##### 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 June 30, 2006
 OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the transition period from  to
 Commission file number: 0-27234
 PHOTON DYNAMICS, INC.
 (Exact name of registrant as specified in its charter)
 California
    
    94-3007502(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)
 5970 Optical Court
San Jose, California 95138-1400  (Address of principal executive offices including zip code)
 (408) 226-9900
 (Registrants telephone number, including area code)
 þ o
  o þ o
 o þ




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##### 



INDEX
 PagePART I FINANCIAL INFORMATIONItem 1
    
    Financial Statements (unaudited)Condensed Consolidated Balance Sheets as of June 30, 2006 and September 30, 2005
    
    
    3Condensed Consolidated Statements of Operations for the Three and Nine Months Ended June
30, 2006 and 2005
    
    
    4Condensed Consolidated Statements of Cash Flows for Nine Months Ended June 30, 2006 and 2005
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    21Item 3
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    43Item 4
    
    Controls and Procedures
    
    
    44PART II OTHER INFORMATIONItem 1
    
    Legal Proceedings
    
    
    45Item 1A
    
    Risk Factors
    
    
    45Item 2
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    45Item 3
    
    Defaults Upon Senior Securities
    
    
    45Item 4
    
    Submission of Matters to a Vote of Security Holders
    
    
    45Item 5
    
    Other Information
    
    
    45Item 6
    
    Exhibits
    
    
    45Signatures
    
    
    
    
    46EXHIBIT 10.1EXHIBIT 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*
 June 30,
    
    
    September 30,2006
    
    
    2005(in thousands)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    22,483
    
    
    $
    20,288Short-term investments
    
    
    68,147
    
    
    
    72,738Accounts receivable, net of allowance for doubtful accounts of $424
and $153 at June 30, 2006 and September 30, 2005, respectively
    
    
    57,253
    
    
    
    27,067Inventories
    
    
    19,754
    
    
    
    32,545Other current assets
    
    
    4,379
    
    
    
    3,932Total current assets
    
    
    172,016
    
    
    
    156,570Land, property and equipment, net
    
    
    16,867
    
    
    
    19,366Other assets
    
    
    4,197
    
    
    
    4,390Intangible assets, net
    
    
    2,088
    
    
    
    3,205Goodwill
    
    
    153
    
    
    
    153Total assets
    
    $
    195,321
    
    
    $
    183,684LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    10,337
    
    
    $
    13,005Warranty
    
    
    5,367
    
    
    
    5,346Other current liabilities
    
    
    13,126
    
    
    
    8,618Deferred gross margin
    
    
    10,016
    
    
    
    13,113Total current liabilities
    
    
    38,846
    
    
    
    40,082Other non-current liabilities
    
    
    19
    
    
    
    1,008Commitments and contingenciesShareholders equity:Common stock, no par value
    
    
    291,554
    
    
    
    287,765Accumulated deficit
    
    
    (135,355
    )
    
    
    (145,489
    )Accumulated other comprehensive income
    
    
    257
    
    
    
    318Total shareholders equity
    
    
    156,456
    
    
    
    142,594Total liabilities and shareholders equity
    
    $
    195,321
    
    
    $
    183,684
 
 *
    
    Amounts as of June 30, 2006 are unaudited. Amounts as of September 30, 2005 are derived
from the September 30, 2005 audited financial statements.  3




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PHOTON DYNAMICS, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 Three Months Ended
    
    
    Nine Months EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005(unaudited)(in thousands, except per share data)Revenue
    
    $
    51,658
    
    
    $
    39,096
    
    
    $
    143,613
    
    
    $
    101,061Cost of revenue
    
    
    32,178
    
    
    
    25,966
    
    
    
    87,629
    
    
    
    67,515Gross margin
    
    
    19,480
    
    
    
    13,130
    
    
    
    55,984
    
    
    
    33,546Operating expenses:Research and development
    
    
    8,508
    
    
    
    8,618
    
    
    
    25,139
    
    
    
    27,906Selling, general and administrative
    
    
    6,968
    
    
    
    7,352
    
    
    
    20,803
    
    
    
    18,143Restructuring charge
    
    
    
    
    
    
    951
    
    
    
    30
    
    
    
    951Impairment of property and equipment
    
    
    50
    
    
    
    174
    
    
    
    50
    
    
    
    556Gain on sale of fixed assets
    
    
    
    
    
    
    (143
    )
    
    
    
    
    
    
    (143
    )Amortization of intangible assets
    
    
    372
    
    
    
    380
    
    
    
    1,117
    
    
    
    1,175Total operating expenses
    
    
    15,898
    
    
    
    17,332
    
    
    
    47,139
    
    
    
    48,588Income (loss) from operations
    
    
    3,582
    
    
    
    (4,202
    )
    
    
    8,845
    
    
    
    (15,042
    )Interest income and other, net
    
    
    999
    
    
    
    472
    
    
    
    2,518
    
    
    
    1,891Income (loss) from continuing operations before income taxes and
discontinued operations
    
    
    4,581
    
    
    
    (3,730
    )
    
    
    11,363
    
    
    
    (13,151
    )Provision for income taxes
    
    
    205
    
    
    
    167
    
    
    
    756
    
    
    
    565Income (loss) from continuing operations before discontinued operations
    
    
    4,376
    
    
    
    (3,897
    )
    
    
    10,607
    
    
    
    (13,716
    )Income (loss) from discontinued operations
    
    
    (127
    )
    
    
    268
    
    
    
    (473
    )
    
    
    258Net income (loss)
    
    $
    4,249
    
    
    $
    (3,629
    )
    
    $
    10,134
    
    
    $
    (13,458
    )Income (loss) per share from continuing operations:Basic
    
    $
    0.26
    
    
    $
    (0.23
    )
    
    $
    0.62
    
    
    $
    (0.81
    )Diluted
    
    $
    0.26
    
    
    $
    (0.23
    )
    
    $
    0.62
    
    
    $
    (0.81
    )Income (loss) per share from discontinued operations:Basic
    
    $
    (0.01
    )
    
    $
    0.02
    
    
    $
    (0.03
    )
    
    $
    0.02Diluted
    
    $
    (0.01
    )
    
    $
    0.02
    
    
    $
    (0.03
    )
    
    $
    0.02Net income (loss) per share:Basic
    
    $
    0.25
    
    
    $
    (0.21
    )
    
    $
    0.60
    
    
    $
    (0.79
    )Diluted
    
    $
    0.25
    
    
    $
    (0.21
    )
    
