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**UNITED STATESSECURITIES AND EXCHANGE COMMISSION****Washington, D.C.  20549**

**FORM10-Q**

**(MarkOne)**
|   | **ý** | **QUARTERLY REPORT  UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|--------|------------|----------------------------------------------------------------------------------------|

**For the quarterly period endedJune 30, 2001**

**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**

**PHOTONDYNAMICS, INC.******(Exact name of registrant as specified inits charter)

| **California**                                                  | **94-3007502**                        |
|-----------------------------------------------------------------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) | (I.R.S. Employer  Identification No.) |
|                                                            |                                  |
| **6325 San Ignacio Avenue San Jose, California**                | **95119**                             |
| (Address of principal  executive offices)                       | (zip code)                            |

 

**(408) 226-9900**(Registrant's telephone number, including area code)

Indicate by check mark whether theregistrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor 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**  NOo

As of July 31, 2001, there were12,920,225 shares outstanding of the Registrant’s Common Stock, no par value.

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**INDEX**

 

| **PART  I  FINANCIAL INFORMATION** |
|-----------------------------------------|
|                                    |   |
| Item  1.                                | Financial  Statements (unaudited) |
|                                    | Condensed  Consolidated Balance Sheets as of June 30, 2001 and September 30, 2000 |
|                                    | Condensed  Consolidated Statements of Operations for the Three- and Nine-Month Periods  Ended June 30, 2001 and 2000 |
|                                    | Condensed  Consolidated Statements of Cash Flows for the Nine-Month Periods Ended June  30, 2001 and 2000 |
|                                    | Notes  to Condensed Consolidated Financial Statements |
|                                    |   |
| Item  2.                                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
|                                    |   |
| Item  3.                                | Quantitative  and Qualitative Disclosures About Market Risk |
|                                    |   |
| **PART  II  OTHER INFORMATION**    |
|                                    |   |
| Item 1.                                 | Legal  Proceedings |
| Item 2.                                 | Changes in  Securities and Use of Proceeds |
| Item 3.                                 | Defaults Upon Senior  Securities |
| Item  4.                                | Submission  of Matters to a Vote of Security Holders |
| Item 5.                                 | Other  Information |
| Item 6.                                 | Exhibits  and Reports on Form 8-K |
|                                    |   |
| Signatures                              |

**PART I.  FINANCIAL INFORMATION**

**ITEM 1. FINANCIAL STATEMENTS**

**PHOTONDYNAMICS, INC.CONDENSED CONSOLIDATED BALANCESHEETS(Unaudited)**

 

| *(in thousands)*                               | June  30, 2001                                   |    | September  30, 2000 |    |
|------------------------------------------------|--------------------------------------------------|---------|---------------------|---------|
|                                           |                                                  |         |                     |    |
|                                           |                                             |    | (Restated)          |    |
| **ASSETS**                                     |                                             |    |                |    |
|                                           |                                             |    |                |    |
| Current assets:                                |                                             |    |                |    |
|                                           | Cash and cash  equivalents                       | $       | 9,734               |    | $ | 9,723 |   |
|                                           | Short-term investments                           | 92,092  |                | 93,003  |   |
|                                           | Accounts receivable,  net                        | 18,048  |                | 24,828  |   |
|                                           | Inventories                                      | 13,266  |                | 16,523  |   |
|                                           | Other current assets                             | 1,907   |                | 2,510   |   |
|                                           |                                             |         |                     |         |   |
|                                           | Total current assets                             | 135,047 |                | 146,587 |   |
|                                           |                                             |    |                |    |
| Land, property and  equipment, net             | 13,324                                           |    | 4,111               |    |
| Other assets                                   | 2,482                                            |    | 2,056               |    |
|                                           |                                                  |         |                     |    |
|                                           | Total assets                                     | $       | 150,853             |    | $ | 152,754 |   |
|                                           |                                                  |    |                     |    |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY** |                                             |    |                |    |
|                                           |                                             |    |                |    |
| Current liabilities:                           |                                             |    |                |    |
|                                           | Accounts payable                                 | $       | 4,300               |    | $ | 6,622 |   |
|                                           | Other current  liabilities                       | 9,977   |                | 12,039  |   |
|                                           | Deferred revenue and  customer deposits          | 791     |                | 1,884   |   |
|                                           |                                             |         |                     |         |   |
|                                           | Total current  liabilities                       | 15,068  |                | 20,545  |   |
|                                           |                                             |    |                |    |
| Other liabilities                              | 383                                              |    | 409                 |    |
| Commitments and  contingencies (See Note 9)    |                                             |    |                |    |
|                                           |                                             |    |                |    |
| Shareholders’ equity:                     |                                             |    |                |    |
|                                           | Preferred stock, no  par value                   | -       |                | -       |   |
|                                           | Common stock, no par  value                      | 160,806 |                | 159,723 |   |
|                                           | Accumulated deficit                              | (25,306 | )                   | (27,926 | ) |
|                                           | Accumulated other  comprehensive income          | (98     | )                   | 3       |   |
|                                           |                                             |         |                     |         |   |
|                                           | Total shareholders’  equity                 | 135,402 |                | 131,800 |   |
|                                           |                                             |         |                     |         |   |
|                                           | Total liabilities and  shareholders’ equity | $       | 150,853             |    | $ | 152,754 |   |
|                                           |                                                  |         |                     |    |
|                                                |                                                  |         |                     |         |  |  |  |  |

