##### 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, 2007
 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
  o þ




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##### 



INDEX
 PagePART I FINANCIAL INFORMATIONItem 1
    
    Financial Statements (unaudited)

    
    3Condensed Consolidated Balance Sheets as of December 31, 2007 and September 30, 2007

    
    3Condensed Consolidated Statements of Operations for the Three Months Ended December
31, 2007 and 2006

    
    4Condensed Consolidated Statements of Cash Flows for the Three Months Ended December
31, 2007 and 2006

    
    5Notes to Condensed Consolidated Financial Statements

    
    6Item 2
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations

    
    20Item 3
    
    Quantitative and Qualitative Disclosures About Market Risk

    
    35Item 4
    
    Controls and Procedures

    
    36PART II OTHER INFORMATIONItem 1
    
    Legal Proceedings

    
    38Item 1A
    
    Risk Factors

    
    38Item 2
    
    Unregistered Sales of Equity Securities and Use of Proceeds

    
    38Item 3
    
    Defaults Upon Senior Securities

    
    38Item 4
    
    Submission of Matters to a Vote of Security Holders

    
    39Item 5
    
    Other Information

    
    39Item 6
    
    Exhibits

    
    39Signatures
    
    
    
    
    40EXHIBIT 10.51EXHIBIT 10.52EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1
  2




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PART I. FINANCIAL INFORMATION
 
 ITEM 1. Financial Statements
 PHOTON DYNAMICS, INC.
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (Unaudited)
 December 31,
    
    
    September 30,2007
    
    
    2007(in thousands)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    40,267
    
    
    $
    41,170Short-term investments
    
    
    30,242
    
    
    
    42,640Accounts receivable, net of allowance for doubtful accounts of $54 and
$239 at December 31, 2007 and September 30, 2007, respectively
    
    
    13,421
    
    
    
    11,934Inventories
    
    
    18,112
    
    
    
    13,292Refundable customs obligations
    
    
    560
    
    
    
    560Other current assets
    
    
    3,795
    
    
    
    3,661Total current assets
    
    
    106,397
    
    
    
    113,257Long-term investments
    
    
    
    
    
    
    1,176Land, property and equipment, net
    
    
    10,166
    
    
    
    10,583Other assets
    
    
    5,672
    
    
    
    5,365Intangible assets, net
    
    
    10,132
    
    
    
    11,023Goodwill
    
    
    6,857
    
    
    
    6,857Total assets
    
    $
    139,224
    
    
    $
    148,261LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    10,128
    
    
    $
    4,217Warranty
    
    
    2,675
    
    
    
    3,217Employee note payable
    
    
    2,781
    
    
    
    Customs obligations
    
    
    1,433
    
    
    
    4,114Other current liabilities
    
    
    7,402
    
    
    
    9,874Deferred gross margin
    
    
    2,184
    
    
    
    3,236Total current liabilities
    
    
    26,603
    
    
    
    24,658Long-term employee note payable
    
    
    2,667
    
    
    
    5,381Other non-current liabilities
    
    
    10
    
    
    
    38Total non-current liabilities
    
    
    2,677
    
    
    
    5,419Commitments and contingenciesShareholders equity:Common stock, no par value
    
    
    300,635
    
    
    
    300,290Accumulated deficit
    
    
    (190,091
    )
    
    
    (181,503
    )Accumulated other comprehensive loss
    
    
    (600
    )
    
    
    (603
    )Total shareholders equity
    
    
    109,944
    
    
    
    118,184Total liabilities and shareholders equity
    
    $
    139,224
    
    
    $
    148,261
  3




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PHOTON DYNAMICS, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 (Unaudited)
 Three Months EndedDecember 31,2007
    
    
    2006(in thousands,except per share data)Revenue
    
    $
    16,176
    
    
    $
    21,435Cost of revenue
    
    
    11,725
    
    
    
    15,950Gross margin
    
    
    4,451
    
    
    
    5,485Operating expenses:Research and development
    
    
    5,216
    
    
    
    7,936Selling, general and administrative
    
    
    7,321
    
    
    
    4,882Restructuring charge
    
    
    
    
    
    
    446Gain on sale of property and equipment
    
    
    (50
    )
    
    
    Amortization of intangible assets
    
    
    891
    
    
    
    373Total operating expenses
    
    
    13,378
    
    
    
    13,637Loss from operations
    
    
    (8,927
    )
    
    
    (8,152
    )Interest income and other, net
    
    
    845
    
    
    
