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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


_____________________

FORM 10-Q

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

For the quarterly period ended December 31, 2002

OR

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

Commission file number: 0-27234

_____________________

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.)

17 Great Oaks Blvd.
San Jose, California 95119
(Address of principal executive offices including zip code)(408) 360-3550
(Registrants telephone number, including area code)

_____________________

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, as amended 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
o

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Securities Exchange Act of 1934, as amended).
Yes x   No o

As of January 31, 2003 there were 15,917,800 shares outstanding of the
Registrants Common Stock, no par value.



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|                              |                                                                                               |                                                      |  |  |  |  |  | 
|----------------------------- | --------------------------------------------------------------------------------------------- | ---------------------------------------------------- |  |  |  |  |  | 
|PART I. FINANCIAL INFORMATION
|                              | ITEM 1. Financial Statements                                                                 
|                              |                                                                                               | CONDENSED CONSOLIDATED BALANCE SHEETS               
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS     
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                              |                                                                                               | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
|                              | Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                              | Item 3. Quantitative and Qualitative Disclosures About Market Risk                           
|                              | Item 4. Controls and Procedures                                                              
|PART II. OTHER INFORMATION   
|                              | Item 1. Legal Proceedings                                                                    
|                              | Item 2. Changes in Securities and Use of Proceeds                                            
|                              | Item 3. Defaults Upon Senior Securities                                                      
|                              | Item 4. Submission of Matters to a Vote of Security Holders                                  
|                              | Item 5. Other Information                                                                    
|                              | Item 6. Exhibits and Reports on Form 8-K                                                     
|                              | SIGNATURES                                                                                   
|CERTIFICATIONS               
|Exhibit Index                
|EXHIBIT 10.5                 
|EXHIBIT 99.1                 



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INDEX

|               |                       |                                                                                                        |  |     
|-------------- | --------------------- | ------------------------------------------------------------------------------------------------------ |  | ----
|               |                       |                                                                                                        |  | Page
|               |                       |                                                                                                        |  |     
|PART I         | FINANCIAL
INFORMATION |                                                                                                        | 
|Item 1.        |                       | Financial Statements (unaudited)                                                                       |  |     
|               |                       | Condensed Consolidated Balance Sheets as of December 31, 2002 and September 30, 2002.                  |  | 3   
|               |                       | Condensed Consolidated Statements of Operations for the Three Months
Ended December 31, 2002 and 2001. |  | 4   
|               |                       | Condensed Consolidated Statements of Cash Flows for the Three Months Ended December
31, 2002 and 2001. |  | 5   
|               |                       | Notes to Condensed Consolidated Financial Statements                                                   |  | 6   
|Item 2.        |                       | Managements Discussion and Analysis of Financial Condition and Results of Operations                  |  | 13  
|Item 3.        |                       | Quantitative and Qualitative Disclosures About Market Risk                                             |  | 25  
|Item 4.        |                       | Controls and Procedures                                                                                |  | 25  
|PART II        | OTHER
INFORMATION    
|Item 1.        |                       | Legal Proceedings                                                                                      |  | 26  
|Item 2.        |                       | Changes in Securities and Use of Proceeds                                                              |  | 26  
|Item 3.        |                       | Defaults Upon Senior Securities                                                                        |  | 26  
|Item 4.        |                       | Submission of Matters to a Vote of Security Holders                                                    |  | 26  
|Item 5.        |                       | Other Information                                                                                      |  | 26  
|Item 6.        |                       | Exhibits and Reports on Form 8-K                                                                       |  | 27  
|Signatures     |                       | 28                                                                                                    
|Certifications |                       | 29                                                                                                    

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PART I. FINANCIAL INFORMATION

ITEM 1.Financial Statements

PHOTON DYNAMICS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS

|                                     |                                        |                                            |        |                |         |               |        |         |         | 
|------------------------------------ | -------------------------------------- | ------------------------------------------ | ------ | -------------- | ------- | ------------- | ------ | ------- | ------- | 
|                                     |                                        |                                            |        | December 31,   |         | September 30,
|                                     |                                        |                                            |        | 2002           |         | 2002         
|                                     |                                        |                                            |        |                |         |              
|                                     |                                        |                                            |        | (unaudited)    |         |               |        |        
|                                     |                                        |                                            |        | (in thousands)
|ASSETS                               |                                        |                                            |        |                |         |               |        |        
|Current assets:                      |                                        |                                            |        |                |         |               |        |        
|                                     | Cash and cash equivalents              |                                            | $      | 18,030         |         |               | $      | 25,580  |        
|                                     | Short-term investments                 |                                            |        | 108,082        |         |               |        | 144,563 |        
|                                     | Accounts receivable, net               |                                            |        | 24,285         |         |               |        | 16,579  |        
|                                     | Inventories                            |                                            |        | 19,150         |         |               |        | 18,650  |        
|                                     | Other current assets                   |                                            |        | 7,088          |         |               |        | 6,367   |        
|                                     |                                        |                                            |        |                |         |               |        |         |        
|                                     |                                        | Total current assets                       |        |                | 176,635 |               |        |         | 211,739 | 
|Land, property and equipment, net    |                                        |                                            | 11,957 |                |         |               | 12,404 |        
|Other assets                         |                                        |                                            | 2,666  |                |         |               | 2,925  |        
|Intangible assets, net               |                                        |                                            | 6,951  |                |         |               | 3,554  |        
|Goodwill                             |                                        |                                            | 10,865 |                |         |               | 18,537 |        
|                                     |                                        |                                            |        |                |         |               |        |         |        
|                                     |                                        | Total assets                               |        | $              | 209,074 |               |        | $       | 249,159 | 
|                                     |                                        |                                            |        |                |         |               |        |         |        
|LIABILITIES AND SHAREHOLDERS EQUITY |                                        |                                            |        |                |         |               |        |        
|Current liabilities:                 |                                        |                                            |        |                |         |               |        |        
|                                     | Accounts payable                       |                                            | $      | 7,429          |         |               | $      | 10,610  |        
|                                     | Other current liabilities              |                                            |        | 10,850         |         |               |        | 10,637  |        
|                                     | Deferred revenue                       |                                            |        | 723            |         |               |        | 304     |        
|                                     |                                        |                                            |        |                |         |               |        |         |        
|                                     |                                        | Total current liabilities                  |        |                | 19,002  |               |        |         | 21,551  | 
|Other liabilities                    |                                        |                                            | 1,319  |                |         |               | 1,465  |        
|Commitments and contingencies        |                                        |                                            |        |                |         |               |        |        
|Shareholders equity:                |                                        |                                            |        |                |         |               |        |        
|                                     | Common stock, no par value             |                                            |        | 276,326        |         |               |        | 288,833 |        
|                                     | Accumulated deficit                    |                                            |        | (88,518        | )       |               |        | (63,500 | )      
|                                     | Accumulated other comprehensive income |                                            |        | 945            |         |               |        | 810     |        
|                                     |                                        |                                            |        |                |         |               |        |         |        
|                                     |                                        | Total shareholders equity                 |        |                | 188,753 |               |        |         | 226,143 | 
|                                     |                                        |                                            |        |                |         |               |        |         |        
|                                     |                                        | Total liabilities and shareholders equity |        | $              | 209,074 |               |        | $       | 249,159 | 
|                                     |                                        |                                            |        |                |         |               |        |         |        

