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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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FORM 10-Q

(Mark One)

|/x/ | QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|--- | ---------------------------------------------------------------------------------

For the quarterly period ended March 31, 2001

OR

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

Commission File Number:0-27234

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

|California(State or other jurisdiction of
incorporation or organization) |  | 94-3007502(I.R.S. Employer Identification No.)
|------------------------------------------------------------------------ |  | ----------------------------------------------

6325 San Ignacio Avenue
San Jose, California 95119(Address of principal executive offices, including zip code)

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

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

As
of April 30, 2001, there were 12,732,563 shares outstanding of the Registrant's Common Stock, no par value.

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INDEX

|           |  |                                                                                                                    |  | Page
|---------- |  | ------------------------------------------------------------------------------------------------------------------ |  | ----
|PART I     |  | FINANCIAL INFORMATION                                                                                              |  |     
|Item 1.    |  | Financial Statements (unaudited)                                                                                   |  |     
|           |  | Condensed Consolidated Balance Sheets as of March 31, 2001 and September 30, 2000                                  |  | 3   
|           |  | Condensed Consolidated Statements of Operations for the Three- and Six-Month Periods Ended March 31, 2001 and 2000 |  | 4   
|           |  | Condensed Consolidated Statements of Cash Flows for the Six-Month Periods Ended March 31, 2001 and 2000            |  | 5   
|           |  | Notes to Condensed Consolidated Financial Statements                                                               |  | 6   
|Item 2.    |  | Management's Discussion and Analysis of Financial Condition and Results of Operations                              |  | 10  
|Item 3.    |  | Quantitative and Qualitative Disclosures About Market Risk                                                         |  | 18  
|PART II    |  | OTHER INFORMATION                                                                                                  |  |     
|Item 1.    |  | Legal Proceedings                                                                                                  |  | 18  
|Item 2.    |  | Changes in Securities and Use of Proceeds                                                                          |  | 18  
|Item 3.    |  | Defaults Upon Senior Securities                                                                                    |  | 19  
|Item 4.    |  | Submission of Matters to a Vote of Security Holders                                                                |  | 19  
|Item 5.    |  | Other Information                                                                                                  |  | 19  
|Item 6.    |  | Exhibits and Reports on Form 8-K                                                                                   |  | 19  
|Signatures |  | 20                                                                                                                

2

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

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

|(in thousands)                       |                                        | March 31,
2001                             |        | September 30,
2000 |        
|------------------------------------ | -------------------------------------- | ------------------------------------------ | ------ | ------------------ | -------
|
|ASSETS                               |                                        |                                            |        |                    |        
|Current assets:                      |                                        |                                            |        |                    |        
|                                     | Cash and cash equivalents              |                                            | $      | 13,010             |        
|                                     | Short-term investments                 |                                            |        | 87,877             |        
|                                     | Accounts receivable, net               |                                            |        | 24,472             |        
|                                     | Inventories                            |                                            |        | 14,937             |        
|                                     | Other current assets                   |                                            |        | 1,514              |        
|                                     |                                        |                                            |        |                    |        
|                                     |                                        | Total current assets                       |        |                    | 141,810
|Land, property and equipment, net    |                                        |                                            | 12,931 |                    |        
|Other assets                         |                                        |                                            | 2,179  |                    |        
|                                     |                                        |                                            |        |                    |        
|                                     |                                        | Total assets                               |        | $                  | 156,920
|                                     |                                        |                                            |        |                    |        
|LIABILITIES AND SHAREHOLDERS' EQUITY |                                        |                                            |        |                    |        
|Current liabilities:                 |                                        |                                            |        |                    |        
|                                     | Accounts payable                       |                                            | $      | 7,311              |        
|                                     | Other current liabilities              |                                            |        | 11,706             |        
|                                     | Deferred revenue and customer deposits |                                            |        | 708                |        
|                                     |                                        |                                            |        |                    |        
|                                     |                                        | Total current liabilities                  |        |                    | 19,725 
|Other liabilities                    |                                        |                                            | 382    |                    |        
|Commitments and contingencies        |                                        |                                            |        |                    |        
|Shareholders' equity:                |                                        |                                            |        |                    |        
|                                     | Preferred stock, no par value          |                                            |        |                   |        
|                                     | Common stock, no par value             |                                            |        | 160,433            |        
|                                     | Accumulated deficit                    |                                            |        | (23,338            | )      
|                                     | Accumulated other comprehensive income |                                            |        | (282               | )      
|                                     |                                        |                                            |        |                    |        
|                                     |                                        | Total shareholders' equity                 |        |                    | 136,813
|                                     |                                        |                                            |        |                    |        
|                                     |                                        | Total liabilities and shareholders' equity |        | $                  | 156,920
|                                     |                                        |                                            |        |                    |        

See
accompanying notes to condensed consolidated financial statements.