    $
    0.59
    
    
    $
    (0.79
    )Weighted average number of shares:Basic
    
    
    17,047
    
    
    
    16,984
    
    
    
    17,023
    
    
    
    16,934Diluted
    
    
    17,077
    
    
    
    16,984
    
    
    
    17,065
    
    
    
    16,934
  4




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PHOTON DYNAMICS, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 Nine Months EndedJune 30,2006
    
    
    2005(unaudited)(in thousands)Cash flows from operating activities:Income (loss) from continuing operations
    
    $
    10,607
    
    
    $
    (13,716
    )Adjustments to reconcile income (loss) from continuing operations to net cash
provided by (used in) operating activities from continuing operations:Depreciation
    
    
    4,326
    
    
    
    4,331Amortization of intangible assets
    
    
    1,117
    
    
    
    1,175Impairment of property and equipment
    
    
    50
    
    
    
    556Loss (gain) on sale of property and equipment
    
    
    
    
    
    
    (143
    )Non-cash stock-based compensation
    
    
    2,954
    
    
    
    Non-employee stock ownership expense
    
    
    14
    
    
    
    44Restructuring charge
    
    
    30
    
    
    
    171Accretion of non-interest bearing notes payable
    
    
    31
    
    
    
    53Changes in operating assets and liabilities:Accounts receivable
    
    
    (30,186
    )
    
    
    19,687Inventories
    
    
    13,084
    
    
    
    8,762Other current assets
    
    
    (622
    )
    
    
    (324
    )Other assets
    
    
    (319
    )
    
    
    109Accounts payable
    
    
    (2,589
    )
    
    
    (9,786
    )Other current liabilities
    
    
    4,109
    
    
    
    252Deferred gross margin
    
    
    (3,097
    )
    
    
    (1,281
    )Other liabilities
    
    
    (40
    )
    
    
    (66
    )Net cash provided by (used in) operating activities from continuing operations
    
    
    (531
    )
    
    
    9,824Net cash used in operating activities from discontinued operations
    
    
    (1,169
    )
    
    
    (589
    )Net cash provided by (used in) operating activities
    
    
    (1,700
    )
    
    
    9,235Cash flows from investing activities:Purchase of property and equipment
    
    
    (1,887
    )
    
    
    (5,070
    )Proceeds from disposal of property and equipment
    
    
    
    
    
    
    270Purchase of short-term investments
    
    
    (100,288
    )
    
    
    (51,481
    )Maturities and sales of short-term investments
    
    
    105,103
    
    
    
    33,678Net cash provided by (used in) investing activities from continuing operations
    
    
    2,928
    
    
    
    (22,603
    )Cash flows from financing activities:Issuance of common stock
    
    
    1,785
    
    
    
    1,756Net repayment of short-term borrowings
    
    
    (533
    )
    
    
    (532
    )Net cash provided by financing activities from continuing operations
    
    
    1,252
    
    
    
    1,224Net cash used in financing activities from discontinued operations
    
    
    
    
    
    
    (198
    )Net cash provided by financing activities
    
    
    1,252
    
    
    
    1,026Effect of exchange rate changes on cash and cash equivalents
    
    
    (285
    )
    
    
    (42
    )Net increase (decrease) in cash and cash equivalents from continuing operations
    
    
    3,364
    
    
    
    (11,597
    )Net decrease in cash and cash equivalents from discontinued operations
    
    
    (1,169
    )
    
    
    (787
    )Net increase (decrease) in cash and cash equivalents
    
    
    2,195
    
    
    
    (12,384
    )Cash and cash equivalents at beginning of period
    
    
    20,288
    
    
    
    25,483Cash and cash equivalents at end of period
    
    $
    22,483
    
    
    $
    13,099
  5




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




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




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Shipping Costs.
 Research and Development Cost.
 Interest Income.
 Variable Interest Entity
 Recent Accounting Pronouncements. .
   8




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NOTE 2  Financial Statement Components
 June 30,
    
    
    September 30,2006
    
    
    2005(in thousands)Inventories:Raw materials
    
    $
    9,933
    
    
    $
    12,476Work-in-process
    
    
    9,558
    
    
    
    19,327Finished goods
    
    
    263
    
    
    
    742Total
    
    $
    19,754
    
    
    $
    32,545Other current liabilities:Compensation
    
    $
    5,242
    
    
    $
    3,838Commissions
    
    
    346
    
    
    
    295Vendor obligations
    
    
    1,836
    
    
    
    286Professional fees
    
    
    1,284
    
    
    
    1,314Employee notes payable
    
    
    1,026
    
    
    
    490Customer deposits
    
    
    1,500
    
    
    
    Other accrued expenses
    
    
    1,892
    
    
    
    2,395Total
    
    $
    13,126
    
    
    $
    8,618Deferred gross margin:Deferred system sales
    
    $
    17,977
    
    
    $
    25,481Deferred cost of revenue related to system sales
    
    
    (7,961
    )
    
    
    (12,368
    )Total
    
    $
    10,016
    
    
    $
    13,113Accumulated other comprehensive income:Foreign currency translation adjustments
    
    $
    358
    
    
    $
    643Unrealized losses on available for sale securities
    
    
    (101
    )
    
    
    (325
    )Total
    
    $
    257
    
    
    $
    318
 NOTE 3  Discontinued Operations
 Printed Circuit Board Assembly Inspection Business
   Three Months
    
    
    Nine MonthsEnded
    
    
    EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005(in thousands)Cost of revenue
    
    $
    
    
    
    $
    5
    
    
    $
    
    
    
    $
    (127
    )Gross margin
    
    
    
    
    
    
    (5
    )
    
    
    
    
    
    
    127Operating expenses:Selling, general and administrative
    
    
    127
    
    
    
    
    
    
    
    501
    
    
    
    139Total operating expenses
    
    
    127
    
    
    
    
    
    
    
    501
    
    
    
    139Loss from discontinued operations
    
    $
    (127
    )
    
    $
    (5
    )
    
    $
    (501
    )
    
    $
    (12
    )
 9




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June 30,
    
    
    September 30,2006
    
    
    2005(in thousands)ASSETSCurrent assets:Other current assets
    
    $
    494
    
    
    $
    175Total current assets
    
    
    494
    
    
    
    175Other assets:Other non-current assets
    
    
    
    
    
    
    1,016Total assets
    
    $
    494
    
    
    $
    1,191LIABILITIESCurrent liabilities:Other current liabilities
    
    $
    534
    
    
    $
    579Total current liabilities
    
    
    534
    
    
    
