndedDecember 31,2006
    
    Change
    
    2005(dollars in millions)Revenue
    
    $
    21.4
    
    
    
    (49
    )%
    
    $
    41.6
  TM TM TM TM
 ArrayChecker TM and ArraySaver TM Product Revenue
 TM TM TM TM
 27




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TM TM
 TM
 TM TM
 PanelMaster TM Product Revenue
 TM TM
 TM TM TM
 Customer Support and Spare Parts Revenue
  International Revenue
  Three Months EndedDecember 31,2006
    
    
    Change
    
    
    2005(dollars in millions)South Korea
    
    $
    6.0
    
    
    
    (83
    )%
    
    $
    35.0Taiwan
    
    
    6.2
    
    
    
    4
    %
    
    
    5.9Japan
    
    
    9.0
    
    
    
    1,259
    %
    
    
    0.7China
    
    
    0.2
    
    
    
    100
    %
    
    
    Total Revenue
    
    $
    21.4
    
    
    
    (49
    )%
    
    $
    41.6
  28




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Revenue Outlook
  Gross Margin
 Three Months EndedDecember 31,2006
    
    Change
    
    2005(dollars in millions)Gross Margin
    
    $
    5.9
    
    
    
    (71
    )%
    
    $
    19.3Gross Margin Percentage
    
    
    26
    %
    
    
    (43
    )%
    
    
    46
    %
  
    
    A lower percentage sales of higher-margin ArrayCheckerTM systems; and,
    
    The under-utilization of our San Jose facilities as a consequence of the industry slowdown.
   
    
    Our revenue mix between higher margin ArrayCheckerTM systems and lower margin ArraySaverTM systems;
    
    The costs of increasing customer service staff to support potential increased demands from new and existing customers;
    
    The additional costs in connection with inefficiencies of manufacturing newly-introduced products;
    
    Competitive pricing pressures, particularly in the array repair market;
    
    The success of our strategy of using both domestic and offshore manufacturing as we begin
limited manufacturing of certain of our ArraySaverTM systems in South Korea;
    
    Reduced production levels as a consequence of either industry slowdown, order
cancellations or customer-initiated changes in delivery schedules by our customers; and
    
    Fluctuations in the level of revenue due to the cyclical nature of customers capital
expenditures.
 29




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##### Table of Contents



Research and Development
 Three Months EndedDecember 31,2006
    
    Change
    
    2005(dollars in millions)Expense
    
    $
    8.0
    
    
    
    (1
    )%
    
    $
    8.1Percentage of Revenue
    
    
    37
    %
    
    
    
    
    
    
    19
    %
    
    
    Focus on product enhancements and improving cost of ownership on our Generation 7, 7.5 and 8 products;
    
    Accelerate investments in our Generation 10 product development program; and
    
    Invest funds in reliability and cost reduction initiatives.
  Selling, General and Administrative
 Three Months EndedDecember 31,2006
    
    Change
    
    2005(dollars in millions)Expense
    
    $
    4.9
    
    
    
    (28
    )%
    
    $
    6.9Percentage of Revenue
    
    
    23
    %
    
    
    
    
    
    
    16
    %
   Stock-Based Compensation
  30




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##### Table of Contents



Three Months EndedDecember 31,2006
    
    
    2005(in thousands)Stock-based compensation expense included in continuing
operations:Cost of revenue
    
    $
    20
    
    
    $
    27Research and development
    
    
    89
    
    
    
    139Selling, general and administrative
    
    
    291
    
    
    
    819Total stock-based compensation expense after income taxes (1)
    
    $
    400
    
    
    $
    985Stock-based compensation expense by type of award:Employee stock options
    
    $
    353
    
    
    $
    925Employee stock purchase plan
    
    
    104
    
    
    
    95Restricted stock awards
    
    
    5
    
    
    
    Amounts capitalized as inventory and deferred gross margin
    
    
    (61
    )
    
    
    (35
    )Net effect on net income (1)
    
    $
    400
    
    
    $
    985
 
 (1)
    
    The income tax benefit on stock-based compensation for all periods presented was not
material.  Restructuring Charge
 Three Months EndedDecember 31,2006
    
    Change
    
    2005Expense
    
    $
    446,000
    
    
    
    619
    %
    
    $
    62,000Percentage of Revenue
    
    
    2
    %
    
    
    
    
    