3

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

|                                   |                                     | Three months ended
March 31, |        | Six months ended
March 31,
|---------------------------------- | ----------------------------------- | ---------------------------- | ------ | --------------------------
|
|
|
|Revenue                            |                                     | $                            | 21,157 |                           
|Cost of revenue                    |                                     |                              | 11,774 |                           
|                                   |                                     |                              |        |                           
|Gross margin                       |                                     |                              | 9,383  |                           
|Operating expenses:                |                                     |                              |        |                           
|                                   | Research and development            |                              |        | 4,636                     
|                                   | Selling, general and administrative |                              |        | 4,381                     
|                                   | Non-recurring acquisition charges   |                              |        |                          
|                                   |                                     |                              |        |                           
|                                   |                                     | Total operating expenses     |        |                           
|Income from operations             |                                     |                              | 366    |                           
|Interest income and other, net     |                                     |                              | 1,577  |                           
|                                   |                                     |                              |        |                           
|Income before income taxes         |                                     |                              | 1,943  |                           
|Provision for income taxes         |                                     |                              | 191    |                           
|                                   |                                     |                              |        |                           
|Net income                         |                                     | $                            | 1,752  |                           
|                                   |                                     |                              |        |                           
|Earnings per share:                |                                     |                              |        |                           
|Basic                              |                                     | $                            | 0.14   |                           
|                                   |                                     |                              |        |                           
|Diluted                            |                                     | $                            | 0.13   |                           
|                                   |                                     |                              |        |                           
|Weighted average number of shares: |                                     |                              |        |                           
|Basic                              |                                     |                              | 12,972 |                           
|Diluted                            |                                     |                              | 13,659 |                           

See
accompanying notes to condensed consolidated financial statements.

4

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

|                                                             |                                                                                   | Six months ended
March 31,                |                                          
|------------------------------------------------------------ | --------------------------------------------------------------------------------- | ----------------------------------------- | -----------------------------------------
|
|
|
|Cash flows from operating activities:                        |                                                                                   |                                           |                                          
|                                                             | Net income                                                                        |                                           | $                                        
|                                                             | Adjustments to reconcile net income to net cash provided by operating activities: |                                           |                                          
|                                                             |                                                                                   | Depreciation and amortization             |                                          
|                                                             |                                                                                   | Reversal of Canadian government liability |                                          
|                                                             |                                                                                   | Stock compensation expense                |                                          
|                                                             |                                                                                   | Unrealized gain on cash equivalents       |                                          
|                                                             |                                                                                   | Changes in assets and liabilities:        |                                          
|                                                             |                                                                                   |                                           | Accounts receivable, net                 
|                                                             |                                                                                   |                                           | Inventories                              
|                                                             |                                                                                   |                                           | Other current assets                     
|                                                             |                                                                                   |                                           | Other assets                             
|                                                             |                                                                                   |                                           | Accounts payable                         
|                                                             |                                                                                   |                                           | Other current liabilities                
|                                                             |                                                                                   |                                           | Deferred revenue and customer deposits   
|                                                             |                                                                                   |                                           |                                          
|                                                             |                                                                                   |                                           | Net cash provided by operating activities
|                                                             |                                                                                   |                                           |                                          
|Cash flows from investing activities:                        |                                                                                   |                                           |                                          
|                                                             | Purchase of property and equipment                                                |                                           |                                          
|                                                             | Purchase of short-term investments                                                |                                           |                                          
|                                                             | Redemption of short-term investments                                              |                                           |                                          
|                                                             |                                                                                   |                                           |                                          
|                                                             |                                                                                   |                                           | Net cash used in investing activities    
|                                                             |                                                                                   |                                           |                                          
|Cash flows from financing activities:                        |                                                                                   |                                           |                                          
|                                                             | Issuance of common stock, net                                                     |                                           |                                          
|                                                             | Proceeds from Canadian government grants                                          |                                           |                                          
|                                                             | Principle payments under bank loan                                                |                                           |                                          
|                                                             | Principle payments under capital leases                                           |                                           |                                          
|                                                             |                                                                                   |                                           |                                          
|                                                             |                                                                                   |                                           | Net cash provided by financing activities
|                                                             |                                                                                   |                                           |                                          
|Effect of exchange rate changes on cash and cash equivalents |                                                                                   |                                           | (337                                     
|                                                             |                                                                                   |                                           |                                          
|Net increase in cash and cash equivalents                    |                                                                                   |                                           | 3,287                                    
|Cash and cash equivalents at beginning of period             |                                                                                   |                                           | 9,723                                    
|                                                             |                                                                                   |                                           |                                          
|Cash and cash equivalents at end of period                   |                                                                                   | $                                         | 13,010                                   
|                                                             |                                                                                   |                                           |                                          

See
accompanying notes to condensed consolidated financial statements.

5

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

NOTE 1Basis of Presentation

In the opinion of management, the accompanying unaudited interim condensed consolidated financial statements of Photon Dynamics, Inc. ("Photon Dynamics"
or "the Company") include all adjustments (consisting of normal recurring accruals) necessary for their fair presentation in accordance with generally accepted accounting principles. Preparing
financial statements requires management to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Actual amounts could differ materially from
those amounts. The results for the six-month period ended March 31, 2001 are not necessarily indicative of results to be expected for the entire year. This financial information
should be read in conjunction with the financial statements and the notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended September 30,
2000.

On
December 22, 2000, the Company acquired Image Processing Systems Inc. ("Image Processing Systems" or "IPS"). This transaction was accounted for as a pooling of
interests. The consolidated financial statements for the three- and six-month periods ended March 31, 2000 have been restated to include the financial position, results of
operations and cash flows of IPS. Financial information for Photon Dynamics, Inc.'s fiscal years ended September 30, 2000 and 1999 have been combined with IPS's financial information for
the twelve months ended September 30, 2000 and the fiscal year ended March 31, 2000, respectively. Therefore, IPS's results of operations for the six months ended March 31, 2000
have been included in both years. The results of operations for those six months are summarized as follows:

|Six months ended March 31,
(in thousands of U.S. dollars) |  | 2000 |      
|--------------------------------------------------------- |  | ---- | -----
|
|Revenue                                                   |  | $    | 7,050
|Operating income                                          |  | $    | 14   
|Net income                                                |  | $    | (15  