    579Other liabilities:Other non-current liabilities
    
    
    
    
    
    
    42Total liabilities
    
    $
    534
    
    
    $
    621
     10




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One-TimeTerminationBenefits
    
    
    Other Costs
    
    
    Total(in thousands)Inception of liability
    
    $
    696
    
    
    $
    1,326
    
    
    $
    2,022Cash payments
    
    
    (614
    )
    
    
    (652
    )
    
    
    (1,266
    )Adjustments to the liability
    
    
    (82
    )
    
    
    (474
    )
    
    
    (556
    )Balance at September 30, 2005
    
    
    
    
    
    
    200
    
    
    
    200Cash payments
    
    
    
    
    
    
    
    
    
    
    Adjustments to the liability
    
    
    
    
    
    
    
    
    
    
    Balance at June 30, 2006
    
    $
    
    
    
    $
    200
    
    
    $
    200
  Cathode Ray Tube Display and High Quality Glass Inspection Business
   Three Months
    
    
    Nine MonthsEnded
    
    
    EndedJune 30,
    
    
    June 30,(in thousands)
    
    
    (in thousands)2006
    
    
    2005
    
    
    2006
    
    
    2005Cost of revenue
    
    $
    
    
    
    $
    (150
    )
    
    $
    (34
    )
    
    $
    (150
    )Gross margin
    
    
    
    
    
    
    150
    
    
    
    34
    
    
    
    150Operating expenses:Selling, general and administrative
    
    
    
    
    
    
    (123
    )
    
    
    7
    
    
    
    (120
    )Total operating expenses
    
    
    
    
    
    
    (123
    )
    
    
    7
    
    
    
    (120
    )Income from discontinued operations
    
    $
    
    
    
    $
    273
    
    
    $
    28
    
    
    $
    270
    June 30,
    
    
    September 30,2006
    
    
    2005(in thousands)LIABILITIESOther current liabilities:
    
    $
    27
    
    
    $
    74
   One-Time
    
    
    ContractTermination
    
    
    TerminationBenefits
    
    
    Costs
    
    
    Other Costs
    
    
    Total(in thousands)Inception of liability
    
    $
    1,116
    
    
    $
    771
    
    
    $
    11
    
    
    $
    1,898Cash payments
    
    
    (1,116
    )
    
    
    (393
    )
    
    
    (61
    )
    
    
    (1,570
    )Adjustments to the liability
    
    
    
    
    
    
    (304
    )
    
    
    50
    
    
    
    (254
    )Balance at September 30, 2005
    
    
    
    
    
    
    74
    
    
    
    
    
    
    
    74Cash payments
    
    
    
    
    
    
    (13
    )
    
    
    
    
    
    
    (13
    )Adjustments to the liability
    
    
    
    
    
    
    (34
    )
    
    
    
    
    
    
    (34
    )Balance at June 30, 2006
    
    $
    
    
    
    $
    27
    
    
    $
    
    
    
    $
    27
 11




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NOTE 4  Goodwill and Other Purchased Intangible Assets
 Goodwill
   Intangible Assets
  NonDeveloped
    
    
    Core
    
    
    License
    
    
    CompeteTechnology
    
    
    Technology
    
    
    Agreement
    
    
    Contract
    
    
    Total(in thousands)Gross carrying amount at June 30, 2006
    
    $
    1,006
    
    
    $
    2,408
    
    
    $
    1,138
    
    
    $
    968
    
    
    $
    5,520Accumulated amortization
    
    
    (515
    )
    
    
    (1,353
    )
    
    
    (853
    )
    
    
    (711
    )
    
    
    (3,432
    )Net carrying amount at June 30, 2006
    
    $
    491
    
    
    $
    1,055
    
    
    $
    285
    
    
    $
    257
    
    
    $
    2,088
  NonDeveloped
    
    
    Core
    
    
    License
    
    
    CompeteTechnology
    
    
    Technology
    
    
    Agreement
    
    
    Contract
    
    
    Total(in thousands)Gross carrying amount at September 30, 2005
    
    $
    1,006
    
    
    $
    2,408
    
    
    $
    1,138
    
    
    $
    968
    
    
    $
    5,520Accumulated amortization
    
    
    (326
    )
    
    
    (902
    )
    
    
    (568
    )
    
    
    (519
    )
    
    
    (2,315
    )Net carrying amount at September 30, 2005
    
    $
    680
    
    
    $
    1,506
    
    
    $
    570
    
    
    $
    449
    
    
    $
    3,205
  NonDeveloped
    
    
    Core
    
    
    License
    
    
    CompeteTechnology
    
    
    Technology
    
    
    Agreement
    
    
    Contract
    
    
    TotalNet carrying amount at September 30, 2005
    
    $
    680
    
    
    $
    1,506
    
    
    $
    570
    
    
    $
    449
    
    
    $
    3,205Amortization during the period
    
    
    (189
    )
    
    
    (451
    )
    
    
    (285
    )
    
    
    (192
    )
    
    
    (1,117
    )Net carrying amount at June 30, 2006
    
    $
    491
    
    
    $
    1,055
    
    
    $
    285
    
    
    $
    257
    
    
    $
    2,088
   12




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NOTE 5  Restructuring Charges
 TM
    One-Time
    
    
    ContractTermination
    
    
    TerminationBenefits
    
    
    Costs
    
    
    Total(in thousands)Inception of liability
    
    $
    430
    
    
    $
    246
    
    
    $
    676Cash payments
    
    
    (526
    )
    
    
    (21
    )
    
    
    (547
    )Costs incurred and charged to expense
    
    
    521
    
    
    
    
    
    
    
    521Adjustments to the liability
    
    
    24
    
    
    
    (166
    )
    
    
    (142
    )Balance at September 30, 2005
    
    
    449
    
    
    
    59
    
    
    
    508Cash payments
    
    
    (483
    )
    
    
    (10
    )
    
    
    (493
    )Costs incurred and charged to expense
    
    
    107
    
    
    
    
    
    
    
    107Adjustments to the liability
    
    
    (73
    )
    
    
    (4
    )
    
    
    (77
    )Balance at June 30, 2006
    
    $
    
    
    
    $
    45
    
    
    $
    45
  13




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##### Table of Contents



NOTE 6  Comprehensive Income
  Three Months Ended
    
    
    Nine Months EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005(in thousands)Net income (loss)
    
    $
    4,249
    
    
    $
    (3,629
    )
    
    $
    10,134
    
    
    $
    (13,458
    )Other comprehensive income (loss):Net change in unrealized gain (loss) on investments
    