See accompanying notes to condensed consolidated financial statements.

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

|                                   |                                                           |                          |         |                                 |        |      |        |       |       | 
|---------------------------------- | --------------------------------------------------------- | ------------------------ | ------- | ------------------------------- | ------ | ---- | ------ | ----- | ----- | 
|                                   |                                                           |                          |         | Three
months ended
December 31,
|                                   |                                                           |                          |         |                                
|                                   |                                                           |                          |         | 2002                            |        | 2001
|                                   |                                                           |                          |         |                                 |        |     
|                                   |                                                           |                          |         | (in thousands, except          
|                                   |                                                           |                          |         | per share data)                
|Revenue                            |                                                           | $                        | 21,727  |                                 |        | $    | 14,205 |      
|Cost of revenue                    |                                                           |                          | 13,940  |                                 |        |      | 9,211  |      
|                                   |                                                           |                          |         |                                 |        |      |        |      
|Gross margin                       |                                                           |                          | 7,787   |                                 |        |      | 4,994  |      
|Operating expenses:                |                                                           |                          |         |                                 |        |      |        |      
|                                   | Research and development                                  |                          |         | 5,722                           |        |      |        | 3,925 |      
|                                   | Selling, general and administrative                       |                          |         | 4,801                           |        |      |        | 4,667 |      
|                                   | Goodwill impairment charge                                |                          |         | 15,083                          |        |      |        |      |      
|                                   | Impairment of purchased intangibles and long-lived assets |                          |         | 5,708                           |        |      |        |      |      
|                                   | Acquired in-process research and development              |                          |         | 1,849                           |        |      |        |      |      
|                                   | Amortization of intangible assets                         |                          |         | 455                             |        |      |        | 287   |      
|                                   |                                                           |                          |         |                                 |        |      |        |      
|                                   |                                                           | Total operating expenses |         |                                 | 33,618 |      |        |       | 8,879 | 
|                                   |                                                           |                          |         |                                 |        |      |        |      
|Loss from operations               |                                                           |                          | (25,831 | )                               |        |      | (3,885 | )    
|Interest income and other, net     |                                                           |                          | 813     |                                 |        |      | 522    |      
|                                   |                                                           |                          |         |                                 |        |      |        |      
|Net loss                           |                                                           | $                        | (25,018 | )                               |        | $    | (3,363 | )    
|                                   |                                                           |                          |         |                                 |        |      |        |      
|Net loss per share:                |                                                           |                          |         |                                 |        |      |        |      
|Basic and diluted                  |                                                           | $                        | (1.55   | )                               |        | $    | (0.24  | )    
|                                   |                                                           |                          |         |                                 |        |      |        |      
|Weighted average number of shares: |                                                           |                          |         |                                 |        |      |        |      
|Basic and diluted                  |                                                           |                          | 16,156  |                                 |        |      | 13,929 |      
|                                   |                                                           |                          |         |                                 |        |      |        |      

See accompanying notes to condensed consolidated financial statements.