*See accompanying notes to condensed consolidated financialstatements.*

**PHOTONDYNAMICS, INC.****CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS****(Unaudited)**

|                                     | Three  months ended June 30,         |   | Nine  months ended June 30, |   |
|------------------------------------------|--------------------------------------|--------|-----------------------------|--------|
| *(in thousands, except per  share data)* | 2001                                 |   | 2000                        |   | 2001 |   | 2000 |   |
|                                     |                                      |        |                             |        |  |  |  |   |
|                                     |                                 |   | (Restated)                  |   |   |   | (Restated) |   |
|                                     |                                 |   |                        |   |   |   |   |   |
| Revenue                                  | $                                    | 12,277 |                        | $      | 25,288 |   | $ | 62,716 |   | $ | 68,381 |   |
|                                     |                                 |   |                        |   |   |   |   |   |
| Cost of revenue                          | 7,903                                |   | 13,464                      |   | 35,467 |   | 36,954 |   |
|                                     |                                      |        |                             |        |  |  |  |   |
| Gross margin                             | 4,374                                |   | 11,824                      |   | 27,249 |   | 31,427 |   |
|                                     |                                 |   |                        |   |   |   |   |   |
| Operating expenses:                      |                                 |   |                        |   |   |   |   |   |
|                                     | Research and  development            | 3,753  |                        | 3,853  |   | 12,888 |   | 9,639 |   |
|                                     | Selling, general and  administrative | 3,896  |                        | 4,356  |   | 13,271 |   | 12,228 |   |
|                                     | Non-recurring  acquisition charges   | -      |                        | -      |   | 2,325 |   | 860 |   |
|                                     |                                 |        |                             |        |  |  |  |  |   |
|                                     | Total operating  expenses            | 7,649  |                        | 8,209  |   | 28,484 |   | 22,727 |   |
|                                     |                                 |   |                        |   |   |   |   |   |
| Income (loss) from  operations           | (3,275                               | )      | 3,615                       |   | (1,235 | ) | 8,700 |   |
| Interest income and  other, net          | 1,066                                |   | 1,627                       |   | 4,323 |   | 2,547 |   |
|                                     |                                      |        |                             |        |  |  |  |   |
| Income (loss) before  income taxes       | (2,209                               | )      | 5,242                       |   | 3,088 |   | 11,247 |   |
|                                     |                                 |   |                        |   |   |   |   |   |
| Provision (benefit)  for income taxes    | (241                                 | )      | 1,000                       |   | 468 |   | 2,120 |   |
|                                     |                                      |        |                             |        |  |  |  |   |
| Net income (loss)                        | $                                    | (1,968 | )                           | $      | 4,242 |   | $ | 2,620 |   | $ | 9,127 |   |
|                                     |                                      |        |                             |        |  |  |  |   |
|                                     |                                 |   |                        |   |   |   |   |   |
| Earnings (loss) per  share:              |                                 |   |                        |   |   |   |   |   |
| Basic                                    | $                                    | (0.15  | )                           | $      | 0.33 |   | $ | 0.20 |   | $ | 0.78 |   |
|                                     |                                      |        |                             |        |  |  |  |   |
| Diluted                                  | $                                    | (0.15  | )                           | $      | 0.31 |   | $ | 0.19 |   | $ | 0.71 |   |
|                                     |                                      |        |                             |        |  |  |  |   |
| Weighted average  number of shares:      |                                 |   |                        |   |   |   |   |   |
| Basic                                    | 13,014                               |   | 12,724                      |   | 12,983 |   | 11,642 |   |
| Diluted                                  | 13,014                               |   | 13,761                      |   | 13,727 |   | 12,819 |   |
|                                     |                                 |   |                        |   |   |   |   |   |
|                                          |                                      |        |                             |        |  |  |  |  |  |  |  |  |  |  |

*See accompanying notes to condensed consolidated financialstatements.*

**PHOTONDYNAMICS, INC.****CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS****(Unaudited)**

|                                                          | Nine  months ended June 30,                                                        |    |
|---------------------------------------------------------------|------------------------------------------------------------------------------------|---------|
| *(in thousands)*                                              | 2001                                                                               |    | 2000 |   |
|                                                          |                                                                                    |         |  |   |
|                                                          |                                                                               |    | (Restated) |   |
| Cash flows from  operating activities:                        |                                                                               |    |   |   |
|                                                          | Net income                                                                         | $       | 2,620 |   | $ | 9,127 |   |
|                                                          | Adjustments to  reconcile net income to net cash provided by operating activities: |    |   |   |   |
|                                                          | Depreciation and  amortization                                                     | 1,670   |   | 1,006 |   |
|                                                          | Loss on disposal of  property and equipment                                        | 6       |   | - |   |
|                                                          | Reversal of Canadian  government liability                                         | -       |   | (264 | ) |
|                                                          | Stock compensation  expense                                                        | 48      |   | 530 |   |
|                                                          | Unrealized gain on  investments                                                    | -       |   | (48 | ) |
|                                                          | Changes in assets and  liabilities:                                                |    |   |   |   |
|                                                          | Accounts receivable,  net                                                          | 6,780   |   | (7,218 | ) |
|                                                          | Inventories                                                                        | 3,257   |   | (5,021 | ) |
|                                                          | Other current assets                                                               | 603     |   | 176 |   |
|                                                          | Other assets                                                                       | (426    | ) | (289 | ) |
|                                                          | Accounts payable                                                                   | (2,322  | ) | 2,373 |   |
|                                                          | Other current  liabilities                                                         | (2,062  | ) | 4,534 |   |
|                                                          | Deferred revenue and  customer deposits                                            | (1,093  | ) | (657 | ) |
|                                                          |                                                                               |         |  |  |   |
|                                                          | Net cash provided by  operating activities                                         | 9,081   |   | 4,249 |   |
|                                                          |                                                                                    |         |  |   |
| Cash flows from  investing activities:                        |                                                                               |    |   |   |
|                                                          | Purchase of property  and equipment                                                | (10,889 | ) | (1,237 | ) |
|                                                          | Purchase of short-term  investments                                                | (88,485 | ) | (40,423 | ) |
|                                                          | Redemption of  short-term investments                                              | 89,504  |   | - |   |
|                                                          |                                                                               |         |  |  |   |
|                                                          | Net cash used in  investing activities                                             | (9,870  | ) | (41,660 | ) |
|                                                          |                                                                                    |         |  |   |
| Cash flows from  financing activities:                        |                                                                               |    |   |   |
|                                                          | Issuance of common  stock, net                                                     | 1,035   |   | 87,983 |   |
|                                                          | Proceeds from Canadian  government grants                                          | -       |   | 286 |   |
|                                                          | Principle payments  under bank loan                                                | -       |   | (629 | ) |
|                                                          | Principle payments  under capital leases                                           | (26     | ) | (6 | ) |
|                                                          |                                                                               |         |  |  |   |
|                                                          | Net cash provided by  financing activities                                         | 1,009   |   | 87,634 |   |
|                                                          |                                                                                    |         |  |   |
| Effect of exchange  rate changes on cash and cash equivalents | (209                                                                               | )       | (22 | ) |
|                                                          |                                                                                    |         |  |   |
| Net increase in cash  and cash equivalents                    | 11                                                                                 |    | 50,201 |   |
| Cash and cash  equivalents at beginning of period             | 9,723                                                                              |    | 6,560 |   |
|                                                          |                                                                                    |    |  |   |
| Cash and cash  equivalents at end of period                   | $                                                                                  | 9,734   |   | $ | 56,761 |   |
|                                                          |                                                                                    |         |  |   |
|                                                               |                                                                                    |         |  |  |  |  |  |  |  |

*See accompanying notes to condensed consolidated financialstatements.*
**PHOTON DYNAMICS, INC.****NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS****(Unaudited)**

**NOTE 1— Basis of Presentation**

             Inthe opinion of management, the accompanying unaudited interim condensedconsolidated financial statements of Photon Dynamics, Inc. (“Photon Dynamics”or “the Company”) include all adjustments (consisting of normal recurringaccruals) necessary for their fair presentation in accordance with generallyaccepted accounting principles. Preparing financial statements requires management to make estimates andassumptions that affect amounts reported in the financial statements andaccompanying notes.  Actual amountscould differ materially from those amounts. The results for the nine-month period ended June 30, 2001 are notnecessarily indicative of results to be expected for the entire year.  This financial information should be read inconjunction with the financial statements and the notes thereto included in theCompany’s Annual Report on Form 10-K for the fiscal year ended September 30,2000.