    
    40
    
    
    
    94
    
    
    
    223
    
    
    
    (163
    )Change in foreign currency translation
    
    
    (25
    )
    
    
    (121
    )
    
    
    (284
    )
    
    
    (42
    )Other comprehensive income (loss)
    
    
    15
    
    
    
    (27
    )
    
    
    (61
    )
    
    
    (205
    )Total comprehensive income (loss)
    
    $
    4,264
    
    
    $
    (3,656
    )
    
    $
    10,073
    
    
    $
    (13,663
    )
 NOTE 7  Stock-Based Compensation
   Prior to the Adoption of SFAS No. 123R.
  Three Months Ended
    
    
    Nine Months EndedJune 30, 2005
    
    
    June 30, 2005(in thousands, except per share data)Net loss  as reported
    
    $
    (3,629
    )
    
    $
    (13,458
    )Less: total stock-based employee
compensation expense determined
under fair value based method for
all awards
    
    
    (959
    )
    
    
    (4,886
    )Net loss  pro forma
    
    $
    (4,588
    )
    
    $
    (18,344
    )Basic net loss per share  as reported
    
    $
    (0.21
    )
    
    $
    (0.79
    )Diluted net loss per share  as reported
    
    $
    (0.21
    )
    
    $
    (0.79
    )Basic net loss per share  pro forma
    
    $
    (0.27
    )
    
    $
    (1.08
    )Diluted net loss per share  pro forma
    
    $
    (0.27
    )
    
    $
    (1.08
    )
 Impact of the adoption of SFAS No. 123R
 14




---



##### Table of Contents



Three Months Ended
    
    
    Nine Months EndedJune 30, 2006
    
    
    June 30, 2006(in thousands, except per share data)Stock-based compensation expense included in continuing
operations:Cost of revenue
    
    $
    34
    
    
    $
    86Research and development
    
    
    169
    
    
    
    502Selling, general and administrative
    
    
    749
    
    
    
    2,366Total stock-based compensation expense after income taxes (1)
    
    $
    952
    
    
    $
    2,954Stock-based compensation expense by type of award:Employee stock options
    
    $
    970
    
    
    $
    2,892Employee stock purchase plan
    
    
    116
    
    
    
    355Amounts capitalized as inventory and deferred gross margin
    
    
    (134
    )
    
    
    (293
    )Net effect on net income (1)
    
    $
    952
    
    
    $
    2,954Effect on net income per share:Basic
    
    $
    0.06
    
    
    $
    0.17Diluted
    
    $
    0.06
    
    
    $
    0.17
 
 (1)
    
    The income tax benefit on stock-based compensation for all periods presented was not
material. Equity Incentive Program
  Number of SecuritiesRemaining Available forFuture Issuance UnderNumber of Securities
    
    
    
    
    
    
    Equityto be Issued upon
    
    
    Weighted-Average
    
    
    Compensation PlansExercise of
    
    
    Exercise Price of
    
    
    (Excluding SecuritiesOutstanding Options
    
    
    Outstanding Options
    
    
    Reflected in Column (a))Plan Category
    
    (a)
    
    
    (b)
    
    
    (c)Equity compensation plans approved by security holders
    
    
    2,060,735
    
    
    $
    23.31
    
    
    
    714,021Equity compensation plans not approved by security holders
    
    
    625
    
    
    $
    16.88
    
    
    
    Total
    
    
    2,061,360
    
    
    $
    23.31
    
    
    
    714,021
  Expected Volatility
 15




---



##### Table of Contents



Expected Term
 Risk-Free Interest Rate
 Expected Dividends
 Forfeitures
  Three Months Ended
    
    Nine Months EndedJune 30,
    
    June 30,2006
    
    2005
    
    2006
    
    2005Stock option plan:Expected volatility
    
    
    42
    %
    
    
    71
    %
    
    
    44
    %
    
    
    74
    %Risk free rate
    
    
    4.9
    %
    
    
    3.9
    %
    
    
    4.5
    %
    
    
    3.1
    %Expected term (in years)
    
    
    3.8
    
    
    
    4.0
    
    
    
    3.7
    
    
    
    5.4
   Weighted-
    
    
    Weighted-Average
    
    
    AggregateAvailable
    
    
    Options
    
    
    Average
    
    
    Remaining Contract
    
    
    Intrinsic Valuefor Grant
    
    
    Outstanding
    
    
    Exercise Price
    
    
    Term (in years)
    
    
    (in thousands)Balances at September 30, 2005
    
    
    1,663,308
    
    
    
    1,946,274
    
    
    $
    24.64Plan shares expired
    
    
    (763,768
    )
    
    
    
    
    
    
    Options granted
    
    
    (443,150
    )
    
    
    443,150
    
    
    
    18.83Options canceled/expired
    
    
    257,631
    
    
    
    (257,631
    )
    
    
    27.72Options exercised
    
    
    
    
    
    
    (70,433
    )
    
    
    15.10Balances at June 30, 2006
    
    
    714,021
    
    
    
    2,061,360
    
    
    $
    23.31
    
    
    7.4
    
    
    $
    246Vested and expected to vest at June 30, 2006
    
    
    
    
    
    
    1,881,801
    
    
    $
    23.71
    
    
        7.3
    
    
    $
    246Exercisable at June 30, 2006
    
    
    
    
    
    
    1,226,005
    
    
    $
    26.12
    
    
    6.8
    
    
    $
    246
  16




---



##### Table of Contents



Employee Stock Purchase Plan.
  Three Months Ended
    
    Nine Months EndedJune 30,
    
    June 30,2006
    
    2005
    
    2006
    
    2005Stock purchase plan:Expected volatility
    
    
    44
    %
    
    
    58
    %
    
    
    44
    %
    
    
    65
    %Risk free rate
    
    
    4.9
    %
    
    
    2.9
    %
    
    
    4.6
    %
    
    
    2.5
    %Expected term (in years)
    
    
    0.5
    
    
    
    1.2
    
    
    
    0.5
    
    
    
    1.3
   NOTE 8  Net Income Per Share
   Three Months Ended
    
    
    Nine Months EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005(in thousands, except per share data)Numerator:Net income (loss) from continuing operations
    
    $
    4,376
    
    
    $
    (3,897
    )
    
    $
    10,607
    
    
    $
    (13,716
    )Net income (loss) from discontinued operations
    
    
    (127
    )
    
    
    268
    
    
    
    (473
    )
    
    
    258Net income (loss)
    