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

|                                      |                                                                             |  |                                                           |          |   |                    |   |          |   |        |   | 
|------------------------------------- | --------------------------------------------------------------------------- |  | --------------------------------------------------------- | -------- | - | ------------------ | - | -------- | - | ------ | - | 
|                                      |                                                                             |  |                                                           |          |   | Three months ended
|                                      |                                                                             |  |                                                           |          |   | December 31,      
|                                      |                                                                             |  |                                                           |          |   |                   
|                                      |                                                                             |  |                                                           |          |   | 2002               |   | 2001    
|                                      |                                                                             |  |                                                           |          |   |                    |   |         
|                                      |                                                                             |  |                                                           |          |   | (in thousands)    
|Cash flows from operating activities: |                                                                             |  |                                                           |          |   |                    |   |         
|                                      | Net loss                                                                    |  | $                                                         | (25,018  | ) |                    | $ | (3,363   | )
|                                      | Adjustments to reconcile net loss to net cash used in operating activities: |  |                                                           |          |   |                    |   |          |  
|                                      |                                                                             |  | Depreciation                                              |          |   | 665                |   |          |   | 890    |  
|                                      |                                                                             |  | Amortization of intangible assets                         |          |   | 755                |   |          |   | 287    |  
|                                      |                                                                             |  | Acquired in-process research and development              |          |   | 1,849              |   |          |   |       |  
|                                      |                                                                             |  | Goodwill impairment charge                                |          |   | 15,083             |   |          |   |       |  
|                                      |                                                                             |  | Impairment of purchased intangibles and long-lived assets |          |   | 5,708              |   |          |   |       |  
|Changes in assets and liabilities:    |                                                                             |  |                                                           |          |   |                    |   |         
|                                      |                                                                             |  | Accounts receivable                                       |          |   | (7,112             | ) |          |   | 1,776  |  
|                                      |                                                                             |  | Inventories                                               |          |   | (678               | ) |          |   | (996   | )
|                                      |                                                                             |  | Other current assets                                      |          |   | 1,171              |   |          |   | (230   | )
|                                      |                                                                             |  | Other assets                                              |          |   | 129                |   |          |   | 304    |  
|                                      |                                                                             |  | Accounts payable                                          |          |   | (3,181             | ) |          |   | (989   | )
|                                      |                                                                             |  | Other current liabilities                                 |          |   | (772               | ) |          |   | (938   | )
|                                      |                                                                             |  | Deferred revenue                                          |          |   | 419                |   |          |   | (924   | )
|                                      |                                                                             |  |                                                           |          |   |                    |   |          |  
|                                      |                                                                             |  | Net cash used in operating activities                     |          |   | (10,982            | ) |          |   | (4,183 | )
|                                      |                                                                             |  |                                                           |          |   |                    |   |          |  
|Cash flows from investing activities: |                                                                             |  |                                                           |          |   |                    |   |         
|                                      | Purchase of property and equipment                                          |  |                                                           | (666     | ) |                    |   | (738     | )
|                                      | Acquisition of Rapid Thermal Processing Division from Intevac, Inc.         |  |                                                           | (20,000  | ) |                    |   |         |  
|                                      | Purchase of short-term investments                                          |  |                                                           | (134,785 | ) |                    |   | (137,490 | )
|                                      | Redemption of short-term investments                                        |  |                                                           | 171,314  |   |                    |   | 136,864  |  
|                                      |                                                                             |  |                                                           |          |   |                    |   |          |  
|                                      |                                                                             |  | Net cash provided by (used in) investing activities       |          |   | 15,863             |   |          |   | (1,364 | )
|                                      |                                                                             |  |                                                           |          |   |                    |   |          |  
|Cash flows from financing activities: |                                                                             |  |                                                           |          |   |                    |   |         
|                                      | Issuance of common stock, net                                               |  |                                                           | 868      |   |                    |   | 1,162    |  
|                                      | Repurchase
of common stock                                                  |  |                                                           | (13,375  | ) |                    |   |         |  
|                                      | Repayment of lease obligations                                              |  |                                                           | (11      | ) |                    |   | (12      | )
|                                      |                                                                             |  |                                                           |          |   |                    |   |          |  
|                                      |                                                                             |  | Net cash provided by (used in) financing activities       |          |   | (12,518            | ) |          |   | 1,150  |  
|                                      |                                                                             |  |                                                           |          |   |                    |   |          |  
|                                      | Effect of exchange rate changes on cash and cash equivalents                |  |                                                           | 87       |   |                    |   | 150      |  
|                                      |                                                                             |  |                                                           |          |   |                    |   |          |  
|                                      | Net decrease in cash and cash equivalents                                   |  |                                                           | (7,550   | ) |                    |   | (4,247   | )
|                                      | Cash and cash equivalents at beginning of period                            |  |                                                           | 25,580   |   |                    |   | 16,528   |  
|                                      |                                                                             |  |                                                           |          |   |                    |   |          |  
|                                      | Cash and cash equivalents at end of period                                  |  | $                                                         | 18,030   |   |                    | $ | 12,281   |  
|                                      |                                                                             |  |                                                           |          |   |                    |   |          |  

See accompanying notes to condensed consolidated financial statements.

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

NOTE 1Basis of Presentation

The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with accounting principles generally accepted
in the United States for interim financial information and with the
instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they
do not include all of the information and footnotes required by accounting
principles generally accepted in the United States for complete financial
statements. In the opinion of management, all adjustments (consisting only of
normal recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the three-month period ended December 31,
2002 are not necessarily indicative of the results that may be expected for the
year ending September 30, 2003. 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,
2002.

The condensed consolidated balance sheet as of September 30, 2002 is
derived from the Companys audited consolidated financial statements as of
September 30, 2002, included in the Companys Annual Report on Form 10-K filed
with the Securities and Exchange Commission, but does not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements.

Revenue Recognition.

The Company recognizes revenue when persuasive evidence of an arrangement
exists, delivery has occurred or services have been rendered, the selling price
is fixed or determinable and collectibility is reasonably assured.

The
Company accounts for certain of its product sales, including sales to
a value added reseller, in its flat panel display and cathode ray
tube display and high quality glass inspection product segments as
arrangements with multiple deliverables. For arrangements with
multiple deliverables, the Company recognizes revenue for the
delivered items if the delivered items have value to the customer on
a standalone basis, the amount of revenue for delivered elements is
not subject to refund, the Company has met defined customer acceptance
experience levels for the delivered items, and the fair value of
undelivered items, such as installation and system upgrade rights, can
be reliably determined. The Company allocates revenue to the delivered
items based on the amount due and billable upon shipment, with the
remaining amount recognized after installation and acceptance when
the final amount becomes due. The Company recognizes all other
product sales upon customer acceptance. The Company recognizes
revenue from the sale of spare parts upon shipment. The Company
generally recognizes revenue from the sale of its printed circuit
board assembly inspection products upon shipment, as such product
sales are not subject to customer acceptance provisions.

The Company records a provision for estimated sales returns in the same
period as the related revenue is recorded, which is netted against revenue.
These estimates are based on historical sales returns and other known factors.
If the historical data the Company uses to calculate these estimates does not properly
reflect future returns, additional provisions may be required.

Recent Accounting Pronouncements

In December 2002, the Financial Accounting Standards Board (FASB) issued
FASB Statement No. 148 Accounting for Stock-Based Compensation  Transition
and Disclosure (FAS 148), which provides for alternative methods to
transition to the fair value method of accounting for stock options in
accordance with the provisions of FASB Statement No. 123 Accounting for Stock
Based Compensation. In addition, FAS 148 requires disclosure of the effects
of an entitys accounting policy with respect to stock-based compensation on
reported net income and earnings per share in annual and interim financial
statements. As permitted by FAS 148, the Company is adopting the disclosure
provisions of FAS 148 beginning with the second quarter of fiscal 2003.