    1,014Loss before income taxes
    
    
    (8,082
    )
    
    
    (7,138
    )Provision for income taxes
    
    
    141
    
    
    
    101Net loss
    
    $
    (8,223
    )
    
    $
    (7,239
    )Net loss per share:Basic
    
    $
    (0.46
    )
    
    $
    (0.44
    )Diluted
    
    $
    (0.46
    )
    
    $
    (0.44
    )Weighted average number of shares:Basic
    
    
    17,741
    
    
    
    16,590Diluted
    
    
    17,741
    
    
    
    16,590
  4




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PHOTON DYNAMICS, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (Unaudited)
 Three Months EndedDecember 31,2007
    
    
    2006(in thousands)Cash flows from operating activities:Net loss
    
    $
    (8,223
    )
    
    $
    (7,239
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation
    
    
    809
    
    
    
    1,217Amortization of intangible assets
    
    
    891
    
    
    
    373Stock-based compensation
    
    
    299
    
    
    
    352Restructuring charge
    
    
    
    
    
    
    273Gain on sale of property and equipment
    
    
    (50
    )
    
    
    Accretion of non-interest bearing notes payable
    
    
    
    
    
    
    8Changes in operating assets and liabilities:Accounts receivable
    
    
    (1,487
    )
    
    
    11,286Inventories
    
    
    (4,776
    )
    
    
    (6,435
    )Other current assets
    
    
    (134
    )
    
    
    (323
    )Other assets
    
    
    (507
    )
    
    
    (839
    )Accounts payable
    
    
    5,911
    
    
    
    (619
    )Other current liabilities
    
    
    (5,966
    )
    
    
    104Deferred gross margin
    
    
    (1,052
    )
    
    
    (4,613
    )Other liabilities
    
    
    (28
    )
    
    
    (1
    )Net cash used in operating activities
    
    
    (14,313
    )
    
    
    (6,456
    )Cash flows from investing activities:Purchase of property and equipment
    
    
    (404
    )
    
    
    (687
    )Proceeds from sale of property and equipment
    
    
    250
    
    
    
    Purchase of short-term investments
    
    
    (8,698
    )
    
    
    (41,795
    )Maturities and sales of short-term investments
    
    
    22,262
    
    
    
    19,373Net cash provided by (used in) investing activities
    
    
    13,410
    
    
    
    (23,109
    )Cash flows from financing activities:Issuance of common stock
    
    
    2
    
    
    
    710Capital lease payments
    
    
    (27
    )
    
    
    (21
    )Net cash provided by (used in) financing activities
    
    
    (25
    )
    
    
    689Effect of exchange rate changes on cash and cash equivalents
    
    
    25
    
    
    
    26Net decrease in cash and cash equivalents
    
    
    (903
    )
    
    
    (28,850
    )Cash and cash equivalents at beginning of period
    
    
    41,170
    
    
    
    47,935Cash and cash equivalents at end of period
    
    $
    40,267
    
    
    $
    19,085
  5




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PHOTON DYNAMICS, INC.
 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 (Unaudited)
 NOTE 1  BASIS OF PRESENTATION
 Basis of Presentation.
   Description of Operations and Principles of Consolidation.
  Management Estimates and Assumptions.
 Revenue Recognition.
  6




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PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
      Accounting Changes
 Recent Accounting Pronouncements.
 .
 7




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PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 .
 NOTE 2  FINANCIAL STATEMENT COMPONENTS
 December 31,
    
    
    September 30,2007
    
    
    2007(in thousands)Inventories:Raw materials
    
    $
    7,434
    
    
    $
    7,465Work-in-process
    
    
    9,309
    
    
    
    4,491Finished goods
    
    
    1,369
    
    
    
    1,336Total
    
    $
    18,112
    
    
    $
    13,292Other current liabilities:Compensation
    
    $
    3,117
    
    
    $
    4,897Professional fees
    
    
    1,913
    
    
    
    2,441Other accrued expenses
    
    
    2,372
    
    
    
    2,536Total
    
    $
    7,402
    
    
    $
    9,874Deferred gross margin:Deferred system revenue
    
    $
    8,830
    
    
    $
    10,269Deferred cost of revenue
    
    
    (6,646
    )
    
    
    (7,033
    )Total
    
    $
    2,184
    
    
    $
    3,236Accumulated other comprehensive loss:Foreign currency translation adjustments
    
    $
    (530
    )
    