    $
    4,249
    
    
    $
    (3,629
    )
    
    $
    10,134
    
    
    $
    (13,458
    )Denominator:Weighted average shares for basic net income per share
    
    
    17,047
    
    
    
    16,984
    
    
    
    17,023
    
    
    
    16,934
 17




---



##### Table of Contents



Three Months Ended
    
    
    Nine Months EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005(in thousands, except per share data)Effect of dilutive securities: Employee stock options
    
    
    29
    
    
    
    
    (1)
    
    
    42
    
    
    
    
    (1)Weighted average shares for diluted net income per share
    
    
    17,076
    
    
    
    16,984
    
    
    
    17,065
    
    
    
    16,934Earnings per share:Basic net income (loss) per share:Net income (loss) from continuing operations
    
    $
    0.26
    
    
    $
    (0.23
    )
    
    $
    0.62
    
    
    $
    (0.81
    )Net income (loss) from discontinued operations
    
    
    (0.01
    )
    
    
    0.02
    
    
    
    (0.03
    )
    
    
    0.02Net income (loss) per share
    
    $
    0.25
    
    
    $
    (0.21
    )
    
    $
    0.60
    
    
    $
    (0.79
    )Diluted net income (loss) per share:Net income (loss) from continuing operations
    
    $
    0.26
    
    
    $
    (0.23
    )
    
    $
    0.62
    
    
    $
    (0.81
    )Net income (loss) from discontinued operations
    
    
    (0.01
    )
    
    
    0.02
    
    
    
    (0.03
    )
    
    
    0.02Net income (loss) per share
    
    $
    0.25
    
    
    $
    (0.21
    )
    
    $
    0.59
    
    
    $
    (0.79
    )
 
 (1)
    
    The effect of potentially dilutive securities from employee stock options to purchase 95,096
and 132,667 shares of common stock for the three and nine months periods ended June 30, 2005
were not included in the computation of diluted net loss per share as the effect is
anti-dilutive.  NOTE 9  Commitments and Contingencies
 Purchase Agreements
  Warranty Obligations
   Nine Months EndedJune 30,2006
    
    
    2005(in thousands)Beginning balance
    
    $
    5,346
    
    
    $
    6,194Estimated warranty cost of new shipments during the period
    
    
    4,947
    
    
    
    3,975Warranty costs during the period
    
    
    (2,824
    )
    
    
    (3,556
    )Changes in liability for pre-existing warranties, including expirations
    
    
    (2,102
    )
    
    
    (279
    )Ending balance
    
    $
    5,367
    
    
    $
    6,334
 18




---



##### Table of Contents



Legal Proceedings
   NOTE 10  Geographic Information
   Three Months
    
    
    Nine MonthsEnded
    
    
    EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005(in thousands)Revenue:Korea
    
    $
    37,388
    
    
    $
    19,550
    
    
    $
    103,563
    
    
    $
    30,585Taiwan
    
    
    13,577
    
    
    
    18,420
    
    
    
    37,927
    
    
    
    40,994Japan
    
    
    693
    
    
    
    1,126
    
    
    
    2,123
    
    
    
    16,200China
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    13,282Total
    
    $
    51,658
    
    
    $
    39,096
    
    
    $
    143,613
    
    
    $
    101,061
  Three Months
    
    Nine MonthsEnded
    
    EndedJune 30,
    
    June 30,2006
    
    2005
    
    2006
    
    2005Revenue:ArrayCheckerTM
    
    
    75
    %
    
    
    71
    %
    
    
    68
    %
    
    
    63
    %ArraySaverTM
    
    
    12
    %
    
    
    21
    %
    
    
    17
    %
    
    
    27
    %PanelMasterTM
    
    
    6
    %
    
    
    
    
    
    
    7
    %
    
    
    1
    %Customer spares and other
    
    
    7
    %
    
    
    8
    %
    
    
    8
    %
    
    
    9
    %Total
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
 19




---



##### Table of Contents



Three Months
    
    Nine MonthsEnded
    
    EndedJune 30,
    
    June 30,2006
    
    2005
    
    2006
    
    2005Customer A
    
    
    52
    %
    
    
    42
    %
    
    
    44
    %
    
    
    26
    %Customer B
    
    
    20
    %
    
    
    *
    
    
    
    28
    %
    
    
    *Customer C
    
    
    19
    %
    
    
    15
    %
    
    
    11
    %
    
    
    *Customer D
    
    
    *
    
    
    
    *
    
    
    
    *
    
    
    
    15
    %Customer E
    
    
    *
    
    
    
    *
    
    
    
    *
    
    
    
    14
    %Customer F
    
    
    *
    
    
    
    *
    
    
    
    *
    
    
    
    12
    %Customer G
    
    
    *
    
    
    
    14
    %
    
    
    *
    
    
    
    *Customer H
    
    
    *
    
    
    
    12
    %
    
    
    *
    
    
    
    *
 
 *
    
    Customer accounted for less than 10% of total revenue for the period.  June 30,
    
    September 30,2006
    
    2005Customer A
    
    
    45
    %
    
    
    29
    %Customer B
    
    
    *
    
    
    
    19
    %Customer C
    
    
    11
    %
    
    
    19
    %Customer D
    
    
    *
    
    
    
    10
    %Customer E
    
    
    11
    %
    
    
    *
 
 *
    
    Customer accounted for less than 10% of total gross accounts receivable for the period.  June 30,
    
    
    September 30,2006
    
    
    2005(In thousands)United States
    
    $
    17,534
    
    
    $
    21,022Canada
    
    
    
    
    
    
    519Other
    
    
    1,574
    
    
    
    1,183Total
    
    $
    19,108
    
    
    $
    22,724
 NOTE 11  Related Party Transactions
   NOTE 12  Provision for Income Taxes
  20




---



##### Table of Contents



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




---



##### Table of Contents



Focus on Flat Panel Display Industry
    
    
    Product Focus:We continue to improve our product performance in defect detection, repair
success, cost of ownership, ease of use and throughput for each of our product generations.
We seek to couple this improved system performance with our expert applications engineering
services to provide the best possible business solutions to our customers.
    
    Quality Focus:We continue to implement processes to drive product quality improvement
and ease of use for our customers.
    
    Technology Leadership:We continue to emphasize our research and development to maintain
our technology leadership in our products.
    
    Financial Improvement:We continue our efforts to improve financial performance. To
achieve these goals, we will continue to look for vertical integration opportunities, source
certain raw materials and certain system integration in Asia, and expand sales and marketing
of our service product offerings.
   