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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:

|                |       |   |                |        |               |   |       |        | 
|--------------- | ----- | - | -------------- | ------ | ------------- | - | ----- | ------ | 
|                |       |   | December 31,   |        | September 30,
|                |       |   | 2002           |        | 2002         
|                |       |   |                |        |              
|                |       |   | (in thousands)
|Raw materials   |       | $ | 6,728          |        |               | $ | 6,782 |       
|Work-in-process |       |   | 8,337          |        |               |   | 7,008 |       
|Finished goods  |       |   | 4,085          |        |               |   | 4,860 |       
|                |       |   |                |        |               |   |       |       
|                | Total |   | $              | 19,150 |               |   | $     | 18,650 | 
|                |       |   |                |        |               |   |       |       

NOTE 3Other Current Liabilities

The components of other current liabilities were as follows:

|                           |       |   |                |        |               |   |       |        | 
|-------------------------- | ----- | - | -------------- | ------ | ------------- | - | ----- | ------ | 
|                           |       |   | December 31,   |        | September 30,
|                           |       |   | 2002           |        | 2002         
|                           |       |   |                |        |              
|                           |       |   | (in thousands)
|Warranty (see Note 10)     |       | $ | 2,867          |        |               | $ | 2,383 |       
|Compensation               |       |   | 3,388          |        |               |   | 4,094 |       
|Commissions                |       |   | 965            |        |               |   | 998   |       
|Acquisition charges        |       |   | 316            |        |               |   | 494   |       
|Due to Akcron shareholders |       |   | 1,642          |        |               |   | 1,642 |       
|Other accrued expenses     |       |   | 1,672          |        |               |   | 1,026 |       
|                           |       |   |                |        |               |   |       |       
|                           | Total |   | $              | 10,850 |               |   | $     | 10,637 | 
|                           |       |   |                |        |               |   |       |       

NOTE 4Acquisitions

In November 2002, the Company acquired certain assets relating to rapid
thermal processing technology (the RTP Assets) from Intevac, Inc.
(Intevac). The acquired technology is used to activate low temperature
poly-silicon films during the manufacturing process for flat panel displays and
expands the Companys product offerings to its current customer base into
process equipment. As such, this acquisition is being included in our flat
panel display segment. The purchase price was $20.0 million of cash, of which
$18.0 million was paid to Intevac at closing and an additional $2.0 million was
placed into escrow, which can be released either to the Company or to Intevac
depending on the occurrence of certain future events during the escrow period
as follows; $1.2 million related to the attainment of a certain level of sales
by Photon of equipment included in the RTP Assets acquired from Intevac,
$500,000 related to the re-issuance of a former rapid thermal processing patent
in Japan for certain acquired technology and $300,000 for indemnification and
reimbursement should Intevac breach any representations and warranties under
the acquisition agreement. The Companys preliminary allocation of the
purchase consideration (see below) excludes the contingent consideration of
$2.0 million and accordingly, amounts allocated to goodwill may increase based
on the outcome of these events. In addition, the Company assumed approximately
$350,000 of liabilities and incurred approximately $500,000 in acquisition
related expenses, consisting primarily of consulting, legal and accounting
fees. The identifiable assets acquired primarily included accounts receivable,
inventory and fixed assets. The funds used to purchase the RTP Assets came out
of the Companys working capital.

The acquisition of the RTP Assets was accounted for under the purchase
method of accounting. The purchase price was allocated by management to the
assets acquired and liabilities assumed taking into account an independent
appraisal of their fair values. To determine the value of the developed and
core technologies, the expected future cash flows attributed to all existing
technology were discounted, taking into account risks related to the
characteristics and application of the technology, existing and future markets
and assessments of the life cycle stage of the technology. The value
attributed to backlog is related to purchase orders that had been received
prior to the close of the acquisition, determined as the expected discounted
cash flow resulting from the revenue related to the shipment of such orders,
less normal profit margins.

The value of in-process research and development was determined based on
the expected cash flow attributed to the in-process projects, taking into
account revenue that is attributable to previously developed technology, the
level of effort to date in the in-process research and development, the
percentage of completion of the project and the level of risk associated with
the in-process

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technology. The projects identified as in-process are those that were
underway as of the acquisition date and that will, after the applicable closing
date, require additional effort in order to establish technological feasibility
and have no alternative future uses. These projects have identifiable
technological risk factors that indicate that even though successful completion
is expected, it is not assured. The value of in-process research and
development has been included in the Companys results of operations.

The Company applied discount factors to the projected cash flows of the
technology in order to determine the present value, based on discount rates
with inherent risk and expected growth of the developed, core and in-process
technologies. The discount rates used were 15%, 20% and 25% for the developed,
core and in-process technologies, respectively.

A summary of the preliminary allocation of the purchase price is as follows:

|                                                                   |       |   |                |        | 
|------------------------------------------------------------------ | ----- | - | -------------- | ------ | 
|                                                                   |       |   | RTP           
|                                                                   |       |   |               
|                                                                   |       |   | (in thousands)
|Acquired core technology                                           |       | $ | 3,764          |       
|Acquired developed technology                                      |       |   | 2,673          |       
|Backlog                                                            |       |   | 557            |       
|Acquired in-process research and development                       |       |   | 1,849          |       
|Goodwill                                                           |       |   | 7,386          |       
|Net fair value of acquired tangible assets and assumed liabilities |       |   | 2,621          |       
|                                                                   |       |   |                |       
|                                                                   | Total |   | $              | 18,850 | 
|                                                                   |       |   |                |       

The acquired core technology and acquired developed technology are being
amortized over a five-year life. Backlog is amortized to cost of sales at the
time revenue is recognized for the related customer order.

NOTE 5Impairment ofGoodwill and Other Long-Lived Assets

In
accordance with FAS 142, the Company is required to review goodwill for
impairment of value, at least annually, and in certain circumstances between
annual tests if there are indicators of impairment. The goodwill impairment test involves a two-step process. Step
one consists of a comparison of the fair value of a reporting unit with its
carrying amount, including the goodwill allocated to the reporting unit. If the
carrying amount is in excess of the fair value, step two requires the
comparison of the implied fair value of the reporting unit goodwill with the
carrying amount of the reporting unit goodwill. Any excess of the carrying
value of the reporting unit goodwill over the implied fair value of the
reporting unit goodwill will be recorded as an impairment loss. In the first
quarter of fiscal 2003, based on further deterioration of business conditions
from the fourth quarter of fiscal 2002 when the Company recorded impairment of
goodwill, the Company performed an interim analysis of the fair value of the
printed circuit board assembly reporting unit. As a result of this analysis,
the Company determined that the remaining goodwill was
impaired and recorded an impairment charge of $15.1 million in the quarter
ended December 31, 2002. The valuation was done as of December 31, 2002, using
established valuation techniques, specifically, the income and market
approaches.