    $
    (543
    )Unrealized
losses on available-for-sale securities
    
    
    (70
    )
    
    
    (60
    )Total
    
    $
    (600
    )
    
    $
    (603
    )
 NOTE 3  GOODWILL AND OTHER PURCHASED INTANGIBLE ASSETS
 Goodwill
   Intangible Assets
  NonDeveloped
    
    
    Core
    
    
    Compete
    
    
    Customer
    
    
    TradeTechnology
    
    
    Technology
    
    
    Contract
    
    
    Relations
    
    
    Name
    
    
    Backlog
    
    
    Total(in thousands)Gross carrying amount at December 31, 2007
    
    $
    7,346
    
    
    $
    3,988
    
    
    $
    2,348
    
    
    $
    910
    
    
    $
    640
    
    
    $
    110
    
    
    $
    15,342Accumulated amortization
    
    
    (1,552
    )
    
    
    (2,325
    )
    
    
    (1,150
    )
    
    
    (95
    )
    
    
    (67
    )
    
    
    (21
    )
    
    
    (5,210
    )Net carrying amount at December 31, 2007
    
    $
    5,794
    
    
    $
    1,663
    
    
    $
    1,198
    
    
    $
    815
    
    
    $
    573
    
    
    $
    89
    
    
    $
    10,132
 8




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PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
  NonDeveloped
    
    
    Core
    
    
    Compete
    
    
    Customer
    
    
    TradeTechnology
    
    
    Technology
    
    
    Contract
    
    
    Relations
    
    
    Name
    
    
    Backlog
    
    
    Total(in thousands)Gross carrying amount at September 30, 2007
    
    $
    7,346
    
    
    $
    3,988
    
    
    $
    2,348
    
    
    $
    910
    
    
    $
    640
    
    
    $
    110
    
    
    $
    15,342Accumulated amortization
    
    
    (1,094
    )
    
    
    (2,111
    )
    
    
    (1,041
    )
    
    
    (38
    )
    
    
    (27
    )
    
    
    (8
    )
    
    
    (4,319
    )Net carrying amount at September 30, 2007
    
    $
    6,252
    
    
    $
    1,877
    
    
    $
    1,307
    
    
    $
    872
    
    
    $
    613
    
    
    $
    102
    
    
    $
    11,023
  NonDeveloped
    
    
    Core
    
    
    Compete
    
    
    Customer
    
    
    TradeTechnology
    
    
    Technology
    
    
    Contract
    
    
    Relations
    
    
    Name
    
    
    Backlog
    
    
    Total(in thousands)Balance as of September 30, 2007
    
    $
    6,252
    
    
    $
    1,877
    
    
    $
    1,307
    
    
    $
    872
    
    
    $
    613
    
    
    $
    102
    
    
    $
    11,023Amortization during the period
    
    
    (458
    )
    
    
    (214
    )
    
    
    (109
    )
    
    
    (57
    )
    
    
    (40
    )
    
    
    (13
    )
    
    
    (891
    )Balance as of December 31, 2007
    
    $
    5,794
    
    
    $
    1,663
    
    
    $
    1,198
    
    
    $
    815
    
    
    $
    573
    
    
    $
    89
    
    
    $
    10,132
   NOTE 4  RESTRUCTURING AND OTHER CHARGES
 November 2006 Restructure
 TM
 April 2005 Restructure
 TM
 9




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PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 NOTE 5  COMPREHENSIVE LOSS
  Three Months EndedDecember 31,2007
    
    
    2006(in thousands)Net loss
    
    $
    (8,223
    )
    
    $
    (7,239
    )Other comprehensive income (loss):Net change in unrealized gain (loss) on investments
    
    
    (10
    )
    
    
    (33
    )Change in foreign currency translation
    
    
    13
    
    
    
    (9
    )Other comprehensive income (loss)
    
    
    3
    
    
    
    (42
    )Total comprehensive loss
    
    $
    (8,220
    )
    
    $
    (7,281
    )
 NOTE 6  STOCK-BASED COMPENSATION PLANS
   Three Months EndedDecember 31,2007
    
    
    2006(in thousands)Stock-based compensation expense included in operations: :Cost of revenue
    
    $
    19
    
    
    $
    20Research and development
    
    
    52
    
    
    
    89Selling, general and administrative
    
    
    228
    
    
    
    243Total stock-based compensation expense after income taxes (1)
    