    
    Gross margin improvement;
    
    New product introduction execution; and
    
    Strengthening market leadership in our yield management portfolio of products.
 Industry
   22




---



##### Table of Contents



Backlog
  Critical Accounting Policies and Estimates
  23




---



##### Table of Contents



Revenue Recognition.
   Allowance for Doubtful Accounts.
  Inventories
  24




---



##### Table of Contents



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




---



##### Table of Contents



Results of Operations
 Selected Financial Data
  Three Months Ended
    
    Nine Months EndedJune 30,
    
    June 30,2006
    
    2005
    
    2006
    
    2005Revenue
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %Cost of revenue
    
    
    62.3
    
    
    
    66.4
    
    
    
    61.0
    
    
    
    66.8Gross margin
    
    
    37.7
    
    
    
    33.6
    
    
    
    39.0
    
    
    
    33.2Operating expenses:Research and development
    
    
    16.5
    
    
    
    22.0
    
    
    
    17.5
    
    
    
    27.6Selling, general and administrative
    
    
    13.5
    
    
    
    18.8
    
    
    
    14.5
    
    
    
    18.0Restructure charge
    
    
    
    
    
    
    2.5
    
    
    
    0.0
    
    
    
    0.9Impairment of property and equipment
    
    
    0.1
    
    
    
    0.5
    
    
    
    0.0
    
    
    
    0.6Gain on sale of fixed assets
    
    
    
    
    
    
    (0.4
    )
    
    
    
    
    
    
    (0.1
    )Amortization of intangible assets
    
    
    0.7
    
    
    
    1.0
    
    
    
    0.8
    
    
    
    1.2Total operating expenses
    
    
    30.8
    
    
    
    44.4
    
    
    
    32.8
    
    
    
    48.1Income (loss) from operations
    
    
    6.9
    
    
    
    (10.8
    )
    
    
    6.2
    
    
    
    (14.9
    )Interest income and other, net
    
    
    1.9
    
    
    
    1.2
    
    
    
    1.8
    
    
    
    1.9Income (loss) from continuing operations
before income taxes and discontinued
operations
    
    
    8.8
    
    
    
    (9.6
    )
    
    
    7.9
    
    
    
    (13.0
    )Provision for income taxes
    
    
    0.4
    
    
    
    0.4
    
    
    
    0.5
    
    
    
    0.6Income (loss) from continuing operations
    
    
    8.4
    
    
    
    (10.0
    )
    
    
    7.4
    
    
    
    (13.6
    )Income (loss) from discontinued operations
    
    
    (0.2
    )
    
    
    0.7
    
    
    
    (0.3
    )
    
    
    0.3Net income (loss)
    
    
    8.2
    %
    
    
    (9.3
    )%
    
    
    7.1
    %
    
    
    (13.3
    )%
 Revenue
 Three Months Ended
    
    Nine Months EndedJune 30,
    
    June 30,2006
    
    Change
    
    2005
    
    2006
    
    Change
    
    2005(dollars in millions)Revenue
    
    $
    51.7
    
    
    
    32
    %
    
    $
    39.1
    
    
    $
    143.6
    
    
    
    42
    %
    
    $
    101.1
  TM TM TM
 ArrayChecker TM and ArraySaver TM Product Revenue
 TM TM
 26




---



##### Table of Contents



TM TM
 TM TM
 TM TM
 TM TM
 PanelMaster TM Product Revenue
 TM TM
 TM
 Customer Support and Spare Parts Revenue
  27




---



##### Table of Contents



International Revenue
  Three Months Ended
    
    
    Nine Months EndedJune 30,
    
    
    June 30,2006
    
    
    Change
    
    
    2005
    
    
    2006
    
    
    Change
    
    
    2005(dollars in millions)Korea
    
    $
    37.4
    
    
    
    91
    %
    
    $
    19.6
    
    
    $
    103.6
    
    
    
    239
    %
    
    $
    30.6Taiwan
    
    
    13.6
    
    
    
    (26
    )%
    
    
    18.4
    
    
    
    37.9
    
    
    
    (8
    )%
    
    
    41.0Japan
    
    
    0.7
    
    
    
    (39
    )%
    
    
    1.1
    
    
    
    2.1
    
    
    
    (87
    )%
    
    
    16.2China
    
    
    
    
    
    
    0
    %
    
    
    
    
    
    
    
    
    
    
    (100
    )%
    
    
    13.3Total Revenue
    
    $
    51.7
    
    
    
    32
    %
    
    $
    39.1
    
    
    $
    143.6
    
    
    
    42
    %
    
    $
    101.1
   Revenue Outlook
  Gross Margin
 Three Months Ended
    
    Nine Months EndedJune 30,
    
    June 30,2006
    
    Change
    
    2005
    
    2006
    
    Change
    
    2006Gross Margin
    
    
    38
    %
    
    
    12
    %
    
    
    34
    %
    
    
    39
    %
    
    
    18
    %
    
    
    33
    %
  
    
    A high mix of higher-margin ArrayCheckerTM systems in both the three and nine
month periods; and,
    
    In the nine month period, a favorable warranty adjustment related to the increased reliability
and serviceability of our tools.
    
    
    Our revenue mix between higher margin ArrayCheckerTM systems and lower margin
ArraySaverTM and PanelMasterTM systems;
    
    The costs of increasing customer service staff to support the increased demands of our customers;
    
    The additional costs in connection with inefficiencies of manufacturing newly-introduced products;
    
    Competitive pricing pressures, particularly in the array repair market;
    
    Reduced production levels as a consequence of either industry slowdown, order
cancellations or customer-initiated changes in delivery schedules by our customers; and
    
    Fluctuations in the level of revenue due to the cyclical nature of customers capital
expenditures.
 28




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##### Table of Contents



Research and Development
 Three Months Ended
    
    Nine Months EndedJune 30
    
    June 302006
    
    Change
    
    2005
    
    2006
    
    Change
    
    2005(dollars in millions)Expense
    
    $
    8.5
    
    
    
    (1
    )%
    
    $
    8.6
    
    
    $
    25.1
    
    
    
    (10
    )%
    
    $
    27.9Percent of Revenue
    
    
    17
    %
    
    
    
    
    
    
    22
    %
    
    
    18
    %
    
    
    
    
    
    
    28
    %
   
    
    Ramp up our automated inspection program to address mass production requirements;
    
    Focus on product enhancements and improving cost of ownership on our Generation 7, 7.5 and 8 products;
    