NOTE 2Inventories

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

|(in thousands) |                 | March 31, 2001 |   | September 30, 2000
|-------------- | --------------- | -------------- | - | ------------------
|Inventories:   |                 |                |   |                   
|               | Raw materials   |                | $ | 8,949             
|               | Work-in-process |                |   | 5,223             
|               | Finished goods  |                |   | 765               
|               |                 |                |   |                   
|               |                 | Total          |   | $                 
|               |                 |                |   |                   

6

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NOTE 3Other Current Liabilities

The components of other current liabilities were as follows:

|(in thousands)             |                        | March 31, 2001 |   | September 30, 2000
|-------------------------- | ---------------------- | -------------- | - | ------------------
|Other current liabilities: |                        |                |   |                   
|                           | Warranty               |                | $ | 3,335             
|                           | Compensation           |                |   | 2,526             
|                           | Commissions            |                |   | 1,217             
|                           | Acquisition charges    |                |   | 700               
|                           | Income taxes           |                |   | 1,111             
|                           | Other accrued expenses |                |   | 2,817             
|                           |                        |                |   |                   
|                           |                        | Total          |   | $                 
|                           |                        |                |   |                   

NOTE 4Comprehensive Income

The components of comprehensive income were as follows:

|                                   |                                          | Three months ended
March 31,      |                            | Six months ended
March 31, |     
|---------------------------------- | ---------------------------------------- | --------------------------------- | -------------------------- | -------------------------- | ----
|
|
|Net income                         |                                          | $                                 | 1,752                      |                            | $   
|Other comprehensive income (loss): |                                          |                                   |                            |                            |     
|                                   | Change in unrealized gain on investments |                                   |                            | 32                         |     
|                                   | Currency translation adjustments         |                                   |                            | (257                       | )   
|                                   |                                          |                                   |                            |                            |     
|                                   |                                          | Other comprehensive income (loss) |                            |                            | (225
|                                   |                                          |                                   |                            |                            |     
|                                   |                                          |                                   | Total comprehensive income |                            | $   
|                                   |                                          |                                   |                            |                            |     

NOTE 5Operations by Industry Segment

During the first quarter of fiscal 2001, the Company changed the structure of its internal organization following the IPS merger that became effective on the
close of business December 22, 2000.

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

Prior
to the acquisition of Image Processing Systems in December 2000, the Company operated in the FPD and semiconductor inspection segments. The Company's management has
determined the

7

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operating segments based upon the manner in which the business is managed and operated. There are no significant intersegment sales or transfers, and the majority of the Company's
long-lived assets are located in the U.S. The Company's principal customers are primarily Asian-based FPD and CRT manufacturers and North American-based PCB assembly and advanced
semiconductor packaging manufacturers.

The
Company's operating segments consisted of the following:

|                                 |                                              | Three months ended
March 31, |   | Six months ended
March 31, |  
|-------------------------------- | -------------------------------------------- | ---------------------------- | - | -------------------------- | -
|
|
|Net sales to external customers: |                                              |                              |   |                            |  
|                                 | FPD products                                 |                              | $ | 13,048                     |  
|                                 | Semiconductor inspection products            |                              |   | 4,453                      |  
|                                 | CRT display and glass inspection products    |                              |   | 3,656                      |  
|                                 |                                              |                              |   |                            |  
|                                 | Consolidated net sales to external customers |                              | $ | 21,157                     |  
|                                 |                                              |                              |   |                            |  
|Operating income (loss):         |                                              |                              |   |                            |  
|                                 | FPD products(1)                              |                              | $ | 899                        |  
|                                 | Semiconductor inspection products(1)         |                              |   | 142                        |  
|                                 | CRT display and glass inspection products(1) |                              |   | (675                       | )
|                                 | Non-recurring acquisition charges            |                              |   |                           |  
|                                 |                                              |                              |   |                            |  
|                                 | Consolidated operating income                |                              | $ | 366                        |  
|                                 |                                              |                              |   |                            |  

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NOTE 6Earnings Per Share

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

|                           |                                                        | Three months ended March 31, |      | Six months ended March 31,
|-------------------------- | ------------------------------------------------------ | ---------------------------- | ---- | --------------------------
|
|
|Numerator:                 |                                                        |                              |      |                           
|                           | Net income for basic and diluted earnings per share:   |                              | $    | 1,752                     
|Denominator:               |                                                        |                              |      |                           
|                           | Weighted average shares for basic earnings per share   |                              |      | 12,972                    
|                           | Effect of dilutive securities:                         |                              |      |                           
|                           |                                                        | Employee stock options       |      |                           
|                           |                                                        | Warrants                     |      |                           
|                           |                                                        |                              |      |                           
|                           | Weighted average shares for diluted earnings per share |                              |      | 13,659                    
|                           |                                                        |                              |      |                           
|Basic earnings per share   |                                                        | $                            | 0.14 |                           
|Diluted earnings per share |                                                        | $                            | 0.13 |                           

NOTE 7Non-Recurring Acquisition Charges

In December 2000, the Company acquired IPS in exchange for approximately 1,139,000 shares of its common stock with the acquisition accounted for as a
pooling of interests. IPS shareholders received

8

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0.0447 exchangeable shares for each common share of IPS held that can be exchanged into Photon Dynamics' common stock on a one-for-one basis at any time within 5 years.
The Company incurred $2.3 million in acquisition related charges primarily of legal, accounting and integration fees.

In
November 1999, the Company acquired CR Technology, Inc. ("CR Technology") in exchange for approximately 1,835,000 shares of its common stock with the acquisition
accounted for as a pooling of interests. The Company incurred $860,000 in acquisition related charges primarily of legal, accounting and investment banking fees.