             OnDecember 22, 2000, the Company acquired Image Processing Systems Inc. (“ImageProcessing Systems” or “IPS”).  Thistransaction was accounted for as a pooling of interests.  The consolidated financial statements forthe three- and nine-month periods ended June 30, 2000 have been restated toinclude the financial position, results of operations and cash flows of IPS.  Financial information for Photon Dynamics, Inc.’sfiscal years ended September 30, 2000 and 1999 have been combined with IPS’sfinancial information for the twelve months ended September 30, 2000 and thefiscal year ended March 31, 2000, respectively.  Therefore, IPS’s results of operations for the six months endedMarch 31, 2000 have been included in both years.  The results of operations for those six months are summarized asfollows:
*Six months ended March 31,* *(in thousands of U.S. dollars)*2000    (Unaudited)    Revenue$7,050 Operating income$14 Net income$(15)
**NOTE 2 – Inventories**

             Inventoriesare stated at the lower of cost (on a first-in, first-out basis) ormarket.  The components of inventorieswere as follows:
*(in thousands)*June  30, 2001 September  30, 2000   Inventories:     Raw materials$8,093 $9,025  Work-in-process4,043 7,311  Finished goods1,130 187     Total$13,266 $16,523     
**NOTE 3 – Other Current Liabilities**

             Thecomponents of other current liabilities were as follows:
*(in thousands)*June  30, 2001 September  30, 2000   Other current  liabilities:     Warranty$3,113 $3,609  Compensation2,247 3,540  Commissions1,166 1,463  Acquisition charges251 528  Income taxes871 284  Other accrued expenses2,329 2,615    Total$9,977 $12,039   
**NOTE 4 – Comprehensive Income**

The components of comprehensive incomewere as follows:
 Three months ended  June 30, Nine months ended June  30, *(in  thousands)*2001 2000 2001 2000   Net income (loss)$(1,968)$4,242 $2,620 $9,127 Other comprehensive  income (loss):         Change in unrealized  gain on investments56 (21)108 (48) Currency translation  adjustments128 (166)(209)(22)   Other comprehensive  income (loss)184 (187)(101)(70)   Total comprehensive  income (loss)$(1,784)$4,055 $2,519 $9,057   
**NOTE 5 – Operations by Industry Segment**

             Duringthe first quarter of fiscal 2001, the Company changed the structure of itsinternal organization following the IPS merger that became effective on theclose of business December 22, 2000.

             TheCompany conducts business in three operating segments: flat panel display(“FPD”) products, printed circuit board (“PCB”) assembly and advancedsemiconductor packaging inspection products (collectively, “semiconductorinspection products”) and cathode ray tube (“CRT”) display and glass inspectionproducts.  The Company’s FPD productsinclude test, repair and inspection equipment. The Company’s FPD test and inspection equipment identifies andcharacterizes defects at early stages of the manufacturing process so that the panelsmay be repaired before the next stage, or, if necessary, discarded, minimizingthe loss of time and materials.  TheCompany’s FPD products gather comprehensive data that enable FPD manufacturersto control and refine their manufacturing processes.  The Company’s semiconductor inspection products enable PCBassembly and advanced semiconductor packaging manufacturers to detect andidentify defects, thereby increasing yields and quality and reducingcosts.  The Company’s CRT display andglass inspection products allow CRT and glass manufacturers to detect andidentify defects such as scratches, pits, bubbles, stones, inclusions anddistortions, thereby increasing yields and quality and reducing costs.

             Priorto the acquisition of Image Processing Systems in December 2000, the Companyoperated in the FPD and semiconductor inspection segments.  The Company’s management has determined theoperating segments based upon the manner in which the business is managed andoperated.  There are no significantintersegment sales or transfers, and the majority of the Company’s long-livedassets are located in the U.S.  TheCompany’s principal customers are primarily Asian-based FPD and CRTmanufacturers and North American-based PCB assembly and advanced semiconductorpackaging manufacturers.             The Company’s operatingsegments consisted of the following: Three  months ended June 30, Nine  months ended June 30, *(in thousands)*2001 2000 2001 2000   Net sales to external  customers:         FPD products$6,508 $17,533 $36,511 $45,409  Semiconductor  inspection products3,440 4,553 14,023 12,720  CRT display and glass  inspection products2,329 3,202 12,182 10,252     Consolidated net sales  to external customers$12,277 $25,288 $62,716 $68,381   Operating income  (loss):         FPD products(1)$(2,746)$3,390 $1,132 $8,255  Semiconductor  inspection products(1)(79)554 763 1,619  CRT display and glass  inspection products(1)(450)(329)(805)(314) Non-recurring  acquisition charges- - (2,325)(860)    Consolidated operating  income (loss)$(3,275)$3,615 $(1,235)$8,700    
(1)         Excludesnon-recurring acquisition charges.

**NOTE 6 – Earnings Per Share**

             Basicearnings per share is calculated using the weighted average number of shares ofcommon stock outstanding.  Dilutedearnings per share is computed in the same manner and also gives effect to alldilutive common equivalent shares outstanding during the period.  Common equivalent shares consist of stockoptions issued to employees under employee stock option plans and ofwarrants.  As the Company incurred aloss for the three months ended June 30, 2001, the effect of dilutivesecurities totaling approximately 837,000 weighted average shares from employeestock options and warrants has been excluded from the computation of dilutedearnings per share as their effect is antidilutive.
 Three  months ended June 30, Nine  months ended June 30, *(in thousands, except per  share data)*2001 2000 2001 2000   Numerator:         Net income (loss) for  basic and diluted earnings per share:$(1,968)$4,242 $2,620 $9,127 Denominator:         Weighted average  shares for basic earnings per share13,014 12,724 12,983 11,642  Effect of dilutive  securities:         Employee stock options- 1,030 737 1,091  Warrants- 7 7 86    Weighted average  shares for diluted earnings per share13,014 13,761 13,727 12,819   Basic earnings (loss)  per share$(0.15)$0.33 $0.20 $0.78 Diluted earnings  (loss) per share$(0.15)$0.31 $0.19 $0.71 
**NOTE 7 – Non-Recurring Acquisition Charges**

             InDecember 2000, the Company acquired IPS in exchange for approximately 1,139,000shares of its common stock with the acquisition accounted for as a pooling ofinterests.  IPS shareholders received0.0447 exchangeable shares for each common share of IPS held that can beexchanged into Photon Dynamics’ common stock on a one-for-one basis at any timewithin 5 years.  The Company incurred$2.3 million in acquisition related charges primarily of legal, accounting andintegration fees.

             InNovember 1999, the Company acquired CR Technology, Inc. (“CR Technology”) inexchange for approximately 1,835,000 shares of its common stock with theacquisition accounted for as a pooling of interests.  The Company incurred $860,000 in acquisition related chargesprimarily of legal, accounting and investment banking fees.