    $
    299
    
    
    $
    352Stock-based compensation expense by type of award: :Employee stock options
    
    $
    62
    
    
    $
    304Employee stock purchase plan
    
    
    
    
    
    
    104Restricted stock awards
    
    
    281
    
    
    
    5Amounts capitalized as inventory and deferred gross margin
    
    
    (44
    )
    
    
    (61
    )Total stock-based compensation expense after income taxes (1)
    
    $
    299
    
    
    $
    352
 
 (1)
    
    The income tax benefit on stock-based compensation for all periods presented was not
material. Equity Incentive and Other Programs
  The 2005 Equity Incentive Plan
 10




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PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
  2006 Non-Employee Directors Stock Incentive Plan
   Valuation and Other Assumption
  Expected Volatility
 Expected Term
 Risk-Free Interest Rate
 Expected Dividends
 Forfeitures
 11




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PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
  Three Months EndedDecember 31, 2006Stock option plan:Expected volatility
    
    
    44
    %Risk free rate
    
    
    4.6
    %Expected term (years)
    
    
    3.4Expected dividends
    
    None
   Three Months EndedDecember 31, 2006Stock purchase plan:Expected volatility
    
    
    44
    %Risk free rate
    
    
    4.7
    %Expected term (years)
    
    
    0.6Expected dividends
    
    None
   12




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PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 Equity Incentive Plan
  Awards
    
    
    
    
    
    
    Weighted-
    
    
    Weighted-Average
    
    
    AggregateAvailable
    
    
    Options
    
    
    Average
    
    
    Remaining Contract
    
    
    Intrinsic Valuefor Grant
    
    
    Outstanding
    
    
    Exercise Price
    
    
    Term (in years)
    
    
    (in thousands)Balances at September 30, 2007
    
    
    1,739,630
    
    
    
    1,245,582
    
    
    $
    19.29Plan shares expired (1)
    
    
    (93,314
    )
    
    
    
    
    
    
    Restricted stock units canceled (2)
    
    
    31,905
    
    
    
    
    
    
    
    Options canceled
    
    
    101,448
    
    
    
    (101,448
    )
    
    
    25.12Options exercised
    
    
    
    
    
    
    (520
    )
    
    
    3.31Balances at December 31, 2007
    
    
    1,779,669
    
    
    
    1,143,614
    
    
    $
    18.78
    
    
    
    5.5
    
    
    $
    75Vested and expected to vest at December 31, 2007
    
    
    
    
    
    
    961,878
    
    
    $
    19.98
    
    
    
    5.5
    
    
    $
    75Exercisable at December 31, 2007
    
    
    
    
    
    
    722,756
    
    
    $
    22.46
    
    
    
    5.4
    
    
    $
    75
 
 (1)
    
    The Companys 1995 Amended and Restated Stock Option Plan expired in November 2005. Option
shares that were available for grant at the time of cancellation and all outstanding option
shares that subsequently are cancelled or expire are no longer available for grant.(2)
    
    Any restricted stock units granted under the 2005 Equity Incentive Plan or 2006 Non-Employee
Directors Stock Incentive Plan shall be counted against the total number of shares issuable
under the Plans. Additional detail of issued restricted stock units are shown below.     Restricted Stock Units
  Weighted-AverageNumber
    
    
    Grant Dateof Shares
    
    
    Fair ValueUnvested restricted stock units at September 30, 2007
    
    
    284,196
    
    
    $
    10.43Unvested restricted stock units cancelled
    
    
    (31,905
    )
    
    $
    10.43Unvested restricted stock units at December 31, 2007
    
    
    252,291
    
    
    $
    10.43
  Employee Stock Purchase Plan
   13




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PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 NOTE 7  NET INCOME (LOSS) PER SHARE
   Three Months EndedDecember 31,2007
    
    
    2006(in thousands,except per share data)Numerator:Net loss
    
    $
    (8,223
    )
    
    $
    (7,239
    )Denominator:Weighted average shares outstanding, excluding unvested restricted stock,
for basic net income (loss) per share
    
    
    17,741
    
    
    
    16,590Effect of dilutive securities: Employee stock options and restricted stock
    
    
    
    (1)
    
    
    
    (1)Weighted average shares for diluted net income (loss) per share
    
    
    17,741
    
    
    
    16,590Earnings per share:Basic net loss per share
    
    $
    (0.46
    )
    
    $
    (0.44
    )Diluted net loss per share
    
    $
    (0.46
    )
    