Changes in the carrying amount of goodwill for the three months ended
December 31, 2002 by reportable segment, are as follows:

|                                    |  |            |        |                       |  |                |         |   |  |   |         |  
|----------------------------------- |  | ---------- | ------ | --------------------- |  | -------------- | ------- | - |  | - | ------- | -
|                                    |  | Flat Panel |        | Printed Circuit Board |  |                |         |  
|                                    |  | Display    |        | Assembly
Inspection   |  | Total         
|                                    |  |            |        |                       |  |               
|                                    |  |            |        |                       |  | (in thousands) |         |   |  |  
|Balance as of September
30,2002     |  | $          | 3,454  |                       |  | $              | 15,083  |   |  | $ | 18,537  |  
|Goodwill acquired during the period |  | $          | 7,386  |                       |  |                |        |   |  | $ | 7,386   |  
|Adjustment to goodwill              |  |            | 25     |                       |  |                |        |   |  |   | 25      |  
|Goodwill impairment charge          |  |            |       |                       |  |                | (15,083 | ) |  |   | (15,083 | )
|                                    |  |            |        |                       |  |                |         |   |  |   |         |  
|Balance as of December 31, 2002     |  | $          | 10,865 |                       |  | $              | 0       |   |  | $ | 10,865  |  
|                                    |  |            |        |                       |  |                |         |   |  |   |         |  

In accordance with Statement of Financial Accounting Standards No. 144,
Impairment of Long-Lived Assets, (FAS 144) the Company performs tests for
impairment of its long-lived assets, including intangible assets whenever
events or circumstances suggest that such assets may be impaired. FAS 144
requires the Company to assess whether the carrying value is recoverable from
undiscounted future cash flows. If the assets are not recoverable, the
impairment is calculated by the difference between the carrying value of the
assets and their fair value which is generally determined based on discounted
future cash flows. Accordingly, in the first quarter of fiscal 2003, based on
certain indicators of impairment in the printed circuit board
assembly inspection division, the Company performed an impairment analysis of purchased intangible
assets and certain other long-lived assets associated with the printed circuit
board assembly inspection reporting unit. As a result, the Company recorded impairment
charges of approximately $2.9 million related to the unamortized portion of the
acquired developed and core technology intangible assets and approximately $2.9
million related to certain other long-lived assets to reduce the carrying
values of purchased intangible assets and other long-lived assets to their
respective estimated values.

8



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Information regarding the Companys other acquisition related intangible
assets is as follows:

|                                                            |  |            |       |            |  |                |        |         |  |       |     |   |  |   |      |   |  |   |        |  
|----------------------------------------------------------- |  | ---------- | ----- | ---------- |  | -------------- | ------ | ------- |  | ----- | --- | - |  | - | ---- | - |  | - | ------ | -
|                                                            |  | Developed  |       | Core       |  |                |        |         |  |       |     |   |  |   |      |  
|                                                            |  | Technology |       | Technology |  | Patents        |        | Backlog |  | Total
|                                                            |  |            |       |            |  |                |        |         |  |      
|                                                            |  |            |       |            |  | (in thousands) |        |         |  |       |     |   |  |  
|Balance as of September 30, 2002                            |  | $          | 557   |            |  | $              | 2,878  |         |  | $     | 119 |   |  | $ |     |   |  | $ | 3,554  |  
|Originating from acquisition of business
during the quarter |  |            | 2,673 |            |  |                | 3,764  |         |  |       |    |   |  |   | 557  |   |  |   | 6,994  |  
|Amortization during the period                              |  |            | (137  | )          |  |                | (311   | )       |  |       | (7  | ) |  |   |     |   |  |   | (455   | )
|Amortization of backlog during the period                   |  |            |      |            |  |                |       |         |  |       |    |   |  |   | (300 | ) |  |   | (300   | )
|Impairment charge                                           |  |            | (470  | )          |  |                | (2,292 | )       |  |       | (80 | ) |  |   |     |   |  |   | (2,842 | )
|                                                            |  |            |       |            |  |                |        |         |  |       |     |   |  |   |      |   |  |   |        |  
|Balance as of December 31, 2002                             |  | $          | 2,623 |            |  | $              | 4,039  |         |  | $     | 32  |   |  | $ | 257  |   |  | $ | 6,951  |  
|                                                            |  |            |       |            |  |                |        |         |  |       |     |   |  |   |      |   |  |   |        |  

NOTE 6Earnings Per Share

Basic net income (loss) 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 warrants. The following table sets forth the computation of basic and
diluted net income (loss) per share:

|                                                         |  |                                       |         |      |  |   |        |    
|-------------------------------------------------------- |  | ------------------------------------- | ------- | ---- |  | - | ------ | ---
|                                                         |  | Three months ended                   
|                                                         |  | December 31,                          |        
|                                                         |  |                                       |        
|                                                         |  | 2002                                  |         | 2001
|                                                         |  |                                       |         |     
|                                                         |  | (in thousands, except per share data)
|Numerator:                                               |  |                                       |         |      |  |   |        |    
|Net loss for basic and diluted earnings per share:       |  | $                                     | (25,018 | )    |  | $ | (3,363 | )  
|Denominator:                                             |  |                                       |         |      |  |   |        |    
|Weighted average shares for basic net income per share   |  |                                       | 16,156  |      |  |   | 13,929 |    
|Effect of dilutive securities:                           |  |                                       |         |      |  |   |        |    
|Employee stock options                                   |  |                                       |        |      |  |   |       |    
|Warrants                                                 |  |                                       |        |      |  |   |       |    
|Weighted average shares for diluted net income per share |  |                                       | 16,156  | (1)  |  |   | 13,929 | (1)
|Basic
and diluted net loss per share:                    |  | $                                     | (1.55   | )    |  | $ | (0.24  | )  
|                                                         |  |                                       |         |      |  |   |        |    



| |                                                                                                                                                                                                                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1)  The effect of dilutive securities from employee stock options and warrants
to purchase 499,000 shares of common stock for the three-months ended December
31, 2002 and 901,000 for the three-months ended December 31, 2001, was not
included in the computation of diluted earnings per share as the effect is
anti-dilutive.