             Thefollowing presents certain statement of operations data of the Company, IPS andCR Technology for the periods prior to the acquisition:
*Year ended September 30,* *(in thousands)*2000 1999 1998   Revenue:       Photon Dynamics$64,221 $31,562 $22,420  Image Processing  Systems12,523 16,580 10,052  CR Technology18,013 13,869 8,550    Consolidated revenue$94,757 $62,011 $41,022   Net income (loss):       Photon Dynamics$12,909 $1,170 $(1,465) Image Processing  Systems(1,218)845 (3,450) CR Technology1,844 1,103 258    Consolidated net  income (loss)$13,535 $3,118 $(4,657)  
**NOTE 8 – Income Taxes**

             Theprovision for income taxes was a benefit of $241,000 and an expense of $468,000for the three- and nine-month periods ended June 30, 2001 compared to expenseof $1.0 million and $2.1 million for the same periods in the prior fiscal year.  The effective tax rate was (11)% and 19% forthe three-month periods ended June 30, 2001 and 2000, respectively.  The effective tax rate was 9% and 18%excluding non-recurring acquisition expenses for the nine-month periods endedJune 30, 2001 and 2000, respectively. The effective tax rate in all periods was lower than the statutory U.S.tax rate of 35% due to the utilization of net operating losses and creditcarryforwards.

**NOTE 9 – Commitmentsand Contingencies**

             TheCompany and certain of its directors and officers have been named as defendantsin a lawsuit captioned Amtower v. Photon Dynamics, Inc. filed on April 30,2001.  The plaintiff in this action haspurported to assert several causes of action arising out of the allegedmisrepresentation and enforcement of the Company’s insider trading policy andis seeking damages of approximately $17.7 million.  While the Company intends to vigorously contest this action, theCompany cannot predict the outcome of this litigation.  The Company believes that an adversedetermination in this litigation would not have a material adverse effect onits financial condition or results of operation.

**NOTE 10 – Derivative Instruments and Hedging Activities**

             OnOctober 1, 2000, the Company adopted FASB Statement No. 133, Accounting forDerivative Instruments and Hedging Activities (“FAS 133”).  FAS 133, as amended, establishes methods forrecording derivative financial instruments and hedging activities related tothose instruments, as well as other hedging activities.  The Company currently does not hold anyderivative instruments and does not engage in hedging activities.  Therefore, the adoption of FAS 133, asamended, has not had any impact on its consolidated financial position orresults of operations.**NOTE 11 – Recently Issued Accounting Pronouncements
             InJune 2000, the Securities and Exchange Commission (“SEC”) issued StaffAccounting Bulletin No. 101B, *SecondAmendment: Revenue Recognition in Financial Statements*(“SAB101B”).  SAB 101B amends StaffAccounting Bulletin No. 101, *RevenueRecognition in Financial Statements*(“SAB 101”), to defer theimplementation date of SAB 101 for registrants until no later than the fourthfiscal quarter of fiscal years beginning after December 15, 1999.  SAB 101 summarizes certain views of the SECin applying generally accepted accounting principles to revenue recognition infinancial statements.  The Company isrequired to adopt SAB 101 in the fourth quarter of its fiscal year endingSeptember 30, 2001.  Accordingly, anyrevenues reported prior to October 1, 2000 and revenue reported for the firstthree quarters of fiscal 2001 that do not meet SAB 101’s guidance will bedeferred and recorded as revenue in whatever future periods SAB 101 guidance ismet.  Changes in the Company’s revenuerecognition policy resulting from the interpretation and implementation of SAB101 would not involve the restatement of prior fiscal year statements, butwould, to the extent applicable, be reported as a change in accountingprinciple with a cumulative catch up adjustment as of October 1, 2000 in thefiscal year ending September 30, 2001, with the appropriate restatement ofinterim periods as required by FASB Statement No. 3, *Reporting Accounting Changes in Interim Financial Statements*.  The Company’s reported results of operationsfor the 12 months ending September 30, 2001 will include a cumulativeadjustment for all prior annual and interim periods as if SAB 101 had beenadopted on October 1, 2000.  While the Companybelieves that the adoption of SAB 101 will have an impact on its reportedresults of operations, it believes that SAB 101 will not affect the underlyingstrength or weakness of its business operations as measured by the dollar valueof its product shipments and cash flows.

**NOTE 12 – Subsequent Event**

             OnJuly 17, 2001, the Company acquired Intelligent Reasoning Systems Inc.(“IRSI”), a privately-held company. IRSI manufactures in-line, advanced optical inspection equipment for theelectronic manufacturing services and high-density interconnect markets.  The Company acquired IRSI in exchange forapproximately 636,000 shares of common stock. The transaction will be accounted for as a purchase, and the purchaseprice will be allocated to the estimated fair value of assets acquired andliabilities assumed based on management estimates.

**Item 2.*****Management’s Discussion and Analysis of Financial Condition and Resultsof Operations***

             Thestatements contained in this report on Form 10-Q that are not purely historicalare forward-looking statements within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of 1934,including statements regarding our expectations, hopes, intentions, orstrategies regarding the future.  Allforward-looking statements included in this document are based on informationavailable to us on the date hereof, and we assume no obligation to update anysuch forward-looking statements.  It isimportant to note that our actual results could differ materially from those insuch forward-looking statements. Factors that could cause actual results to differ materially are thosediscussed under “Factors Affecting Operating Results” at the end of this Item2. and elsewhere in this Form 10-Q.

             Thefollowing discussion should be read in conjunction with the condensedconsolidated financial statements and notes thereto in Item 1. above and withour audited financial statements and notes thereto for the year ended September30, 2000 contained in our Annual Report on Form 10-K filed November 7, 2000.**Results of Operations
             Weare a leading global supplier of integrated yield management solutions for thedisplay, electronics and glass markets. Our patented image acquisition and image processing technology,electro-optical design and systems engineering expertise are currently used fortest and repair of FPDs; inspection of CRT display and automotive glass; andinspection of advanced semiconductors and printed wiring assembly packagingsolutions. We develop systems that enable manufacturers to collect data fromthe production line, analyze it, and quickly diagnose and repairprocess-related defects. We focus specifically on delivering solutions thathelp manufacturers decrease material costs and improve throughput.

*             Revenue.*  Revenuefor the three-month period ended June 30, 2001 was $12.3 million compared to$25.3 million for the same period in the prior fiscal year, representing adecrease of 51%.  Sales of FPD productsrepresented $6.5 million, or 53% of revenue, for the three-month period endedJune 30, 2001 compared to $17.5 million, or 69% of revenue, for the same periodin the prior fiscal year.  Sales ofsemiconductor inspection products represented $3.5 million, or 28% of revenue,for the three-month period ended June 30, 2001 compared to $4.6 million, or 18%of revenue, for the same period in the prior fiscal year.  Sales of CRT display and glass inspectionproducts represented $2.3 million, or 19% of revenue, for the three-monthperiod ended June 30, 2001 compared to $3.2 million, or 13% of revenue, for thesame period in the prior fiscal year. The decrease in revenue across all market segments was attributable tothe delayed capital spending plans by our customers due to the recent economicdownturn.