The
following presents certain statement of operations data of the Company, IPS and CR Technology for the periods prior to the acquisition:

|Year ended September 30,
(in thousands) |                          | 2000                           |   | 1999   |        | 1998 |       
|--------------------------------------- | ------------------------ | ------------------------------ | - | ------ | ------ | ---- | ------
|Revenue:                                |                          |                                |   |        |        |      |       
|                                        | Photon Dynamics          |                                | $ | 64,221 |        | $    | 31,562
|                                        | Image Processing Systems |                                |   | 12,523 |        |      | 16,580
|                                        | CR Technology            |                                |   | 18,013 |        |      | 13,869
|                                        |                          |                                |   |        |        |      |       
|                                        |                          | Consolidated revenue           |   | $      | 94,757 |      | $     
|                                        |                          |                                |   |        |        |      |       
|Net income (loss):                      |                          |                                |   |        |        |      |       
|                                        | Photon Dynamics          |                                | $ | 12,909 |        | $    | 1,170 
|                                        | Image Processing Systems |                                |   | (1,218 | )      |      | 845   
|                                        | CR Technology            |                                |   | 1,844  |        |      | 1,103 
|                                        |                          |                                |   |        |        |      |       
|                                        |                          | Consolidated net income (loss) |   | $      | 13,535 |      | $     
|                                        |                          |                                |   |        |        |      |       

NOTE 8Income Taxes

The provision for income taxes was $191,000 and $709,000 for the three- and six-month periods ended March 31, 2001 compared to $730,000 and
$1.1 million for the same periods in the prior fiscal year. The effective tax rate was 10% and 18% for the three-month periods ended March 31, 2001 and 2000, respectively. The effective
tax rate was 9% and 16% excluding non-recurring acquisition expenses for the six-month periods ended March 31, 2001 and 2000, respectively. The effective tax rate in all
periods was lower than the statutory U.S. tax rate of 35% due to the utilization of net operating losses and credit carryforwards.

NOTE 9Credit Arrangements

The Company renegotiated the terms of its $4.0 million bank line of credit that expired in March 2001. The Company entered into a non-formula
bank line of credit of $4.0 million which expires in March 2002. This line of credit is secured by substantially all of the Company's assets and contains certain financial and other
covenants. The Company's wholly-owned subsidiary, CR Technology, renegotiated the terms of its $1.5 million unsecured bank line of credit and entered into a new unsecured bank line of credit of
$1.5 million which expires in February 2003. Both credit facilities bear interest at the bank's prime rate (8.00% at March 31, 2001). At March 31, 2001, no amounts were
outstanding under the lines of credit, and the Company was in compliance with all bank covenants.

NOTE 10Derivative Instruments and Hedging Activities

On October 1, 2000, the Company adopted FASB Statement No. 133,Accounting for Derivative Instruments and Hedging
Activities("FAS 133"). FAS 133, as amended, establishes methods for recording derivative financial instruments and hedging activities related to those
instruments, as well as other hedging activities. The Company currently does not hold any derivative instruments and does not engage in hedging activities. Therefore, the adoption of FAS 133,
as amended, has not had any impact on its consolidated financial position or results of operations.

9

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NOTE 11Recently Issued Accounting Pronouncements

In June 2000, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 101B,Second Amendment:
Revenue Recognition in Financial Statements("SAB 101B"). SAB 101B amends Staff Accounting Bulletin No. 101,Revenue Recognition in Financial
Statements("SAB 101"), to defer the implementation date of SAB 101 for registrants until no later than the fourth fiscal quarter of fiscal years beginning after
December 15, 1999. SAB 101 summarizes certain views of the SEC in applying generally accepted accounting principles to revenue recognition in financial statements. The Company is required to
adopt SAB 101 in the fourth quarter of its fiscal year ending September 30, 2001. Accordingly, any revenues reported prior to October 1, 2000 and revenue reported for the first three
quarters of fiscal 2001 that do not meet SAB 101's guidance will be deferred and recorded as revenue in whatever future periods SAB 101 guidance is met. Changes in the Company's revenue recognition
policy resulting from the interpretation and implementation of SAB 101 would not involve the restatement of prior fiscal year statements, but would, to the extent applicable, be reported as a change
in accounting principle with a cumulative catch up adjustment as of October 1, 2000 in the fiscal year ending September 30, 2001, with the appropriate restatement of interim periods as
required by FASB Statement No. 3,Reporting Accounting Changes in Interim Financial Statements. The Company's reported results of operations for
the 12 months ending September 30, 2001 will include a cumulative adjustment for all prior annual and interim periods as if SAB 101 had been adopted on October 1, 2000. While the
Company believes that the adoption of SAB 101 will have an impact on its reported results of operations, it believes that SAB 101 will not affect the underlying strength or weakness of its business
operations as measured by the dollar value of its product shipments and cash flows.

Item 2.Management's Discussion and Analysis of Financial Condition and Results of Operations

The statements contained in this report on Form 10-Q that are not purely historical are 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, including statements regarding our expectations, hopes, intentions, or strategies
regarding the future. All forward-looking statements included in this document are based on information available to us on the date hereof, and we assume no obligation to update any such
forward-looking statements. It is important to note that our actual results could differ materially from those in such forward-looking statements. You should consult the risk factors listed from time
to time in our reports and other filings with the Securities and Exchange Commission. Among the factors that could cause actual results to differ materially are those discussed under "Factors
Affecting Operating Results" at the end of this Item 2. and elsewhere in this Form 10-Q.