NOTE 7Operations by Industry Segment

Through December 31, 2002, the Company has conducted business in three
operating segments; flat panel display products, cathode ray tube display and
high quality glass inspection products and printed circuit board assembly
inspection products. The Companys flat panel display products include test,
repair, inspection and rapid thermal process equipment. The Companys flat
panel display 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 flat panel display test and
inspection products gather comprehensive data that enable flat panel display
manufacturers to control and refine their manufacturing processes. The
Companys rapid thermal process equipment enables manufacturers of flat panel
displays to thermally activate low temperature poly-silicon films at
temperatures that would otherwise distort or destroy underlying glass
substrates. The Companys cathode ray tube display and high quality glass
inspection products allow cathode ray tube display manufacturers to locate and
characterize defects 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. The Companys printed
circuit board assembly inspection products enable printed circuit board assembly
inspection manufacturers to detect and identify defects, thereby increasing yields and
quality and reducing costs. In January 2003, the Company implemented a plan
to exit the printed circuit board assembly inspection business. Beginning in the Companys
second

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quarter of fiscal 2003, this business segment will be reported as a
discontinued operation (see Note 13).

The Companys management has determined the operating segments based upon
the manner in which the business is managed and operated. There are no
significant inter-segment 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 flat panel display and cathode ray tube display
manufacturers.

The Company sells its products for the flat panel display industry
directly to customers in Korea and Taiwan and through a value-added reseller,
Ishikawajima-Harima Heavy Industries Co., Ltd. (IHI), in Japan. The Company
sells its products for the cathode ray tube display and glass industries
directly except in Japan where a sales representative is used. The Company
sells its products for the printed circuit board assembly industry primarily
through sales representatives and distributors, although in January 2003 the
Company has elected to exit the printed circuit board assembly
inspection business (see
Note 13).

A significant portion of the segments expenses currently arise from
shared services and infrastructure provided to the segments in order to realize
economies of scale and to efficiently use resources. These expenses include
sales and marketing, field service, finance, human resource, information
technology services and other corporate infrastructure costs. These expenses
are allocated to the segments and the allocations have been determined on a
basis that the Company considers to be a reasonable reflection of the
utilization of services provided to or benefits received by the segments. The
Company does not allocate interest and other income, interest and other
expenses or taxes to operating segments. Accounting policies for segment
reporting are the same as for the Company as a whole.

The Companys operating segments consisted of the following:

|                                             |                                                        |   |                    |         |      |   |        |        |  
|-------------------------------------------- | ------------------------------------------------------ | - | ------------------ | ------- | ---- | - | ------ | ------ | -
|                                             |                                                        |   | Three months ended
|                                             |                                                        |   | December 31,      
|                                             |                                                        |   |                   
|                                             |                                                        |   | 2002               |         | 2001
|                                             |                                                        |   |                    |         |     
|                                             |                                                        |   | (in
thousands)    
|Net sales to external customers:             |                                                        |   |                    |         |      |   |        |       
|                                             | Flat panel display products                            |   | $                  | 19,162  |      |   | $      | 9,172  |  
|                                             | Printed
circuit board assembly inspection products     |   |                    | 1,855   |      |   |        | 2,837  |  
|                                             | Cathode ray tube display and glass inspection products |   |                    | 710     |      |   |        | 2,196  |  
|                                             |                                                        |   |                    |         |      |   |        |        |  
|Consolidated net sales to external customers |                                                        | $ | 21,727             |         |      | $ | 14,205 |       
|                                             |                                                        |   |                    |         |      |   |        |        |  
|Operating income (loss):                     |                                                        |   |                    |         |      |   |        |       
|                                             | Flat panel display products                            |   | $                  | (2,071  | )(1) |   | $      | (857   | )
|                                             | Printed
circuit board assembly inspection products     |   |                    | (23,077 | )(2) |   |        | (2,609 | )
|                                             | Cathode ray tube display and glass inspection products |   |                    | (683    | )(3) |   |        | (419   | )
|                                             |                                                        |   |                    |         |      |   |        |        |  
|Consolidated loss from operations            |                                                        | $ | (25,831            | )       |      | $ | (3,885 | )     
|                                             |                                                        |   |                    |         |      |   |        |        |  



| | (1) |  | Includes non-recurring charges of $1,849,000 for acquired in-process
research and development in connection with the acquisition of the RTP
assets.
| | --- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------
| | (2) |  | Includes non-recurring charges of $20,488,000 for goodwill impairment
and impairment of purchased intangibles and long-lived assets.               
| | (3) |  | Includes non-recurring charges of $303,000 for impairment of
long-lived assets.                                                                    

Identifiable assets and long-lived assets by operating segments are as follows:

|                    |                     |  |            |         |          |  |                |        |            |  |   |       |  |  |   |         | 
|------------------- | ------------------- |  | ---------- | ------- | -------- |  | -------------- | ------ | ---------- |  | - | ----- |  |  | - | ------- | 
|                    |                     |  |            |         |          |  | PrintedCircuit |        | CRTDisplay |  |   |       | 
|                    |                     |  | Flat Panel |         | Board    |  | and High       |        |            |  |  
|                    |                     |  | Display    |         | Assembly |  | QualityGlass   |        |            |  |  
|                    |                     |  | Products   |         | Products |  | Products       |        | Total     
|                    |                     |  |            |         |          |  |                |        |           
|                    |                     |  |            |         |          |  | (in
thousands) |        |            |  |  
|December 31, 2002:  |                     |  |            |         |          |  |                |        |            |  |   |       |  |  |   |        
|                    | Identifiable assets |  | $          | 192,870 |          |  |                | 10,651 |            |  | $ | 5,553 |  |  | $ | 209,074 | 
|                    | Long-lived assets   |  |            | 31,591  |          |  |                | 73     |            |  |   | 775   |  |  |   | 32,439  | 
|September 30, 2002: |                     |  |            |         |          |  |                |        |            |  |   |       |  |  |   |        
|                    | Identifiable assets |  | $          | 211,119 |          |  | $              | 30,610 |            |  | $ | 7,430 |  |  | $ | 249,159 | 
|                    | Long-lived assets   |  |            | 15,891  |          |  |                | 20,054 |            |  |   | 1,475 |  |  |   | 37,420  | 