             Revenuefor the first nine months of fiscal 2001 was $62.7 million compared to $68.4million for the same period in the prior fiscal year, representing a decreaseof 8%.  Sales of FPD productsrepresented $36.5 million, or 58% of revenue, for the first nine months offiscal 2001 compared to $45.4 million, or 66% of revenue, for the same periodin the prior fiscal year.  This decreasein revenue was primarily attributable to the delayed capital spending plans byour FPD customers due to the recent economic downturn.  Sales of semiconductor inspection productsrepresented $14.0 million, or 22% of revenue, for the first nine months offiscal 2001 compared to $12.7 million, or 19% of revenue, for the same periodin the prior fiscal year.  Sales of CRTdisplay and glass inspection products represented $12.2 million, or 20% ofrevenue, for the first nine months of fiscal 2001 compared to $10.3 million, or15% of revenue, for the same period in the prior fiscal year.  The increase in revenue for these two marketsegments was primarily attributable to the number of units sold due toincreased capital spending by CRT, PCB assembly and advanced semiconductorpackaging manufacturers during the first three months of fiscal 2001.

*             GrossMargin*.  Gross margins were 36% for the three-monthperiod ended June 30, 2001 compared to 47% for the same period in the priorfiscal year.  Gross margins from FPDproducts decreased to 29% for the three-month period ended June 30, 2001 from48% for the same period in the prior fiscal year.  This decrease was attributable to decreased capacity utilizationresulting from the lower production volume of FPD products.  Gross margins from semiconductor inspectionproducts decreased to 44% for the three-month period ended June 30, 2001 from 45%for the same period in the prior fiscal year. This decrease was attributable to increased customer support costsassociated with the increase in the installed base of semiconductor inspectionproducts.  Gross margins from CRTdisplay and glass inspection products were 41% for both three-month periodsended June 30, 2001 and 2000.

             Grossmargins were 43% for the nine-month period ended June 30, 2001 compared to 46%for the same period in the prior fiscal year. Gross margins from FPD products decreased to 45% for the first ninemonths of fiscal 2001 from 47% for the same period in the prior fiscalyear.  This decrease was attributable todecreased capacity utilization resulting from the lower production volume ofFPD products during the three-month period ended June 30, 2001 which was offsetby the mix of higher margin products sold during the first half of fiscal 2001as compared to the same period in the prior fiscal year.  Gross margins from semiconductor inspectionproducts decreased to 44% for the first nine months of fiscal 2001 from 46% forthe same period in the prior fiscal year. This decrease was attributable to increased customer support costsassociated with the increase in the installed base of semiconductor inspectionproducts.  Gross margins from CRTdisplay and glass inspection products decreased to 38% for the first ninemonths of fiscal 2001 from 42% for the same period in the prior fiscalyear.  This decrease was primarilyattributable to an OEM shipment during the first three months of fiscal 2001having a lower gross margin than typical product shipments.  Overall gross margins will fluctuate on aquarterly basis due to production volume, product mix and other factors.*             Research and Development*. Research and development expenses were $3.8 million and $12.9 millionfor the three- and nine-month periods ended June 30, 2001, respectively,compared to $3.9 million and $9.6 million for the same periods in the priorfiscal year.  As a percentage ofrevenue, research and development expenses were 31% and 21% for the three- andnine-month periods ended June 30, 2001, respectively, compared to 15% and 14%for the same periods in the prior fiscal year. The decrease in research and development expenses for the three-monthperiod ended June 30, 2001 was primarily attributable to reduced incentivecompensation expenses in the FPD and CRT display and glass segments as a resultof the recent economic downturn.  Theincrease in research and development expenses for the first nine months offiscal 2001 was primarily the result of expenses for new FPD productdevelopment and enhancements to existing FPD products in addition to increasedexpenses related to new product development for semiconductor and CRT displayand glass inspection products during the first half of fiscal 2001.
*             Selling,General and Administrative*.  Selling, general and administrative expenseswere $3.9 million and $13.3 million for the three- and nine-month periods endedJune 30, 2001, respectively, compared to $4.4 million and $12.2 million for thesame periods in the prior fiscal year. As a percentage of revenue, selling, general and administrative expenseswere 32% and 21% for the three- and nine-month periods ended June 30, 2001,respectively, compared to 17% and 18% for the same periods in the prior fiscalyear.  The decrease in selling, generaland administrative expenses for the three-month period ended June 30, 2001 isprimarily attributable to lower compensation related expenses and spending as aresult of decreased sales of FPD products. The increase in selling, general and administrative expenses for thefirst nine months of fiscal 2001 was primarily attributable to higher sellingexpenses and to the investment in additional personnel to support the growth insemiconductor inspection products.

*             Non-RecurringAcquisition Charges*.  In December 2000, we acquired ImageProcessing Systems Inc. in exchange for approximately 1,139,000 shares ofcommon stock.  We accounted for thetransaction as a pooling of interests and incurred $2.3 million in acquisitionrelated charges consisting of legal, accounting and integration fees.

             InNovember 1999, we acquired CR Technology, Inc. in exchange for approximately1,835,000 shares of common stock.  Weaccounted for the transaction as a pooling of interests and incurred $860,000in acquisition related charges consisting of legal, accounting and investmentbanking fees.

*             InterestIncome and Other, Net*.  Interest income and other, net was $1.1million and $4.3 million for the three- and nine-month periods ended June 30,2001, respectively, compared to $1.6 million and $2.5 million for the sameperiods in the prior fiscal year.  Thedecrease for the three-month period ended June 30, 2001 was primarilyattributable to decreased  interestincome as a result of lower interest rates on cash and investment balancesoffset in part by higher average cash and investment balances.  The increase for the first nine months offiscal 2001 was primarily attributable to interest income on higher averagecash and investment balances as a result of the net proceeds from a publicoffering in February 2000 and cash flows from operations since that date.

*             Provisionfor Income Taxes*.  The effective tax rate for the three- andnine-month periods ended June 30, 2001 was (11)% and 15%, respectively,compared to an effective tax rate of 19% for both periods in the prior fiscalyear.  The effective tax rate in allperiods was lower than the statutory rate due to the utilization of netoperating losses and credit carryforwards.**Liquidity and Capital Resources
             Wehave financed our growth primarily through a combination of cash flows fromoperations, public stock offerings, lines of credit and loans.  Working capital was $120.0 million as ofJune 30, 2001 compared to $126.0 million as of September 30, 2000.  A major component of working capital was$101.8 million of cash, cash equivalents and short-term investments as of June30, 2001 compared to $102.7 million as of September 30, 2000.