    $
    (0.44
    )Potentially anti-dilutive securities
    
    
    1,170
    (2)
    
    
    1,984
    (2)
 
 (1)
    
    The effect of potentially dilutive securities from employee stock options and restricted
stock units of 263,415 and 67,696 shares of common stock for the three months ended December
31, 2007 and 2006, respectively, were not included in the computation of diluted net loss per
share as the effect is anti-dilutive.(2)
    
    These securities are excluded from the computation of diluted earnings per share because the
exercise price, including unamortized stock-based compensation net of tax benefits, was
greater than the average market price of common shares for the periods presented. As a result,
their effect would have been anti-dilutive. NOTE 8  COMMITMENTS AND CONTINGENCIES
 Purchase Agreements
   Warranty Obligations
  14




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PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
  Three Months EndedDecember 31,2007
    
    
    2006(in thousands)Beginning balance
    
    $
    3,217
    
    
    $
    8,058Estimated warranty cost of new shipments during the period
    
    
    379
    
    
    
    995Warranty costs during the period
    
    
    (1,384
    )
    
    
    (1,539
    )Changes in liability for pre-existing warranties, including expirations
    
    
    463
    
    
    
    344Ending balance
    
    $
    2,675
    
    
    $
    7,858
 TM
 Legal Proceedings
     15




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PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 NOTE 9  SEGMENT REPORTING AND GEOGRAPHIC INFORMATION
   
    
    Flat Panel Display Segment. Includes test and repair equipment used in the flat panel
display industry to collect and analyze data from the liquid crystal display production
lines and to diagnose and repair defects in the production line.
 
    
    High-Performance Digital Imaging Segment. Includes high-performance digital cameras used
in the defense, industrial and scientific/medical industries for a variety of applications.
In the defense industry, high-performance digital camera applications include targeting,
unmanned vehicle guidance, discrimination of decoy versus real targets and daytime and
nighttime surveillance. Industrial customers use high-performance digital cameras for
inspection, metrology and machine guidance. Scientific and medical industry applications
include X-ray, fluoroscopy, mammography, veterinary x-ray and semiconductor process
monitoring and non-destructive testing.
     Three MonthsEndedDecember 31,2007
    
    
    2006(in thousands)Revenue:Flat panel display segment
    
    $
    14,826
    
    
    $
    21,435High-performance digital imaging segment
    
    
    1,350
    
    
    
    Consolidated revenue
    
    $
    16,176
    
    
    $
    21,435Operating Loss:Flat panel display segment
    
    $
    7,674
    
    
    $
    7,354High-performance digital imaging segment
    
    
    1,004
    
    
    
    Total segment operating loss
    
    $
    8,678
    
    
    $
    7,354
 16




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##### Table of Contents



PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
  Three MonthsEndedDecember 31,2007
    
    
    2006(in thousands)Operating loss:Total segment operating loss
    
    $
    8,678
    
    
    $
    7,354Unallocated costs
    
    
    299
    
    
    
    352Restructuring costs
    
    
    
    
    
    
    446Gain on sale of property and equipment
    
    
    (50
    )
    
    
    Consolidated loss from operations
    
    $
    8,927
    
    
    $
    8,152
  Three MonthsEndedDecember 31,2007
    
    
    2006(in thousands)Revenue:South Korea
    
    $
    3,978
    
    
    $
    6,021Taiwan
    
    
    4,632
    
    
    
    6,162Japan
    
    
    5,872
    
    
    
    9,034China
    
    
    344
    
    
    
    218United States
    
    
    1,350
    
    
    
    Total
    
    $
    16,176
    
    
    $
    21,435
  Three MonthsEndedDecember 31,2007
    
    2006Customer A
    
    
    40
    %
    
    
    42
    %Customer B
    
    
    20
    %
    
    
    11
    %Customer C
    
    
    16
    %
    
    
    22
    %Customer D
    
    
    *
    
    
    
    14
    %
 
 *
    
    Customer accounted for less than 10% of total revenue for the period.   December 31,
    
    September 30,2007
    
    2007Customer A
    
    
    26
    %
    
    
    28
    %Customer B
    
    
    21
    %
    
    
    19
    %Customer C
    
    
    18
    %
    
    
    *Customer D
    
    
    *
    
    
    
    26
    %
 
 *
    
    Customer accounted for less than 10% of total accounts receivable.  17




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##### Table of Contents



PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
  December 31,
    
    
    September 30,2007
    
    
    2007(In thousands)United States
    
    $
    26,431
    
    
    $
    27,518South Korea
    
    
    557
    
    
    