    
    0
    %
 TM
     31




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##### Table of Contents



Amortization of Intangibles
 Three Months EndedDecember 31,2006
    
    Change
    
    2005Expense
    
    $
    373,000
    
    
    
    0
    %
    
    $
    372,000Percentage of Revenue
    
    
    2
    %
    
    
    
    
    
    
    1
    %
  Interest Income and Other, Net
 Three Months EndedDecember 31,2006
    
    Change
    
    2005Expense
    
    $1.1 million
    
    
    116
    %
    
    $
    500,000Percentage of Revenue
    
    
    5
    %
    
    
    
    
    
    
    1
    %
  Provision for Income Taxes
 Three Months EndedDecember 31,2006
    
    Change
    
    2005Expense
    
    $
    101,000
    
    
    
    (71
    )%
    
    $
    352,000Percentage of Revenue
    
    
    1
    %
    
    
    
    
    
    
    1
    %
   Discontinued Operations
 Three Months EndedDecember 31,2006
    
    Change
    
    2005Loss
    
    $
    0
    
    
    
    (100
    )%
    
    $
    (680,000
    )
   Liquidity and Capital Resources
  32




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##### Table of Contents



Operating Activities of Continuing Operations
  Investing Activities of Continuing Operations
  Financing Activities of Continuing Operations
    Operating, Investing and Financing Activities of Discontinued Operations
  Contractual Obligations
  Payments Due by Fiscal YearContractual Obligations
    
    Total
    
    
    2007(1)
    
    
    2008
    
    
    2009
    
    
    2010
    
    
    2011
    
    
    Thereafter(In thousands)Operating lease obligations
    
    $
    11,558
    
    
    $
    2,512
    
    
    $
    2,833
    
    
    $
    2,727
    
    
    $
    2,785
    
    
    $
    701
    
    
    $
    Capital lease obligations
    
    
    180
    
    
    
    49
    
    
    
    71
    
    
    
    60
    
    
    
    
    
    
    
    
    
    
    
    Purchase obligations
    
    
    24,431
    
    
    
    23,530
    
    
    
    901
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    36,169
    
    
    $
    26,091
    
    
    $
    3,805
    
    
    $
    2,787
    
    
    $
    2,785
    
    
    $
    701
    
    
    $
    
 
 (1)
    
    Remaining nine months 33




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##### Table of Contents



Working Capital
   Impact of Accounting Pronouncements
 .
   34




---



##### Table of Contents



ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
 Foreign Currency Exchange Rate Risk
     Market Risk
  35




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##### Table of Contents



ITEM 4. Controls and Procedures
    Remediation of the Material Weakness That Existed as of December 31, 2006
  
    
    We are working with outside advisors on the development of new valuation and
declaration processes to ensure compliance with all customs regulations of each of the
countries into which we import parts.
    
    We are reviewing and evaluating our internal controls, including our internal reporting
processes, to ensure that legal, regulatory and other matters that could have a
significant financial statement impact are evaluated and documented by management and
escalated on a timely basis, where appropriate, to the Audit Committee.
   Changes in Control Over Financial Reporting in the First Quarter of Fiscal 2007
  Inherent Limitations of Disclosure Controls and Procedures and Internal Control Over Financial
Reporting.
  36




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##### Table of Contents



PART II. OTHER INFORMATION
 
 ITEM 1. Legal Proceedings
   
 ITEM 1A. Risk Factors
 Our operations and financial results are subject to various risks and uncertainties, including
those described below, that could adversely affect our business, financial condition, results of
operations, cash flows and trading price of our common stock. You should refer also to our Annual
Report on Form 10-K for fiscal year 2006 for additional information concerning these and other
uncertainties that could negatively impact our Company.
 We have sustained losses and we may sustain losses in the future.
   Because none of our customers is obligated to purchase our products, each of our customers may
cancel or defer its purchases at any time and on short notice, which could harm our operating
results.
  
    
    may stop purchasing our products or defer their purchases at any time without penalty;
    
    are free to purchase products from our competitors;
    
    are not required to make minimum purchases; and
    
    may cancel orders that they place with us.
  37




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##### Table of Contents



Our operating results are difficult to predict and may vary from investors expectations,
which could cause our stock price to fall.
   