*             OperatingActivities.*  Cash provided by operating activities was$9.1 million for the nine-month period ended June 30, 2001 compared to $4.2million for the same period in the prior fiscal year.  The increase in cash provided by operating activities wasprimarily due to decreases in accounts receivable and inventories offset inpart by decreases in accounts payable and other current liabilities.

*             InvestingActivities*.  Cash used in investing activities was $9.9million for the nine-month period ended June 30, 2001 compared to cash used ininvesting activities of $41.7 million for the same period in the prior fiscalyear.  The cash used during thenine-month period ended June 30, 2000 was primarily due to the investment ofnet proceeds from the Company’s public offering in February 2000.  Capital expenditures were $10.9 million forthe nine-month period ended June 30, 2001 compared to $1.2 million for the sameperiod in the prior fiscal year.  InMarch 2001, we purchased a new 22,000 square foot facility in San Jose,California for $6.0 million.  Theremaining capital expenditures during the nine-month period ended June 30, 2001were primarily for internal test and repair equipment.

*             FinancingActivities*.  Cash provided by financing activities was$1.0 million for the nine-month period ended June 30, 2001 compared to $87.6million for the same period in the prior fiscal year.  The cash provided during the nine-month period ended June 30,2000 was primarily attributable to a public offering of 2,000,000 shares of ourcommon stock in which we sold approximately 1,321,000 shares for proceeds ofapproximately $68.0 million, net of issuance costs, in February 2000.  In March 2000, we received additionalproceeds of approximately $15.6 million as a result of the underwritersexercising their over-allotment option.

             Wehave a borrowing capacity of $4.0 million available under a bank line ofcredit, secured by substantially all of our assets, that expires in March2002.  Our wholly-owned subsidiary, CRTechnology, has an unsecured borrowing capacity of $1.5 million under a bankline of credit that expires in February 2003. Both credit facilities bear interest at the bank’s prime rate.  Our wholly-owned subsidiary, IPS, has aborrowing capacity of $1.2 million available under a bank line of creditsecured by substantially all of IPS’s assets and bearing interest at theCanadian prime rate plus 3 percent.  AtJune 30, 2001, no amounts were outstanding under the lines of credit, and wewere in compliance with all bank covenants.

             Webelieve that existing liquid capital resources and funds generated from operationscombined with the ability, if necessary, to borrow funds will be sufficient tomeet our operating and capital requirements and obligations for at least thenext twelve months.  We believe thatsuccess in our industry requires substantial capital in order to maintain theflexibility to take advantage of opportunities as they may arise.  We may, from time to time, invest in oracquire complementary businesses, products or technologies and may seekadditional equity or debt financing to fund such activities.  There can be no assurance that such fundingwill be available to us on commercially reasonable terms.  The sale of additional equity or convertibledebt could result in dilution to our shareholders.

**Factors Affecting Operating Results**

**Fluctuations in Operating Results**

             Wehave experienced and expect to continue to experience significant fluctuationsin our quarterly results.  Our backlogat the beginning of each quarter does not necessarily determine actual salesfor any succeeding period.  A substantialpercentage of our revenue is derived from the sale of a small number of yieldmanagement systems ranging in price from $250,000 to $1.5 million.  Therefore, the timing of the sale of asingle system could have a significant impact on our quarterly results.  Moreover, customers may cancel or rescheduleshipments, and production difficulties could delay shipments.  Other factors that may influence ouroperating results in a particular quarter include:

•       the downturn in capital spending by ourcustomers as a result of the recent economic slowdown;•       the timing of the receipt oforders from major customers;•       product mix;•       competitive pricing pressures;•       condition of the financial marketsand economic stability in Asia;•       the relative proportions ofdomestic and international sales;•       our ability to design, manufactureand introduce new products on a cost-effective and timely basis;•       the delay between incurringexpenses to further develop marketing and service capabilities and therealization of        benefits from those improvedcapabilities;•       the introduction of new productsby our competitors; and•       the adoption of SAB 101.

**Customer Concentration**

             TheFPD industry is extremely concentrated with a small number of manufacturersproducing the majority of the world’s FPDs. Sales of FPD products represented 58% and 66% of our revenue for thenine-month period ended June 30, 2001 and fiscal 2000, respectively.  Ishikawajima-Harima Heavy Industries Co.,Ltd. (“IHI”) and Quanta, both of whom are customers of our FPD products, and LGElectronics and Samsung, both of whom are customers of our FPD and CRT displayand glass inspection products, accounted for 55% of revenue for the nine-monthperiod ended June 30, 2001.  Hyundai andUnipac, both of whom are customers of our FPD products, and LG Electronics andSamsung, both of whom are customers of our FPD and CRT display and glassinspection products, accounted for 58% of revenue in fiscal 2000.  If one or more of our major customers ceasedor significantly curtailed their purchases, our results of operations would beharmed.

**Flat Panel Display Industry Volatility**

             Ourbusiness depends in large part upon capital expenditures by FPD manufacturers,which in turn depend on the current and anticipated market demand for FPDs andproducts that use FPDs.  The FPDindustry is highly cyclical and has experienced periods of oversupply resultingin significantly reduced demand for capital equipment.  There can be no assurance that the FPDindustry will not experience further downturns or slowdowns in the future,which may harm our business and operating results.  In addition, the need to invest in the engineering, research anddevelopment and marketing required to penetrate targeted foreign markets andmaintain extensive service and support capabilities limits our ability toreduce expenses during such downturns.

**International Operations**

             Salesto Japan, Taiwan, Korea and China accounted for 73% and 75% of our revenue forthe nine-month period ended June 30, 2001 and fiscal 2000, respectively.  We expect sales to these countries tocontinue to represent a significant percentage of revenue.  A number of factors may harm ourinternational sales and operations, including:

•       imposition of governmental controls;•       fluctuations in the U.S. dollar,which could increase the foreign sales prices of our products in localcurrencies;•       export license requirements;•       restrictions on the export oftechnology;•       political instability;•       trade restrictions;•       changes in tariffs; and•       difficulties in staffing andmanaging international operations.

             In1998, many Asian countries experienced an economic recession that resulted in adecline in the purchasing power of our Asian customers.  A future downturn in economic conditions inAsia could result in our customers failing to place new orders for ourproducts.  In addition, the laws of someforeign countries may not protect our intellectual property rights to the sameextent as U.S. laws.**Key Suppliers
             Weobtain some of the components for our systems from a single source or a limitedgroup of suppliers.  For example, wecurrently obtain materials handling platforms, ultra high-resolution camerasand high-speed image processing systems for our FPD products from single sourcesuppliers.  We also currently obtainX-ray sources for our PCB assembly and advanced semiconductor packagingproducts from limited source suppliers. Although we seek to reduce dependence on our sole and limited sourcesuppliers, alternative sources of supply for these components may not beavailable on favorable terms or at all. The loss of one or more sole or limited source suppliers could harm ourresults of operations and damage customer relationships.  Furthermore, a significant increase in theprice of one or more of these components could harm our results of operations.