    756Other
    
    
    167
    
    
    
    189Total
    
    $
    27,155
    
    
    $
    28,463
 NOTE 10  FINANCIAL INSTRUMENTS
     18




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##### Table of Contents



PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 NOTE 11  NOTES PAYABLE
  NOTE 12  INCOME TAXES
 Tax Provision
 Adoption of FIN 48
    19




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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: our ability to remediate material
weaknesses in our internal controls; our ability to attract and retain qualified employees;
possible further changes in our customs duty liability; possible civil and criminal liability in
connection with customs duty issues; the adoption of new technology by our existing and potential
customers; our customers response to prevailing economic and market conditions; the changing
customer investment climate, which could lead to the impairment of our assets; our ability to
successfully migrate our manufacturing operations offshore; our ability to maintain competitive
pricing; the introduction of competing products having technological and/or pricing advantages,
which would reduce the demand for our products; our ability to operate and integrate our newly
acquired subsidiary; and failure to comply with a variety of Untied States and foreign federal,
state and local laws and regulation, which could lead to the Company incurring additional
penalties, interest and other expenses. 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, 2007, contained in our Annual Report
on Form 10-K , as filed with the SEC on January 24, 2008.
 BUSINESS AND COMPANY OVERVIEW
 Our Company
  Flat Panel Display Segment
 Flat Panel Display Market
  20




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##### Table of Contents



TM TM TM TM
    Flat Panel Display Industry Trends
  21




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##### Table of Contents



High-Performance Digital Imaging Segment
 High-Performance Digital Imaging Market
      High-Performance Digital Imaging Industry Trends
   22




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##### Table of Contents



Backlog
  CRITICAL ACCOUNTING POLICIES AND ESTIMATES
     Revenue Recognition
   23




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##### Table of Contents



Allowance for Doubtful Account
   Inventories
   Warranty
  24




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##### Table of Contents



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




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##### Table of Contents



RESULTS OF OPERATIONS
 Selected Financial Data
  Three Months EndedDecember 31,2007
    
    2006Revenue
    
    
    100.0
    %
    
    
    100.0
    %Cost of revenue
    
    
    72.5
    
    
    
    74.4Gross margin
    
    
    27.5
    
    
    
    25.6Operating expenses:Research and development
    
    
    32.2
    
    
    
    37.0Selling, general and administrative
    
    
    45.3
    
    
    
    22.8Restructure charge
    
    
    
    
    
    
    2.1Gain on sale of property and equipment
    
    
    (0.3
    )
    
    
    Amortization of intangible assets
    
    
    5.5
    
    
    
    1.7Total operating expenses
    
    
    82.7
    
    
    
    63.6Loss from operations
    
    
    (55.2
    )
    
    
    (38.0
    )Interest income and other, net
    
    
    5.2
    
    
    
    4.7Loss from operations
    
    
    (50.0
    )
    
    
    (33.3
    )Provision for income taxes
    
    
    0.9
    
    
    
    0.5Net loss
    
    
    (50.9
    )%
    
    
    (33.8
    )%
   Three Months EndedDecember 31,2007
    
    
    Change
    
    
    2006(dollars in millions)South Korea
    
    $
    4.0
    
    
    
    (34
    )%
    
    $
    6.0Taiwan
    
    
    4.6
    
    
    
    (25
    )%
    
    
    6.2Japan
    
    
    5.9
    
    
    
    (35
    )%
    
    
    9.0China
    
    
    0.3
    
    
    
    58
    %
    
    
    0.2United States
    
    
    1.4
    
    
    
    n/a
    
    
    
    Total Revenue
    
    $
    16.2
    
    
    
    (25
    )%
    
    $
    21.4
  Operating Segments
  26




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##### Table of Contents



Flat Panel Display Segment
 TM TM
  Three Months EndedDecember 31,2007
    
    Change
    
    2006(dollars in millions)Revenue
    
    $
    14.8
    
    
    
    (31
    )%
    
    $
    21.4Gross margin
    
    $
    4.0
    
    
    
    (28
    )%
    
    $
    5.5Research and development
    
    $
    5.1
    
    
    
    (36
    )%
    
    $
    7.8Selling, general and administrative
    
    $
    6.4
    
    
    
    39
    %
    
    $
    4.6Amortization of intangible assets
    
    $
    0.2
    
    
    