The
following discussion should be read in conjunction with the attached condensed consolidated financial statements and notes thereto in Item 1. above and with our audited financial
statements and notes thereto for the year ended September 30, 2000.

Results of Operations

We are a leading provider of yield management solutions to the FPD industry and offer yield management solutions for the PCB assembly, advanced semiconductor
packaging, CRT display and glass inspection industries. Our test, repair and inspection systems are used by manufacturers to collect data, analyze product quality and identify and repair product
defects at critical steps in the manufacturing process.

In
December 2000, we acquired Image Processing Systems. This acquisition expanded our product offering in the display industry and allowed us to leverage IPS's technology and
skills in FPD inspection applications.

10

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Revenue.Revenue for the three-month period ended March 31, 2001 was $21.2 million compared to
$23.6 million for the same period in the prior fiscal year, representing a decrease of 10%. Sales of FPD products represented $13.0 million, or 62% of revenue, for the three-month period
ended March 31, 2001 compared to $15.1 million, or 64% of revenue, for the same period in the prior fiscal year. This decrease in revenue is primarily the result of delayed capital
spending plans by our FPD customers due to the recent economic downturn. Sales of semiconductor inspection products represented $4.5 million, or 21% of revenue, for the three-month period ended
March 31, 2001 compared to $4.1 million, or 17% of revenue, for the same period in the prior fiscal year. This increase in revenue is attributable to increased sales of our combined
X-ray and automated optical inspection system that was introduced to the market during the second half of fiscal 2000. Sales of CRT display and glass inspection products represented
$3.7 million, or 17% of revenue, for the three-month period ended March 31, 2001 compared to $4.4 million, or 19% of revenue, for the same period in the prior fiscal year. This
decrease in revenue is attributable to the delayed capital spending plans by our CRT display customers due to the recent economic downturn.

Revenue
for the first six months of fiscal 2001 was $50.4 million compared to $43.1 million for the same period in the prior fiscal year, representing an increase of
17%. Sales of FPD products represented $30.0 million, or 59% of revenue, for the first six months of fiscal 2001 compared to $27.9 million, or 65% of revenue, for the same period in the
prior fiscal year. Sales of semiconductor inspection products represented $10.6 million, or 21% of revenue, for the first six months of fiscal 2001 compared to $8.2 million, or 19% of
revenue, for the same period in the prior fiscal year. Sales of CRT display and glass inspection products represented $9.9 million, or 20% of revenue, for the first six months of fiscal 2001
compared to $7.1 million, or 16% of revenue, for the same period in the prior fiscal year. The increase in revenue across all market segments was primarily attributable to increased capital
spending by FPD, CRT and PCB assembly and advanced semiconductor packaging manufacturers during the first three months of fiscal 2001.

Gross Margin.Gross margins were 44% for both three-month periods ended March 31, 2001 and 2000. Gross margins
from FPD products decreased to 47% for the three-month period ended March 31, 2001 from 48% for the same period in the prior fiscal year. This decrease was attributable to pass through sales of
equipment manufactured by others ("OEM shipments") having lower gross margins than typical product shipments. Gross margins from semiconductor inspection products decreased to 44% for the three-month
period ended March 31, 2001 from 45% for the same period in the prior fiscal year. This decrease was attributable to increased customer support costs associated with the increase in the
installed base of semiconductor inspection products. Gross margins from CRT display and glass inspection products increased to 36% for the three-month period ended March 31, 2001 from 27% for
the same period in the prior fiscal year. This increase was attributable to the mix of higher margin products sold during the current period as compared to the same period in the prior fiscal year
which included OEM shipments in both the current and prior fiscal year periods having lower gross margins than typical product shipments.

Gross
margins were 45% for both six-month periods ended March 31, 2001 and 2000. Gross margins from FPD products increased to 48% for the first six months of fiscal
2001 from 46% for the same period in the prior fiscal year. This increase was attributable to the mix of higher margin products sold during the current period as compared to the same period in the
prior fiscal year and to the increased capacity utilization resulting from the higher production volume during the first three months of fiscal 2001. Gross margins from semiconductor inspection
products decreased to 45% for the first six months of fiscal 2001 from 46% for the same period in the prior fiscal year. This decrease was attributable to increased customer support costs associated
with the increase in the installed base of semiconductor inspection products. Gross margins from CRT display and glass inspection products decreased to 37% for the first six months of fiscal 2001 from
42% for the same period in the prior fiscal year. This decrease was primarily attributable to an OEM shipment during the first three months

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of fiscal 2001 having a lower gross margin than typical product shipments. Overall gross margins will fluctuate on a quarterly basis due to production volume, product mix and other factors.

Research and Development.Research and development expenses were $4.6 million and $9.1 million for the
three- and six-month periods ended March 31, 2001, respectively, compared to $3.0 million and $5.8 million for the same periods in the prior fiscal year. As a
percentage of revenue, research and development expenses were 22% and 18% for the three- and six-month periods ended March 31, 2001, respectively, compared to 13% for both periods
in the prior fiscal year. The increase in research and development expenses across all market segments was attributable to investments in personnel and prototype materials for development of new
products and enhancements to existing products. We believe we must continually invest in research and development to remain competitive and expect research and development expenses to continue to
increase as a percentage of revenue during fiscal 2001.

Selling, General and Administrative.Selling, general and administrative expenses were $4.4 million and
$9.4 million for the three- and six-month periods ended March 31, 2001, respectively, compared to $4.2 million and $7.9 million for the same periods in the
prior fiscal year. As a percentage of revenue, selling, general and administrative expenses were 21% and 19% for the three- and six-month periods ended March 31, 2001, respectively,
compared to 18% for both periods in the prior fiscal year. The
increase in selling, general and administrative expenses across all market segments was attributable to higher selling expenses and to the investment in additional personnel to support our expansion.