**Japanese Market and Competition**

             Webelieve that competing Japanese companies in the FPD industry have acompetitive advantage in Japan because of the preference of some Japanesecustomers for local equipment suppliers. Historically, foreign companies have found it difficult to penetrate theJapanese market and often depend upon local sales channels to sell theirproducts in Japan.  Since June 1997, wehave depended on IHI as our exclusive value-added reseller to sell our FPDproducts in Japan.  For the nine-monthperiod ended June 30, 2001 and fiscal 2000, 14% and 6% of our revenue came fromsales to IHI, respectively.  If IHIreduced the resources allocated to the customization, sale and support of ourFPD products in Japan, our business would be harmed.

             Inaddition, IHI’s rights to continue as our exclusive value-added reseller inJapan are currently unresolved.  IHI mayhave the right to market some or all of our FPD products in Japan on anexclusive basis, even as to us.  If so,we may not be able to compete effectively in Japan.  Although IHI must purchase some critical components from us, IHImay manufacture competing array test systems based on our technology.  If this occurs, our business could beharmed.

             Wehave granted IHI the non-exclusive right to manufacture and sell array testsystems based on our technology, excluding technology incorporated into somecritical components, in Korea, Taiwan and several other countries.  Although IHI has never manufactured theseproducts, nor sold these products in countries other than Japan, our businesscould be harmed if IHI manufactures and sells array test systems in competitionwith our own in these countries.

**Competition**

             TheFPD, CRT and PCB assembly and advanced semiconductor packaging industries arehighly competitive.  We face substantialcompetition from established competitors that have greater financial,engineering and manufacturing resources than we do and have larger serviceorganizations and long-standing customer relationships.  Our competitors can be expected to continueto improve the design and performance of their products and to introduce newproducts with competitive price/performance characteristics.  Competitive pressures may force pricereductions that could harm our results of operations.  Our customers may also develop technology and equipment that mayreduce or eliminate their need to purchase our products.  Although we believe we have certaintechnological and other advantages over our competitors, maintaining andcapitalizing on these advantages will require us to continue maintaining a highlevel of investment in engineering, research and development, marketing andcustomer service support. There can be no assurance that we will have sufficientresources to continue to make these investments or that we will be able to makethe technological advances necessary to maintain such competitive advantages.

**New Products andProcesses**

             Webelieve that our future success will depend in part upon our ability tocontinue to enhance our existing products and to develop and manufacture newproducts.  For example, the size of FPDsubstrates and resolution of FPDs have changed frequently and may continue tochange thus requiring us to redesign or reconfigure our FPD products.  Similarly, as semiconductors, PCBs,semiconductor packaging and CRT display technologies have become more complex,our wholly owned subsidiaries, CR Technology and IPS, have been forced tocontinually redefine their product offerings. In addition, a substantial portion of our revenue is derived from salesof products based upon active matrix liquid crystal display (“AMLCD”)technology.  An industry shift away fromAMLCD technology to existing or new competing technologies could reduce thedemand for our products and harm our business.

             Asa result, we expect to continue to make a significant investment inengineering, research and development. There can be no assurance that we will be successful in theintroduction, marketing and cost effective manufacture of any of our newproducts; that we will be able to timely develop and introduce new products andenhance our existing products and processes to satisfy customer needs orachieve market acceptance; or that the new markets for which we are developingnew products or expect to sell current products will develop sufficiently.  To develop new products successfully, wedepend on close relationships with our customers and the willingness of thosecustomers to share information with us. The failure to develop products and introduce them successfully and in atimely manner could harm our competitive position and results of operations.

**Key Employees**

             Ourfuture success depends in part upon our ability to retain key personnel,particularly senior management and engineers. We also need to attract additional skilled personnel in all areas of ourbusiness to grow.  There can be noassurance that we will be able to retain our existing personnel or attractadditional qualified employees in the future. Other than Kenneth Wawrew, Vice President of Photon Dynamics andPresident, CRT Display and Glass Division, we generally do not have employmentcontracts with and do not maintain key person life insurance on any of our keyemployees.

**Acquisitions**

             Wehave recently acquired Intelligent Reasoning Systems Inc. (“IRSI”), and we maypursue additional acquisitions of complementary product lines, technologies orbusinesses.  Acquisitions may result inpotentially dilutive issuances of equity securities, incurrence of debt andcontingent liabilities and amortization expenses related to goodwill and otherintangible assets, which could harm our profitability.  In addition, current acquisitions such asIRSI or future acquisitions involve numerous risks, including the assumption ofunknown liabilities, difficulties in the assimilation of the operations,technologies and products of the acquired company, the diversion ofmanagement’s attention from other business concerns, risks of entering marketsin which we have no or limited direct prior experience, and the potential lossof key employees of the acquired company. There can be no assurance that we will be able to successfully integrateIRSI or accurately predict the effect of future acquisitions on our business oroperating results.

**Intellectual Property and Infringement**

             Oursuccess depends in large part upon our intellectual property.  While we attempt to protect our intellectualproperty through patents, copyrights and trade secrets, there can be noassurance that we will successfully protect our technology or that competitorswill not be able to develop similar technology independently.  No assurance can be given that the claimsallowed on any patents held by us will be sufficiently broad to protect ourtechnology.  In addition, no assurancecan be given that any patents issued to us will not be challenged, invalidatedor circumvented or that the rights granted thereunder will provide competitiveadvantages to us.  Litigation may benecessary in the future to enforce our patents and other intellectual propertyrights, to protect our trade secrets or to determine the validity and scope ofthe proprietary rights of others.  Evenif successful, litigation could be expensive and divert important managementresources.  If our intellectual propertywere not properly protected, our business could be harmed.

**Regional ElectricShortages**

             Recently,California has been experiencing an electric power supply shortage that hasresulted in the intermittent loss of power in some areas in the form of rollingblackouts.  While we have notexperienced any power failures to date, a blackout may affect our ability tomanufacture products and meet scheduled deliveries.  If blackouts were to interrupt our power supply, we would betemporarily unable to continue operations at some of our facilities.  Any such interruption in our ability tocontinue operations at our facilities could damage our reputation, harm ourability to retain existing customers and to obtain new customers, and couldresult in lost revenue, any of which could harm our business and results ofoperations.

**Environmental Regulations**

             Someof our PCB assembly and advanced semiconductor packaging products are subjectto regulation by the U.S. Food and Drug Administration, the CaliforniaDepartment of Public Health and other agencies in each jurisdiction where theseproducts are sold or used.  Compliancewith these regulations is time-consuming and expensive and may delay or evenprevent sales in the U.S. or other jurisdictions.  If we fail to comply with these regulations, we could face finesor penalties, and sales of our products could be prohibited.  These fines, penalties and prohibitionscould harm our business.

             Weare also subject to federal, state and local regulations related to the use,storage, discharge, handling, emission, generation, manufacture and disposal oftoxic or other hazardous substances used in our manufacturing process.  Failure to comply with current or futureregulations could result in substantial fines being imposed on us, suspensionof production, alteration of our manufacturing processes or cessation ofoperations.  New environmentalregulations could also require us to purchase expensive equipment or incur othersignificant expenses to ensure compliance. Unanticipated environmental compliance costs could harm our business.