    Accelerate development of our next-generation products; and
    
    Invest funds in reliability and cost reduction initiatives.
  Selling, General and Administrative
 Three Months Ended
    
    Nine Months EndedJune 30
    
    June 302006
    
    Change
    
    2005
    
    2006
    
    Change
    
    2005(dollars in millions)Expense
    
    $
    7.0
    
    
    
    (5
    )%
    
    $
    7.4
    
    
    $
    20.8
    
    
    
    15
    %
    
    $
    18.1Percent of Revenue
    
    
    14
    %
    
    
    
    
    
    
    19
    %
    
    
    15
    %
    
    
    
    
    
    
    18
    %
   29




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##### Table of Contents



Stock-Based Compensation
       Three Months Ended
    
    
    Nine Months EndedJune 30, 2006
    
    
    June 30, 2006(in thousands)Stock-based compensation expense included in continuing
operations:Cost of revenue
    
    $
    34
    
    
    $
    86Research and development
    
    
    169
    
    
    
    502Selling, general and administrative
    
    
    749
    
    
    
    2,366Total stock-based compensation expense after income taxes (1)
    
    $
    952
    
    
    $
    2,954
 
 (1)
    
    The income tax benefit on stock-based compensation for all periods presented was not
material.  30




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##### Table of Contents



Restructuring Charge
 Three Months Ended
    
    Nine Months EndedJune 30
    
    June 302006
    
    Change
    
    2005
    
    2006
    
    Change
    
    2005Expense
    
    $
    0
    
    
    
    (100
    )%
    
    $
    951,000
    
    
    $
    30,000
    
    
    
    (97
    )%
    
    $
    951,000Percent of Revenue
    
    
    0
    %
    
    
    
    
    
    
    2
    %
    
    
    0
    %
    
    
    
    
    
    
    1
    %
    Impairment of Property and Equipment
 Three Months Ended
    
    Nine Months EndedJune 30
    
    June 302006
    
    Change
    
    2005
    
    2006
    
    Change
    
    2005Expense
    
    $
    50,000
    
    
    
    (71
    )%
    
    $
    174,000
    
    
    $
    50,000
    
    
    
    (91
    )%
    
    $
    556,000Percent of Revenue
    
    
    0
    %
    
    
    
    
    
    
    0
    %
    
    
    0
    %
    
    
    
    
    
    
    1
    %
  Gain on Sale of Property and Equipment
 Three Months Ended
    
    Nine Months EndedJune 30
    
    June 302006
    
    Change
    
    2005
    
    2006
    
    Change
    
    2005Expense
    
    $
    0
    
    
    
    (100
    )%
    
    $
    143,000
    
    
    $
    0
    
    
    
    (100
    )%
    
    $
    143,000Percent of Revenue
    
    
    0
    %
    
    
    
    
    
    
    0
    %
    
    
    0
    %
    
    
    
    
    
    
    0
    %
  Amortization of Intangibles
 Three Months Ended
    
    Nine Months EndedJune 30
    
    June 302006
    
    Change
    
    2005
    
    2006
    
    Change
    
    2005Expense
    
    $
    372,000
    
    
    
    (2
    )%
    
    $
    380,000
    
    
    $1.1 million
    
    
    (5
    )%
    
    $1.2 millionPercent of Revenue
    
    
    1
    %
    
    
    
    
    
    
    1
    %
    
    
    1
    %
    
    
    
    
    
    
    1
    %
   31




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Interest Income and Other, Net
 Three Months Ended
    
    Nine Months EndedJune 30
    
    June 302006
    
    Change
    
    2005
    
    2006
    
    Change
    
    2005Expense
    
    $
    999,000
    
    
    
    112
    %
    
    $
    472,000
    
    
    $2.5 million
    
    
    33
    %
    
    $1.9 millionPercent of Revenue
    
    
    2
    %
    
    
    
    
    
    
    1
    %
    
    
    2
    %
    
    
    
    
    
    
    2
    %
  Provision for Income Taxes
 Three Months Ended
    
    Nine Months EndedJune 30
    
    June 302006
    
    Change
    
    2005
    
    2006
    
    Change
    
    2005Expense
    
    $
    205,000
    
    
    
    23
    %
    
    $
    167,000
    
    
    $
    756,000
    
    
    
    34
    %
    
    $
    565,000Percent of Revenue
    
    
    0
    %
    
    
    
    
    
    
    0
    %
    
    
    1
    %
    
    
    
    
    
    
    1
    %
    Discontinued Operations
 Three Months Ended
    
    Nine Months EndedJune 30
    
    June 302006
    
    Change
    
    2005
    
    2006
    
    Change
    
    2005Income (loss)
    
    $
    (127,000
    )
    
    na
    
    $
    268,000
    
    
    $
    (473,000
    )
    
    na
    
    $
    258,000
   32




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Liquidity and Capital Resources
  Operating Activities of Continuing Operations
  Investing Activities of Continuing Operations
  Financing Activities of Continuing Operations
    33




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Operating, Investing and Financing Activities of Discontinued Operations
  Nine Months EndedJune 30,2006
    
    
    2005(In thousands)Printed circuit board business
    
    $
    (1,149
    )
    
    $
    (523
    )Cathode ray tube display and high quality glass inspection business
    
    
    (20
    )
    
    
    (264
    )Net cash used in discontinued operations
    
    $
    (1,169
    )
    
    $
    (787
    )
  Contractual Obligations
  Payments Due by Fiscal YearContractual Obligations
    
    Total
    
    
    2006(1)
    
    
    2007
    
    
    2008
    
    
    2009
    
    
    2010
    
    
    Thereafter(In thousands)Notes payable
    
    $
    1,050
    
    
    $
    50
    
    
    $
    1,000
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Operating lease obligations
    
    
    12,421
    
    
    
    748
    
    
    
    2,984
    
    
    
    2,667
    
    
    
    2,624
    
    
    
    2,714
    
    
    
    684Purchase obligations
    
    
    27,517
    
    
    
    12,111
    
    
    
    15,278
    
    
    
    128
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    40,988
    
    
    $
    12,909
    
    
    $
    19,262
    
    
    $
    2,795
    
    
    $
    2,624
    
    
    $
    2,714
    
    
    $
    684
 
 (1)
    
    Remaining three months    Working Capital
   Impact of Accounting Pronouncements
  34




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##### Table of Contents



.
   Factors Affecting Operating Results
 We have sustained losses and we may sustain losses in the future.
  Our operating results are difficult to predict and may vary from investors expectations, which
could cause our stock price to fall.
  35