    
    the timing of the receipt of orders from major customers;
    
    the result of sudden, unanticipated changes in customer requirements;
    
    the cancellation, delay or extension of firm orders;
    
    the receipt of final acceptance on new products;
    
    the product mix that makes up our revenue;
    
    our inability to reduce our expense levels quickly in the event of market or demand
downturns, due to the fact that a high percentage of our expenses, including those related
to manufacturing, engineering, research and development, sales and marketing and general and
administrative functions, is fixed in the short term;
    
    the result of competitive pricing pressures;
    
    the ability to obtain components from our single or limited source suppliers in a timely manner;
    
    the ability to effectively implement our strategy of migrating manufacturing offshore;
    
    the effects of global economic uncertainty;
    
    the ability of our manufacturing operations in Korea to timely produce and deliver
products in the quantity and of the quality our customers require;
    
    the costs of operations in the global markets in which we do business;
    
    the effects of changing international economic conditions;
    
    the effects of currency exchange rate fluctuations;
    
    the outcome of the appeal of litigation with a former executive officer;
    
    the effects of worldwide political instability;
    
    the ability to design, manufacture and introduce new products on a cost-effective and timely basis;
 38




---



##### Table of Contents




    
    the delay between expenses to further develop marketing and service capabilities and the
realization of benefits from those improved capabilities; and
    
    the introduction of new products by our competitors.
  If our products experience performance, reliability or quality problems, our customers may
reduce their orders.
 TM TM
 
    
    delays in receiving final acceptance, which in turn delays recognition of the associated revenue;
    
    delays in collecting accounts receivable;
    
    reduced orders;
    
    additional warranty and service expenses; and
    
    higher manufacturing costs.
  TM
 Capital investment by manufacturers of flat panel display products can be highly cyclical and
may decline in the future.
  39




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##### Table of Contents



We depend on sales to a few large customers in the flat panel display industry, and if we lose
any of our large customers our revenue could decrease significantly.
  We rely upon sales of a limited range of products, and if demand for one product decreases for
any reason it could cause our revenue to decline significantly.
  TM TM TM TM TM TM TM TM TM TM
 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.
    40




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##### Table of Contents



If we are not able to receive sufficient parts to meet our production requirements, we may
experience significant delays in producing our products, which could decrease our revenue for an
extended period of time.
  All of our revenue is derived from sales to companies located outside the United States, which
exposes us to risks that we would not experience with domestic sales.
  
    
    political instability and the possibility of hostilities, terrorist attacks, or war;
    
    imposition of governmental controls;
    
    fluctuations in interest and currency exchange rates;
    
    export license requirements;
    
    restrictions on the export of technology;
    
    limited foreign protection of intellectual property rights;
    
    trade restrictions;
    
    periodic or local international downturns;
    
    decreases in productivity, temporary plant shutdowns or infrastructure service
disruptions resulting from widespread health alerts including Severe Acute Respiratory
Syndrome (SARS) and warnings of an Avian Flu pandemic;
    
    changes in tariffs; and
    
    difficulties in staffing and managing international operations.
  Our
lengthy and varying-duration customer qualification and customer sales cycle requires us to incur substantial costs
to make a sale, and if the sale does not occur then we will have incurred these expenses without
obtaining increased sales.
   41




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##### Table of Contents



Our ability to efficiently and effectively implement our strategy of using both domestic and
offshore manufacturing may impact our profitability.
   
    
    political instability and the possibility of hostilities, terrorist attacks, or war;
    
    imposition of governmental controls;
    
    fluctuations in interest and currency exchange rates;
    
    limited foreign protection of intellectual property rights;
    
    trade restrictions;
    
    periodic or local international downturns;
    
    decreases in productivity, temporary plant shutdowns or infrastructure service
disruptions resulting from widespread health alerts including SARS and warnings of an Avian
Flu pandemic; and
    
    difficulties in staffing and managing international manufacturing.
  Any failure of, or other problems at or with, our third party manufacturers could delay
shipments of our flat panel display products, harm our relationships with our customers or
otherwise negatively impact our business.
  If we do not compete effectively in our target markets, we will lose market share.
  42




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##### Table of Contents



Our success depends in large part on the strength of the active matrix liquid crystal display
in the flat panel display industry.
  We may have difficulty integrating the businesses or assets we have acquired and may acquire
in the future, and we may not realize the benefits that we expect from these acquisitions.
  