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Sales to individual unaffiliated customers in excess of 10% of total revenue
were as follows:

|                         |  |                    |    |      |  |  |    |  
|------------------------ |  | ------------------ | -- | ---- |  |  | -- | -
|                         |  | Three months ended
|                         |  | December 31,      
|                         |  |                   
|                         |  | 2002               |    | 2001
|                         |  |                    |    |     
|LG Philips LCD Co., Ltd. |  |                    | 43 | %    |  |  | 57 | %
|Samsung America, Inc.    |  |                    | 24 | %    |  |  |    | *
|Toppoly                  |  |                    | 11 | %    |  |  |    | *

* Customer accounted for less than 10% for the period.

The following is a summary of revenue by geographic area based on location
where the product was shipped:

|         |               |       |   |                    |        |      |   |       |        | 
|-------- | ------------- | ----- | - | ------------------ | ------ | ---- | - | ----- | ------ | 
|         |               |       |   | Three months ended
|         |               |       |   | December 31,      
|         |               |       |   |                   
|         |               |       |   | 2002               |        | 2001
|         |               |       |   |                    |        |     
|         |               |       |   | (in thousands)    
|Revenue: |               |       |   |                    |        |      |   |      
|         | Korea         |       | $ | 14,696             |        |      | $ | 8,335 |       
|         | Taiwan        |       |   | 4,124              |        |      |   | 1,264 |       
|         | United States |       |   | 1,956              |        |      |   | 1,935 |       
|         | Europe        |       |   | 455                |        |      |   | 1,514 |       
|         | Japan         |       |   | 377                |        |      |   | 196   |       
|         | China         |       |   | 86                 |        |      |   | 599   |       
|         | Canada        |       |   |                   |        |      |   | 11    |       
|         | Other         |       |   | 33                 |        |      |   | 351   |       
|         |               |       |   |                    |        |      |   |       |       
|         |               | Total |   | $                  | 21,727 |      |   | $     | 14,205 | 
|         |               |       |   |                    |        |      |   |       |       

Accounts receivable from individual unaffiliated customers in excess of 10% of
total gross accounts receivable were as follows:

|                         |  |              |    |               |  |  |    |  
|------------------------ |  | ------------ | -- | ------------- |  |  | -- | -
|                         |  | December 31, |    | September 30,
|                         |  | 2002         |    | 2002         
|                         |  |              |    |              
|LG Philips LCD Co., Ltd. |  |              | 32 | %             |  |  | 32 | %
|Samsung America, Inc.    |  |              | 21 | %             |  |  |    | *

* Customer accounted for less than 10% for the period.

NOTE 8Comprehensive Income

The components of comprehensive income were as follows:

|                            |                                          |                                   |                          |    |                    |         |        |     |    |        |  
|--------------------------- | ---------------------------------------- | --------------------------------- | ------------------------ | -- | ------------------ | ------- | ------ | --- | -- | ------ | -
|                            |                                          |                                   |                          |    | Three months ended
|                            |                                          |                                   |                          |    | December 31,      
|                            |                                          |                                   |                          |    |                   
|                            |                                          |                                   |                          |    | 2002               |         | 2001  
|                            |                                          |                                   |                          |    |                    |         |       
|                            |                                          |                                   |                          |    | (in thousands)    
|Net loss                    |                                          | $                                 | (25,018                  | )  |                    | $       | (3,363 | )  
|Other comprehensive income: |                                          |                                   |                          |    |                    |         |        |    
|                            | Change in unrealized gain on investments |                                   |                          | 48 |                    |         |        | (61 | ) 
|                            | Currency translation adjustments         |                                   |                          | 87 |                    |         |        | 150 |   
|                            |                                          |                                   |                          |    |                    |         |        |    
|                            |                                          | Other comprehensive income (loss) |                          |    | 135                |         |        |     | 89 |       
|                            |                                          |                                   |                          |    |                    |         |        |    
|                            |                                          |                                   | Total comprehensive loss |    | $                  | (24,883 | )      |     | $  | (3,274 | )
|                            |                                          |                                   |                          |    |                    |         |        |    

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NOTE 9Restructure Charges

During the fourth quarter of fiscal 2002, the Company implemented a
restructuring plan to reduce its workforce, consolidate and close certain
facilities and write-off related fixed assets in accordance with a management
approved plan. The Company recorded a restructuring charge of $2.6 million,
which was comprised of approximately $550,000 for employee severance and
related benefits,$1.3 million related to excess facilities and $700,000 of abandoned assets
with no future economic benefit. The charge for excess facilities relates to
rent obligations under long term operating lease agreements which are to be
paid in cash through December 2006. As of December 31, 2002, the remaining
liability associated with the restructuring plan is $1.4 million, consisting of
approximately $200,000 of employee related costs and $1.2 million of operating
lease obligations associated with excess facilities. Management expects to
settle all employee severance and related benefits by the end of the second
quarter of fiscal 2003. There have been no adjustments to the liability.

During the fourth quarter of fiscal 2001, the Company implemented a
restructuring plan as a result of several initiatives, including the
integration of IRSI into the printed circuit board assembly
inspection division, the combining of sales and service into one organization and the Companys
continuing strategy to outsource manufacturing. As of December 31, 2002 the
remaining liability associated with this restructuring plan is approximately
$400,000 which represents contractual payments to be paid to a former executive
officer of the Company through March 2004. There have been no adjustments to
the liability.