    (52
    )%
    
    $
    0.4Operating loss
    
    $
    7.7
    
    
    
    5
    %
    
    $
    7.4
 Revenue
  ArrayChecker TM and ArraySaver TM Product Revenue. TM TM
 Three Months EndedDecember 31,2007
    
    2006Revenue by generation:Generation 6 and earlier
    
    
    26
    %
    
    
    8
    %Generation 7 and 8
    
    
    50
    %
    
    
    72
    %Revenue by product:ArrayCheckerTM
    
    
    75
    %
    
    
    64
    %ArraySaverTM
    
    
    1
    %
    
    
    15
    %
 TM TM TM
 27




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##### Table of Contents



TM TM
 TM TM
 Customer Support and Spare Parts Revenue. TM TM
 Gross Margin
 TM
 Research and Development
   Selling, General and Administrative
   Amortization of Intangible Assets
   28




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##### Table of Contents



Operating Loss
  
    
    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;
    
    The success of our strategy of using both domestic and offshore manufacturing;
    
    The success of outsourcing certain manufacturing to third-party vendors;
    
    The under-utilization of manufacturing facilities as a consequence of industry slowdown,
order cancellations or changes in delivery schedules by our customers;
    
    The unanticipated need for additional warranty charges;
    
    The level of spending required on developing new Generations of our ArrayCheckerTM
and ArraySaverTM products; and
    
    The inability to reduce our expense levels quickly in the event of market 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.
  High-Performance Digital Imaging Segment
   Three Months EndedDecember 31, 2007(dollars in millions)Revenue
    
    $
    1.4Gross margin
    
    $
    0.5Research and development
    
    $
    0.1Selling, general and administrative
    
    $
    0.7Amortization of intangible assets
    
    $
    0.7Operating loss
    
    $
    1.0
 29




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##### Table of Contents



Revenue
   Gross Margin
  Research and Development
   Selling, General and Administrative
   Amortization of Intangible Assets
   Operating Loss
  
    
    The costs of increasing marketing and customer service staff to increase market share and
support potential increased demands from new and existing customers;
    
    The additional costs in connection with inefficiencies of manufacturing newly-introduced
products;
    
    The modification, cancellation or termination of contracts and subcontracts by the U.S.
government;
    
    The unanticipated need for additional warranty charges; and
    
    The inability to reduce our expense levels quickly in the event of market 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.
 30




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##### Table of Contents



Restructuring Charge
 Three Months EndedDecember 31,2007
    
    Change
    
    2006Expense
    
    $
    0
    
    
    
    (100
    )%
    
    $
    446,000Percentage of Revenue
    
    
    0
    %
    
    
    
    
    
    
    2
    %
 TM
 Gain on Sale of Property and Equipment
 Three Months EndedDecember 31,2007
    
    Change
    
    2006Gain
    
    $
    50,000
    
    
    
    n/a
    
    
    $
    0Percentage of Revenue
    
    
    0
    %
    
    
    
    
    
    
    0
    %
  Interest Income and Other, Net
 Three Months EndedDecember 31,2007
    
    Change
    
    2006Income
    
    $
    845,000
    
    
    
    (17
    )%
    
    $1.0 millionPercentage of Revenue
    
    
    5
    %
    
    
    
    
    
    
    5
    %
  Provision for Income Taxes
 Three Months EndedDecember 31,2007
    
    Change
    
    2006Expense
    
    $
    141,000
    
    
    
    40
    %
    
    $
    101,000Percentage of Revenue
    
    
    1
    %
    
    
    
    
    
    
    1
    %
 31




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##### Table of Contents



Stock-Based Compensation
   Three Months EndedDecember 31,2007
    
    
    2006(in thousands)Stock-based compensation expense included in operations:Cost of revenue
    
    $
    19
    
    
    $
    20Research and development
    
    
    52
    
    
    
    89Selling, general and administrative
    
    
    228
    
    
    
    243Total stock-based compensation expense after income taxes (1)
    
    $
    299
    
    
    $
    352Stock-based compensation expense by type of award:Employee stock options
    
    $
    62
    
    
    $
    304Employee stock purchase plan
    
    
    
    
    
    
    104Restricted stock awards
    
    
    281
    
    
    
    5Amounts capitalized as inventory and deferred gross margin
    
    
    (44
    )
    
    
    (61
    )Net effect on net income (1)
    
    $
    299
    
    
    $
    352
 
 (1)
    