    
    difficulty in the assimilation of the technologies and products of the acquired company;
    
    entering markets in which we have no or limited direct prior experience;
    
    loss of key customers of the acquired company;
    
    diversion of management resources from the business of the combined company;
    
    incompatibility of business cultures or practices;
    
    loss of key employees of the acquired company;
    
    costs and delays in implementing common systems and procedures;
    
    potential inefficiencies in delivering services to the customers of the combined company; and
    
    assumption of unknown or undisclosed liabilities.
   Compliance with new reporting requirements may strain our resources and we may be unable to
implement in a timely manner additional finance and accounting systems, procedures and controls in
the future to satisfy new reporting requirements, which could cause our stock price to fall.
 43




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##### Table of Contents



Our business could be harmed if we fail to properly protect our intellectual property.
   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.
   44




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##### Table of Contents



Our failure to comply with governmental regulations related to international activities could
subject us to liability and additional expense.
    We must attract and retain key employees and our management team and employees must work
effectively together to maintain and grow our business.
  Terrorism and international political instability may negatively affect our operations.
   Our manufacturing facilities and our customers manufacturing facilities may be subject to
disruption from natural disasters.
   45




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##### Table of Contents



We have exposure to various risks related to the regulatory environment.
  Computer viruses may disrupt our operations.
  Additional Risks in Owning our Common Stock
 Our stock price may fluctuate significantly.
  
    
    announcements of technological innovations or new products by us or by our competitors;
    
    government regulations;
    
    developments in patent or other property rights; and
    
    developments in our relationships with our customers.
  Some anti-takeover provisions may affect the price of our common stock.
  We do not anticipate paying cash dividends.
  
 ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds
  
 ITEM 3. Defaults Upon Senior Securities
  
 ITEM 4. Submission of Matters to a Vote of Security Holders
  46




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##### Table of Contents



ITEM 5. Other Information
  
 ITEM 6. Exhibits
 Exhibits
  47




---



##### Table of Contents



SIGNATURES
  PHOTON DYNAMICS, INC.By:
    /s/ Michael SchradleMichael SchradleChief Financial Officer
(Duly authorized and principal financial
officer)  48




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##### Table of Contents



Exhibit Index
 Number
    
    Exhibit3.1(1)
    
    Amended and Restated Articles of Incorporation of the Registrant.3.2(1)
    
    Certificate of Amendment to Articles of Incorporation of the Registrant.3.3(2)
    
    Bylaws of the Registrant.4.1
    
    Reference is made to Exhibits 3.1, 3.2 and 3.3.10.41
    
    Form of Restricted Stock Unit Agreement under the 2005 Equity Incentive Plan, as amended.10.43
    
    Form of Stock Option Agreement under the 2005 Equity Incentive Plan, as amended.10.44
    
    Photon Dynamics, Inc. 2005 Equity Incentive Plan, as amended.10.47(3)
    
    Photon Dynamics, Inc. 2006 Non-Employee Directors Stock Incentive Plan.10.55(3)
    
    Form of Restricted Stock Unit Agreements under the 2006 Non-Employee Directors Stock Incentive Plan.10.56
    
    Form of Stock Option Agreement under the 2006 Non-Employee Directors Stock Incentive Plan.31.1
    
    Certification required by Rule 13a-14(a) or Rule 15d-14(a).31.2
    
    Certification required by Rule 13a-14(a) or Rule 15d-14(a).32.1**
    
    Certifications required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title
18 of the United States Code (18 U.S.C. §1350).
 Key to Exhibits:
 
 (1)
    
    Previously filed as the like-numbered exhibit to the Registrants Registration Statement on
Form S-1 (Commission File No. 333-76650) as filed with the Securities and Exchange Commission
on January 14, 2002, as amended, and incorporated herein by reference.(2)
    
    Previously filed as the like-described exhibit to the Registrants Quarterly Report on Form
10Q for the quarter ended December 31, 2005 as filed with the Securities and Exchange
Commission on February 9, 2006, and incorporated herein by reference.(3)
    
    Previously filed as an exhibit to the Registrants Current Report on Form 8-K (Commission
File No. 000-27234) as filed with SEC on January 31, 2007, and incorporated herein by
reference.**
    
    The certification attached as Exhibit 32.1 accompanies the Quarterly Report on Form 10-Q
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed filed by
the Company for purposes of Section 18 of the Securities Exchange Act of 1934, as amended. 49