Non-Recurring Acquisition Charges.In December 2000, we acquired Image Processing
Systems Inc. in exchange for approximately 1,139,000 shares of common stock. We accounted for the transaction as a pooling of interests and incurred $2.3 million in acquisition related
charges consisting of legal, accounting and integration fees.

In
November 1999, we acquired CR Technology, Inc. in exchange for approximately 1,835,000 shares of common stock. We accounted for the transaction as a pooling of
interests and incurred $860,000 in acquisition related charges consisting of legal, accounting and investment banking fees.

Interest Income and Other, Net.Interest income and other, net was $1.6 million and $3.3 million for the
three- and six-month periods ended March 31, 2001, respectively, compared to $919,000 and $920,000 for the same periods in the prior fiscal year. The increase was primarily
attributable to interest income on higher average cash and investment balances as a result of the net proceeds from a public offering in February 2000 and cash flows from operations since that
date.

Provision for Income Taxes.The effective tax rate for the three- and six-month periods ended
March 31, 2001 was 10% and 13%, respectively, compared to an effective tax rate of 18% and 19% for the same periods in the prior fiscal year. The effective tax rate in all periods was lower
than the statutory rate due to the utilization of net operating losses and credit carryforwards.

Liquidity and Capital Resources

We have financed our growth primarily through a combination of cash flows from operations, public stock offerings, lines of credit and loans. Working capital
was $122.1 million as of March 31, 2001 compared to $126.0 million as of September 30, 2000. A major component of working capital is $100.9 million of cash, cash
equivalents and short-term investments as of March 31, 2001 compared to $102.7 million as of September 30, 2000.

Operating Activities.Cash provided by operating activities was $7.7 million for the six-month
period ended March 31, 2001 compared to $6.3 million for the same period in the prior fiscal year. The increase in cash provided by operating activities was primarily due to decreases in
accounts receivable,

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inventories and other current assets and increases in accounts payable offset by decreases in other current liabilities and deferred revenue and customer deposits.

Investing Activities.Cash used in investing activities was $4.7 million for the six-month period
ended March 31, 2001 compared to cash used in investing activities of $39.6 million for the same period in the prior fiscal year. The cash used during the six-month period
ended March 31, 2000 was primarily due to the investment of net proceeds from the Company's public offering in February 2000. Capital expenditures were $9.8 million for the
six-month period ended March 31, 2001 compared to $737,000 for the same period in the prior fiscal year. In March 2001, we purchased a new 22,000 square foot corporate
headquarters and training facility in San Jose, California for $6.0 million. The remaining capital expenditures during the six-month period ended March 31, 2001 were for test
equipment and office furnishings and equipment to support our expansion.

Financing Activities.Cash provided by financing activities was $635,000 for the six-month period ended
March 31, 2001 compared to $86.8 million for the same period in the prior fiscal year. The cash provided during the six-month period ended March 31, 2000 was
attributable to a private offering of approximately 213,000 warrants by IPS, as adjusted for the common stock exchange ratio of 0.0447, in December 1999 for net proceeds of $3.0 million
and to a public offering of 2,000,000 shares of our common stock of which we sold approximately 1,321,000 shares for proceeds of approximately $68.0 million, net of issuance costs, in
February 2000. In March 2000, we received additional proceeds of approximately $15.6 million as a result of the underwriters exercising their over-allotment option.

We
have a borrowing capacity of $4.0 million available under a bank line of credit secured by substantially all of our assets that expires in March 2002. Our
wholly-owned subsidiary, CR Technology, has an unsecured borrowing capacity of $1.5 million under a bank line of credit that expires in February 2003. Both credit facilities bear
interest at the bank's prime rate. Our wholly-owned subsidiary, IPS, has a borrowing capacity of $1.3 million available under a bank line of credit secured by substantially all of IPS's assets
and bearing interest at the Canadian prime rate plus 3 percent. At March 31, 2001, no amounts were outstanding under the lines of credit, and we were in compliance with all bank
covenants.

We
believe that existing liquid capital resources and funds generated from operations combined with the ability, if necessary, to borrow funds will be sufficient to meet our operating
and capital requirements and obligations for at least the next twelve months. We believe that success in our industry requires substantial capital in order to maintain the flexibility to take
advantage of opportunities as they may arise. We may, from time to time, invest in or acquire complementary businesses, products or technologies and may seek additional equity or debt financing to
fund such activities. There can be no assurance that such funding will be available to us on commercially reasonable terms. The sale of additional equity or convertible debt could result in dilution
to our shareholders.

Factors Affecting Operating Results

Fluctuations in Operating Results

We have experienced and expect to continue to experience significant fluctuations in our quarterly results. Our backlog at the beginning of each quarter does
not necessarily determine actual sales for any succeeding period. A substantial percentage of our revenue is derived from the sale of a small number of yield management systems ranging in price from
$250,000 to $1.5 million. Therefore, the timing of the sale of a single system could have a significant impact on our quarterly results. Moreover, customers may cancel or reschedule shipments,
and production difficulties could delay shipments. Other factors that may influence our operating results in a particular quarter include:



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Customer Concentration

The FPD industry is extremely concentrated with a small number of manufacturers producing the majority of the world's FPDs. Sales of FPD products represented
59% and 66% of our revenue for the six-month period ended March 31, 2001 and fiscal 2000, respectively. Ishikawajima-Harima Heavy Industries Co., Ltd. ("IHI") and Quanta,
both of whom are customers of our FPD products, and LG Electronics and Samsung, both of whom are customers of our FPD and CRT display and glass inspection products, accounted for 64% of revenue for
the six-month period ended March 31, 2001. Hyundai and Unipac, both of whom are customers of our FPD products, and LG Electronics and Samsung, both of whom are customers of our FPD
and CRT display and glass inspection products, accounted for 58% of revenue in fiscal 2000. If one or more of our major customers ceased or significantly curtailed their purchases, our results of
operations would be harmed.