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##### Table of Contents




    
    the timing of the receipt of orders from major customers;
    
    our product mix;
    
    competitive pricing pressures;
    
    our ability to obtain components from our single or limited source suppliers in a timely manner;
    
    global economic uncertainty;
    
    changing international economic conditions;
    
    the outcome of the appeal of our litigation with a former executive officer;
    
    worldwide political instability;
    
    our ability to design, manufacture and introduce new products on a cost-effective and timely basis;
    
    the delay between expenses to further develop marketing and service capabilities and the
realization of benefits from those improved capabilities; and
    
    the introduction of new products by our competitors.
  If our products experience performance, reliability or quality problems, our customers may reduce
their orders.
 TM TM
 
    
    delays in collecting accounts receivable;
    
    reduced orders;
    
    additional service expenses; and
    
    higher manufacturing costs.
   36




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##### Table of Contents



Capital investment by manufacturers of flat panel display products can be highly cyclical and may
decline in the future.
   We depend on sales to a few large customers in the flat panel display industry, and if we lose
any of our large customers our revenue could decrease significantly.
  We rely upon sales of a limited range of products, and if demand for one product decreases for
any reason it could cause our revenue to decline significantly.
  We may not be able to develop and introduce new products that respond to evolving industry
requirements in a timely manner, which could reduce our ability to compete effectively.
    37




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##### Table of Contents



If we are not able to obtain critical components from our single or limited source suppliers, we
may experience significant delays in producing our products, which could decrease our revenue for
an extended period of time.
  All of our revenue is derived from sales to companies located outside the United States, which
exposes us to risks that we would not experience with domestic sales.
  
    
    political instability and the possibility of hostilities, terrorist attacks, or war;
    
    imposition of governmental controls;
    
    fluctuations in interest and currency exchange rates;
    
    export license requirements;
    
    restrictions on the export of technology;
    
    limited foreign protection of intellectual property rights;
    
    trade restrictions;
    
    periodic or local international downturns;
    
    decreases in productivity, temporary plant shutdowns or infrastructure service
disruptions resulting from widespread health alerts including SARS and warnings of an Avian
Flu pandemic;
    
    changes in tariffs; and
    
    difficulties in staffing and managing international operations.
  Compliance with new reporting requirements may strain our resources and we may be unable to
implement in a timely manner additional finance and accounting systems, procedures and controls
in the future to satisfy new reporting requirements, which could cause our stock price to fall.
  38




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##### Table of Contents



We may have difficulty integrating the businesses or assets we have acquired and may acquire in
the future, and we may not realize the benefits that we expect from these acquisitions.
  
    
    difficulty in the assimilation of the technologies and products of the acquired company;
    
    entering markets in which we have no or limited direct prior experience;
    
    loss of key customers of the acquired company;
    
    diversion of management resources from the business of the combined company;
    
    incompatibility of business cultures or practices;
    
    loss of key employees of the acquired company;
    
    costs and delays in implementing common systems and procedures;
    
    potential inefficiencies in delivering services to the customers of the combined company; and
    
    assumption of unknown or undisclosed liabilities.
   Any failure of, or other problems at or with, our third party manufacturers could delay shipments
of our flat panel display products, harm our relationships with our customers or otherwise
negatively impact our business.
  39




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##### Table of Contents



If we do not compete effectively in our target markets, we will lose market share.
  Our success depends in large part on the strength of the active matrix liquid crystal display in
the flat panel display industry.
  Our business could be harmed if we fail to properly protect our intellectual property.
   Litigation may be necessary to enforce or defend against claims of intellectual property
infringement, which could be expensive and, if we lose, could prevent us from selling our
products.
   40




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##### Table of Contents



We must attract and retain key employees and our management team and employees must work
effectively together to maintain and grow our business.
  Terrorism and international political instability may negatively affect our operations.
   Our manufacturing facilities may be subject to disruption from natural disasters.
   Exposure to various risks related to the regulatory environment.
  Computer viruses may disrupt our operations.
  Additional Risks in Owning our Common Stock
 Our stock price may fluctuate significantly.
  
    
    announcements of technological innovations or new products by us or by our competitors;
 41




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##### Table of Contents




    
    government regulations;
    
    developments in patent or other property rights; and
    
    developments in our relationships with our customers.
  Some anti-takeover provisions may affect the price of our common stock.
  We do not anticipate paying cash dividends.
  42




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##### Table of Contents



ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
 Foreign Currency Exchange Rate Risk
   Market Risk
  43




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##### Table of Contents



ITEM 4. Controls and Procedures
   
    
    Identification of those transactions that warrant timely documentation and evaluation,
    
    Assessment to ensure that such identified transactions are appropriately documented and evaluated,
    
    Identification of those transactions, if any, that rise to the level of communication to the Audit Committee, and
    
    Communication to the Audit Committee those transactions, if any, that, by the nature
of the transaction, were identified as rising to the level of communication to the Audit
Committee.
   Changes in Control Over Financial Reporting in the Third Quarter of Fiscal 2006
  Inherent Limitations of Disclosure Controls and Procedures and Internal Control Over Financial
Reporting.
  44




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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
  
 ITEM 4. Submission of Matters to a Vote of Security Holders
  
 ITEM 5. Other Information
  
 ITEM 6. Exhibits
 Exhibits
  45




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##### Table of Contents



SIGNATURES
  PHOTON DYNAMICS, INC.By:
    
    /s/ Maureen L. Lamb

Maureen L. LambChief Financial Officer and Secretary(Duly authorized and principal financial officer)Dated: August 9, 2006
 46




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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 3.3.10.1
    
    Compensation for Outside Directors, Effective May 24, 2006.31.1
    
    Certification required by Rule 13a-14(a) or Rule 15d-14(a).31.2
    
    Certification required by Rule 13a-14(a) or Rule 15d-14(a).32.1**
    
    Certifications required by Rule 13a-14(b) or Rule 15d-14(b) and Section
1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C.
§1350).
 Key to Exhibits:
 
 (1)
    
    Previously filed as the like-numbered exhibit to the Registrants Registration Statement on
Form S-1 (Commission File No. 333-76650) as filed with the Securities and Exchange Commission
on January 14, 2002, as amended, and incorporated herein by reference.(2)
    
    Previously filed as the like-described exhibit to the Registrants Quarterly Report on Form
10Q for the quarter ended December 31, 2005 as filed with the Securities and Exchange
Commission on February 9, 2006, and incorporated herein by reference.**
    
    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. 47