    The income tax benefit on stock-based compensation for all periods presented was not
material.   LIQUIDITY AND CAPITAL RESOURCES
  32




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##### Table of Contents



Operating Activities
  Investing Activities
  Financing Activities
    Contractual Obligations
  Payments Due by Fiscal YearContractual Obligations
    
    Total
    
    
    2008(1)
    
    
    2009
    
    
    2010
    
    
    2011
    
    
    2012
    
    
    Thereafter(In thousands)Purchase obligations
    
    $
    12,260
    
    
    $
    11,690
    
    
    $
    570
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Operating lease obligations
    
    
    9,009
    
    
    
    2,575
    
    
    
    2,881
    
    
    
    2,830
    
    
    
    723
    
    
    
    870
    
    
    $
    Notes payable, including interest
    
    
    5,600
    
    
    
    
    
    
    
    2,800
    
    
    
    2,800
    
    
    
    
    
    
    
    
    
    
    
    Capital lease obligations
    
    
    125
    
    
    
    86
    
    
    
    39
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    26,994
    
    
    $
    14,351
    
    
    $
    6,290
    
    
    $
    5,630
    
    
    $
    723
    
    
    $
    870
    
    
    $
    
 
 (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
   
    
    The absence of adequate processes for detecting noncompliance with applicable laws and
regulations and our employee code of conduct, evaluating the effect of such noncompliance
on our financial statements on a timely and accurate basis, and communicating such
noncompliance and related evaluation to our Audit Committee;
    
    The absence of adequate processes and programs in our control environment to educate
employees on our employee code of conduct and applicable laws and regulations; and
    
    Insufficient accounting and finance personnel with the knowledge and experience required
to ensure an appropriate level of review of financial statement accounts.
  Remediation of the Material Weakness That Existed as of December 31, 2007
  
    
    Review and evaluation of our internal controls, including our internal reporting
processes, to ensure that legal, regulatory and other matters that could have a significant
financial statement effect are identified and evaluated and documented by management and
escalated on a timely basis, where appropriate, to the Audit Committee.
    
    Development, with the assistance of outside advisors, of new valuation and declaration
processes to ensure compliance with all customs regulations of each of the countries into
which we import parts, including replacing manual invoices with an automated customs
commercial invoice process that requires review by legal and finance personnel.
    
    Enhanced compliance and ethics training for employees, including implementation of an
online compliance system in four languages, increasing awareness of the employee code of
conduct through mandatory training for all employees, and reinforcing the ethics policy by
requiring an annual ethics certification for all employees.
    
    With respect to personnel who were determined to have known, or who should have known,
that the Companys customs practices were non-compliant, certain of such personnel have
been terminated or have otherwise left the Company, and others, including a former
executive officer, have had their responsibilities and reporting relationships modified.
 36




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##### Table of Contents



Changes in Control Over Financial Reporting in the First Quarter of Fiscal 2008
  Inherent Limitations of Disclosure Controls and Procedures and Internal Control Over Financial
Reporting.
  37




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##### Table of Contents



PART II. OTHER INFORMATION
 
 ITEM 1. Legal Proceedings
     
 ITEM 1A. Risk Factors
  
 ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds
  
 ITEM 3. Defaults Upon Senior Securities
  38




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##### Table of Contents



ITEM 4. Submission of Matters to a Vote of Security Holders
  
 ITEM 5. Other Information
  
 ITEM 6. Exhibits
 Exhibits
  39




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##### Table of Contents



SIGNATURES
  PHOTON DYNAMICS, INC.By:
    /s/ Jeffrey A. HawthorneJeffrey A. HawthornePresident, Chief Executive Officer,
Acting Chief Financial Officer and Director
(Acting Duly authorized and principal financial officer)  40




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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 3.3.10.51
    
    Separation and Release Agreement, dated December 6, 2007, between Photon Dynamics,
Inc. and Michael Schradle.10.52
    
    Research and Business Development Agreement, dated December 1, 2007, among Photon
Dynamics, Inc., Lam Toshima Solar, LLC, Dr. Kam Law and Masato Toshima LLC.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
10-Q for the quarter ended December 31, 2005 as filed with the Securities and Exchange
Commission on February 9, 2006, and incorporated herein by reference.**
    
    The certification attached as Exhibit 32.1 accompanies the Quarterly Report on Form 10-Q
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed filed by
the Company for purposes of Section 18 of the Securities Exchange Act of 1934, as amended.