**Common Stock Price Volatility**

             Themarket price of our common stock could fluctuate significantly in response tovariations in quarterly operating results and other factors, such as:

•       announcements of technologicalinnovations or new products by us or by our competitors;•       government regulations;•       developments in patent or otherproperty rights; and•       developments in our relationshipswith our customers.

             Inaddition, the stock market has in recent years experienced significant pricefluctuations.  These fluctuations oftenhave been unrelated to the operating performance of the specific companieswhose stock is traded.  Broad marketfluctuations, general economic condition and specific conditions in the FPD,CRT and PCB assembly and advanced semiconductor packaging industries mayadversely affect the market price of our common stock.

**Impact of Accounting Pronouncements**

             InJune 2000, the Securities and Exchange Commission (“SEC”) issued StaffAccounting Bulletin No. 101B,*SecondAmendment: Revenue Recognition in Financial Statements* (“SAB101B”).  SAB 101B amends StaffAccounting Bulletin No. 101, *RevenueRecognition in Financial Statements* (“SAB 101”), to defer theimplementation date of SAB 101 for registrants until no later than the fourthfiscal quarter of fiscal years beginning after December 15, 1999.  SAB 101 summarizes certain views of the SECin applying generally accepted accounting principles to revenue recognition infinancial statements.  We are requiredto adopt SAB 101 in the fourth quarter of our fiscal year ending September 30,2001.  Accordingly, any revenuesreported prior to October 1, 2000 and revenue reported for the first threequarters of fiscal 2001 that do not meet SAB 101’s guidance will be deferredand recorded as revenue in whatever future periods SAB 101 guidance ismet.  Changes in our revenue recognitionpolicy resulting from the interpretation and implementation of SAB 101 wouldnot involve the restatement of prior fiscal year statements, but would, to theextent applicable, be reported as a change in accounting principle with acumulative catch up adjustment as of October 1, 2000 in the fiscal year endingSeptember 30, 2001, with the appropriate restatement of interim periods asrequired by FASB Statement No. 3, *ReportingAccounting Changes in Interim Financial Statements*.  Our reported results of operations for the12 months ending September 30, 2001 will include a cumulative adjustment forall prior annual and interim periods as if SAB 101 had been adopted on October1, 2000.  While we believe that theadoption of SAB 101 will have an impact on our reported results of operations,we believe that SAB 101 will not affect the underlying strength or weakness ofour business operations as measured by the dollar value of our productshipments and cash flows.

**Item 3.         *Quantitative and Qualitative Disclosures about MarketRisk***

**ForeignCurrency Exchange Rate Risk**

**                    **As of June 30, 2001 the current foreign exchange exposurein all international operations is deemed to be immaterial. We believe theimpact of a 10% change in exchange rates would not be material to our financialcondition and results of operations. Accordingly, we do not use derivativefinancial investments to hedge our current foreign exchange exposure.

**MarketRisk**

**                    **As of June 30, 2001, our exposure to market risk forchanges in interest rates relates primarily to our short-term investmentportfolio. We do not have derivative financial instruments in our portfolio. Webelieve that a sudden change in interest rates would not be material to thevalue of our short-term investment portfolio.

**PART II.  OTHER INFORMATION**

**Item 1.         *LegalProceedings***

             Photon Dynamics and certain of itsdirectors and officers have been named as defendants in a lawsuit captionedAmtower v. Photon Dynamics, Inc., No. CV797876, filed on April 30, 2001 in theSuperior Court of the State of California, County of Santa Clara.  The plaintiff in this action has purportedto assert several causes of action under state law arising out of the allegedmisrepresentation and enforcement of the Company's insider trading policy andis seeking damages of approximately $17.7 million.  While Photon Dynamics intends to vigorously contest this action,we cannot predict the outcome of this litigation.  We believe that an adverse determination in this litigation wouldnot have a material adverse effect on our financial condition or results ofoperation.

**Item 2.**         ***Changes in Securities and Use of Proceeds***

             EffectiveJuly 16, 2001, we issued a total of 635,918 shares of our common stock to 53preferred shareholders of Intelligent Reasoning Systems Inc. (“IRSI”) inconnection with our acquisition of IRSI in a stock-for-stock merger.  In addition, we issued a total of 63,092shares to one former creditor of IRSI, who received these shares asconsideration for the repayment of $1,688,242 of outstanding debt of IRSI.  We also issued a warrant to purchase 28,766shares of our common stock at an exercise price of $54.23 per share to onewarrant holder of IRSI as a replacement warrant for an IRSI warrant assumed inthe acquisition.  The shares of commonstock and warrant were issued in reliance upon Rule 506 of Regulation D underthe Securities Act of 1933, as amended, in that all of the entities thatreceived our common stock and warrant, with the exception of only two of theshareholders of IRSI, were “accredited investors” as defined in Regulation D.

**Item 3.**         ***Defaults Upon Senior Securities***

             Not applicable.

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

             Not applicable.

**Item 5.**         ***Other Information***

             Not applicable.

**Item 6.         *Exhibits andReports on Form 8-K***

**(a)**      **Exhibits**
**Number****Exhibit**4.1(1)Restated  Articles of Incorporation, as amended, of Registrant.4.2(2)Bylaws  of Registrant.4.3(3)Certificate  of Determination.  Key to Exhibits:(1)Incorporated  by reference to the exhibit so designated of Registrant's Registration  Statement on Form SB-2 filed with the Securities and Exchange Commission  ("SEC") on November 15, 1995.(2)Incorporated  by reference to Exhibit 3.2 of Registrant's Form 10-KSB filed with the SEC on  December 18, 1998.(3)Incorporated  by reference to Exhibit 4.1 of Registrant’s Current Report on Form 8-K filed  with the SEC on December 29, 2000.
**(b)**      **Form 8-K**

None.

SIGNATURES

             Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.
 PHOTON  DYNAMICS, INC.     By:  /s/   RICHARD L. DISSLY  Richard  L. Dissly Chief  Financial Officer and Secretary   Dated:  August 10, 2001
 

**EXHIBIT INDEX**
**Number****Exhibit**4.1(1)Restated  Articles of Incorporation, as amended, of Registrant.4.2(2)Bylaws  of Registrant.4.3(3)Certificate  of Determination.  
 
Key  to Exhibits:(1)Incorporated  by reference to the exhibit so designated of Registrant's Registration  Statement on Form SB-2 filed with the Securities and Exchange Commission  ("SEC") on November 15, 1995.(2)Incorporated  by reference to Exhibit 3.2 of Registrant's Form 10-KSB filed with the SEC on  December 18, 1998.(3)Incorporated  by reference to Exhibit 4.1 of Registrant’s Current Report on Form 8-K filed  with the SEC on December 29, 2000.
 ********