Flat Panel Display Industry Volatility

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

International Operations

Sales to Japan, Taiwan, Korea and China accounted for 76% and 75% of our revenue for the six-month period ended March 31, 2001 and fiscal
2000, respectively. We expect sales to these countries to continue to represent a significant percentage of revenue. A number of factors may harm our international sales and operations, including:



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In
1998, many Asian countries experienced an economic recession that resulted in a decline in the purchasing power of our Asian customers. A future downturn in economic conditions in
Asia could result in our customers failing to place new orders for our products. In addition, the laws of some foreign countries may not protect our intellectual property rights to the same extent as
U.S. laws.

Key Suppliers

We obtain some of the components for our systems from a single source or a limited group of suppliers. For example, we currently obtain materials handling
platforms, ultra high-resolution cameras and high-speed image processing systems for our FPD products from single source suppliers. We also currently obtain X-ray
sources for our PCB assembly and advanced semiconductor packaging products from limited source suppliers. Although we seek to reduce dependence on our sole and limited source suppliers, alternative
sources of supply for these components may not be available on favorable terms or at all. The loss of one or more sole and limited source suppliers could harm our results of operations and damage
customer relationships. Furthermore, a significant increase in the price of one or more of these components could harm our results of operations.

Japanese Market and Competition

We believe that competing Japanese companies in the FPD industry have a competitive advantage in Japan because of the preference of some Japanese customers for
local equipment suppliers. Historically, foreign companies have found it difficult to penetrate the Japanese market and often depend upon local sales channels to sell their products in Japan. Since
June 1997, we have depended on IHI as our exclusive value-added reseller to sell our FPD products in Japan. We anticipate that this relationship will continue in the future. For the
six-month period ended March 31, 2001 and fiscal 2000, 17% and 6% of our revenue came from sales to IHI, respectively. If IHI reduced the resources allocated to the customization,
sale and support of our FPD products in Japan, our business would be harmed.

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

We
have granted IHI the non-exclusive right to manufacture and sell array test systems based on our technology, excluding technology incorporated into some critical
components, in Korea, Taiwan and several other countries. Although IHI has never manufactured these products, nor sold these products in countries other than Japan, our business could be harmed if IHI
manufactures and sells array test systems in competition with our own in these countries.

Competition

The FPD, CRT and PCB assembly and advanced semiconductor packaging industries are highly competitive. We face substantial competition from established
competitors that have greater financial, engineering and manufacturing resources than us and have larger service organizations and

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long-standing customer relationships. Our competitors can be expected to continue to improve the design and performance of their products and to introduce new products with competitive
price/performance characteristics. Competitive pressures may force price reductions that could harm our results of operations. Our customers may also develop technology and equipment which may reduce
or eliminate their need to purchase our products. Although we believe we have certain technological and other advantages over our competitors, maintaining and capitalizing on these advantages will
require us to continue a high level of investment in engineering, research and development, marketing and customer service support. There can be no assurance that we will have sufficient resources to
continue to make these investments or that we will be able to make the technological advances necessary to maintain such competitive advantages.

New Products and Processes

We believe that our future success will depend in part upon our ability to continue to enhance our existing products and to develop and manufacture new
products. For example, the size of FPD substrates and resolution of FPDs have changed frequently and may continue to change requiring us to redesign or reconfigure our FPD products. Similarly, as
semiconductors, PCBs, semiconductor packaging and CRT display technologies have become more complex, our wholly owned subsidiaries, CR Technology and IPS, have been forced to continually redefine
their product offerings. In addition, a substantial portion of our revenue is derived from sales of products based upon AMLCD technology. An industry shift away from AMLCD technology to existing or
new competing technologies could reduce the demand for our products and harm our business.

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

Key Employees

Our future success depends in part upon our ability to retain key personnel, particularly senior management and engineers. We also need to attract additional
skilled personnel in all areas of our business to grow. There can be no assurance that we will be able to retain our existing personnel or attract additional qualified employees in the future. Other
than Richard Amtower, Vice President of Photon Dynamics and President, Electronics Division, and Kenneth Wawrew, Vice President of Photon Dynamics and President, CRT Display and Glass Division, we
generally do not have employment contracts with and do not maintain key person life insurance on any of our key employees.

Acquisitions

We may pursue acquisitions of complementary product lines, technologies or businesses, such as the acquisition of IPS in December 2000 and CR Technology
in November 1999. Acquisitions may result in potentially dilutive issuances of equity securities, incurrence of debt and contingent liabilities and amortization expenses related to goodwill and
other intangible assets, which could harm our profitability. In addition, current or future acquisitions involve numerous risks, including difficulties in
the assimilation of the operations, technologies and products of the acquired company, the diversion of management's attention from other business concerns, risks of entering markets in which we have
no or

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limited direct prior experience, and the potential loss of key employees of the acquired company. There can be no assurance as to the effect of future acquisitions on our business or operating
results.

Intellectual Property and Infringement

Our success depends in large part upon our intellectual property. While we attempt to protect our intellectual property through patents, copyrights and trade
secrets, there can be no assurance that we will successfully protect our technology or that competitors will not be able to develop similar technology independently. No assurance can be given that the
claims allowed on any patents held by us will be sufficiently broad to protect our technology. In addition, no assurance can be given that any patents issued to us will not be challenged, invalidated
or circumvented or that the rights granted thereunder will provide competitive advantages to us. Litigation may be necessary in the future to enforce our patents and other intellectual property
rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Even if successful, litigation could be expensive and divert important management
resources. If our intellectual property were not properly protected, our business could be harmed.

Regional Electric Shortages

Recently, California has been experiencing an electric power supply shortage that has resulted in the intermittent loss of power in some areas in the form of
rolling blackouts. While we have not experienced any power failures to date, a blackout may affect our ability to manufacture products and meet scheduled deliveries. If blackouts were to interrupt our
power supply, we would be temporarily unable to continue operations at some of our facilities. Any such interruption in our ability to continue operations at our facilities could damage our
reputation, harm our ability to retain existing customers and to obtain new customers, and could result in lost revenue, any of which could harm our business and results of operations.

Environmental Regulations

Some of our PCB assembly and advanced semiconductor packaging products are subject to regulation by the U.S. Food and Drug Administration, the California
Department of Public Health and other agencies in each jurisdiction where these products are sold or used. Compliance with these regulations is time-consuming and expensive and may delay
or even prevent sales in the U.S. or other jurisdictions. If we fail to comply with these regulations, we could face fines or penalties, and sales of our products could be prohibited. These fines,
penalties and prohibitions could harm our business.

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

Common Stock Price Volatility

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



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In
addition, the stock market has in recent years experienced significant price fluctuations. These fluctuations often have been unrelated to the operating performance of the specific
companies whose stock is traded. Broad market fluctuations, general economic condition and specific conditions in the FPD, CRT and PCB assembly and advanced semiconductor packaging industries may
adversely affect the market price of our common stock.

Impact of Accounting Pronouncements

In June 2000, the Securities and Exchange Commission ("SEC") issued Staff Accounting Bulletin No. 101B,Second Amendment:
Revenue Recognition in Financial Statements("SAB 101B"). SAB 101B
amends Staff Accounting Bulletin No. 101,Revenue Recognition in Financial Statements("SAB 101"), to defer the implementation date of SAB 101
for registrants until no later than the fourth fiscal quarter of fiscal years beginning after December 15, 1999. SAB 101 summarizes certain views of the SEC in applying generally accepted
accounting principles to revenue recognition in financial statements. We are required to adopt SAB 101 in the fourth quarter of our fiscal year ending September 30, 2001. Accordingly, any
revenues reported prior to October 1, 2000 and revenue reported for the first three quarters of fiscal 2001 that do not meet SAB 101's guidance will be deferred and recorded as revenue in
whatever future periods SAB 101 guidance is met. Changes in our revenue recognition policy resulting from the interpretation and implementation of SAB 101 would not involve the restatement of prior
fiscal year statements, but would, to the extent applicable, be reported as a change in accounting principle with a cumulative catch up adjustment as of October 1, 2000 in the fiscal year
ending September 30, 2001, with the appropriate restatement of interim periods as required by FASB Statement No. 3,Reporting Accounting Changes in Interim
Financial Statements. Our reported results of operations for the 12 months ending September 30, 2001 will include a cumulative adjustment for all prior annual and
interim periods as if SAB 101 had been adopted on October 1, 2000. While we believe that the adoption of SAB 101 will have an impact on our reported results of operations, we believe that SAB
101 will not affect the underlying strength or weakness of our business operations as measured by the dollar value of our product shipments and cash flows.

Item 3.Quantitative and Qualitative Disclosures about Market Risk

Foreign Currency Exchange Rate Risk

As of March 31, 2001, the current foreign exchange exposure in all international operations is deemed to be immaterial. We believe the impact of a 10%
change in exchange rates would not be material to our financial condition and results of operations. Accordingly, we do not use derivative financial investments to hedge our current foreign exchange
exposure.

Market Risk

As of March 31, 2001, our exposure to market risk for changes in interest rates relates primarily to our short-term investment portfolio. We
do not have derivative financial instruments in our portfolio.

PART II. OTHER INFORMATION

Item 1.Legal Proceedings

The Company is not currently involved in any material legal proceedings.

Item 2.Changes in Securities and Use of Proceeds

None.

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Item 3.Defaults Upon Senior Securities

None.

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

No matters were submitted to a vote of our security holders during the quarter.

Item 5.Other Information

None.

Item 6.Exhibits and Reports on Form 8-K



Number

Exhibit4.1
(1)
Restated Articles of Incorporation, as amended, of Registrant.4.2
(2)
Bylaws of Registrant.4.3
(3)
Certificate of Determination.10.1

Promissory Note from Bruce P. Delmore dated March 5, 2001.10.2

Purchase Agreement for Commercial Property dated February 12, 2001.


Key
to Exhibits:



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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

| |  | PHOTON DYNAMICS, INC.
| |  | ---------------------
| |  | By:                  
| |  | Dated: May 4, 2001   

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EXHIBIT INDEX

|Number |     | Exhibit                                                            
|------ | --- | -------------------------------------------------------------------
|4.1    | (1) | Restated Articles of Incorporation, as amended, of Registrant.     
|4.2    | (2) | Bylaws of Registrant.                                              
|4.3    | (3) | Certificate of Determination.                                      
|10.1   |     | Promissory Note from Bruce P. Delmore dated March 5, 2001.         
|10.2   |     | Purchase Agreement for Commercial Property dated February 12, 2001.

Key
to Exhibits:

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