NOTE 10Warranty Obligations

The Company generally offers warranty coverage for a period of one year
from the date of final customer acceptance. Upon product shipment, the Company
records the estimated cost of warranty coverage, primarily material and labor
to repair and service the equipment. Factors that affect the Companys
warranty liability include the number of installed units under warranty,
product failure rates, material usage rates and the efficiency by which the
product failure is corrected. The Company periodically assesses the adequacy
of its recorded warranty liability and adjusts the amount as necessary.

Changes in the Companys product liability during the three month period ended
December 31, 2002 are as follows:

|                                                                        |  |                |       |  
|----------------------------------------------------------------------- |  | -------------- | ----- | -
|                                                                        |  | December 31,  
|                                                                        |  | 2002          
|                                                                        |  |               
|                                                                        |  | (in thousands)
|Balance at September 30, 2002                                           |  | $              | 2,383 |  
|Estimated warranty cost of new shipments during the period              |  |                | 712   |  
|Warranty charges during the period                                      |  |                | (515  | )
|Changes in liability for pre-existing warranties, including expirations |  |                | 137   |  
|Liability assumed as a result of the acquisition of the RTP Assets      |  |                | 150   |  
|                                                                        |  |               
|Balance at December 31, 2002                                            |  | $              | 2,867 |  
|                                                                        |  |               

NOTE 11Stock Repurchase Program

In August 2002, the Companys Board of Directors approved a stock
repurchase program authorizing the Company to repurchase up to an aggregate of
$25.0 million of the Companys common stock. The repurchases are made from time
to time on the open market at prevailing prices, in negotiated transactions off
the market or pursuant to a 10b5-1 plan adopted by the Company. The 10b5-1
plan, allows the Company to repurchase its shares during a period in which the
Company is in possession of material non-public information, provided that the
Company communicated share repurchase instructions to the broker at a time when
it was not in possession of such material non-public information. During the
three-month period ended December 31, 2002, the Company purchased 698,400
shares for an aggregate repurchase price of approximately $13.4 million.
Subsequent to December 31, 2002, the Company repurchased an additional 204,632
shares for an aggregate repurchase price of approximately $4.3 million. Total
repurchases under the program have been 1,253,932 shares for an aggregate
repurchase price of approximately $24.6 million.

NOTE 12Legal Proceedings

The Company has been named as defendant in a lawsuit captioned Thomason v.
Photon Dynamics, Inc., No. 02CC03568, filed on February 28, 2002 in the
Superior Court of the State of California, County of Orange. The plaintiff in
this action has purported

12



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to assert that he was wrongly not allowed to exercise
certain stock options and is seeking damages of approximately $900,000. On
March 29, 2002, the Company responded to the lawsuit and filed a counterclaim
against the plaintiff for breach of a general release agreement. On December
19, 2002, the Company filed a motion for summary judgment. While the Company
intends to vigorously contest the action, it cannot predict the outcome of this
litigation. The Company believes that an adverse determination in this
litigation would not have a material adverse effect on its financial condition
or results of operations.

The Company and certain of its directors and officers have been named as
defendants in a lawsuit captioned Amtower v. Photon Dynamics, Inc., No.
CV797876, filed on April 30, 2001 in the Superior Court of the State of
California, County of Santa Clara. The plaintiff, a former officer of Photon,
has asserted several causes of action arising out of alleged misrepresentations
made to plaintiff regarding the existence and enforcement of the Companys
insider trading policy. Plaintiff seeks damages of approximately $17.7 million
for defendants alleged refusal to allow plaintiff to sell Photon stock in May
of 2000, plus unspecified emotional distress and punitive damages. On December 6, 2001, the court granted defendants
motion to dismiss the complaint for failure to allege facts sufficient to state
a cause of action, with leave to file an amended complaint. On January 17,
2002, plaintiff filed his amended complaint and defendants again moved to
dismiss the action. On June 27, 2002, the court issued an order granting in
part and denying in part the motion, and further granted plaintiff an
opportunity to restate certain claims. On October 1, 2002, plaintiff filed his
Second Amended Complaint. Defendants motion to dismiss is pending and
scheduled to be heard in March of 2003. The Company believes the plaintiffs
case is without merit and intends to defend this action vigorously. Although
the Company cannot predict the outcome of this litigation, the Company believes
that any adverse judgment in this litigation would not have a material adverse
effect on the Companys financial condition or results of operations.

The Company filed a lawsuit captioned Photon Dynamics, Inc. vs.
PanelVision Technology and Guillermo Tora-Lira, No. CO202563PJH filed on May
28, 2002 in the U.S. District Court for the Northern District of California,
County of Santa Clara. The Company is alleging infringement of a U.S. Patent
owned by it and seeking full compensatory damages and an injunction against the
defendants. On July 17, 2002, the defendants answered the Companys complaint
and asserted a counterclaim alleging damages of at least $6.0 million in
compensatory damages for loss of business. The Company believes that the
counterclaims are without merit and intends to vigorously contest the
counterclaims. On January 23, 2003, the Company added Shimadzu Corporation to
the complaint. Although the Company cannot predict the outcome of this
litigation, the Company believes that any adverse determination in this
litigation would not have a material adverse effect on its financial condition
or results of operations.

NOTE 13Subsequent Events

In January 2003 the Company implemented a plan to exit the printed
circuit board assembly inspection business. Benefits offered to all 46
employees being terminated were determined and communicated in sufficient
detail so that each affected employee was able to determine the type and amount
of benefits he or she was entitled to receive. The Company will attempt to
sell the assets and to sublease the facilities associated with this business
segment, but there can be no assurances that the Company will be successful in
recovering any costs associated with this business segment. The Company
expects an additional write-off of $10.0 million to $12.0 million related to
inventory and other assets in the second quarter of fiscal 2003. Beginning in
the Companys second quarter of fiscal 2003, this business segment will be
reported as a discontinued operation and the Company will operate in two
segments.




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 and elsewhere in this Form 10-Q. Generally, the words anticipate,
expect, intend, believe and similar expressions identify forward-looking
statements. The information included in this Form 10-Q is as of the filing date
with the Securities and Exchange Commission and future events or circumstances
could differ significantly from the forward-looking statements included here.
Accordingly, we caution readers not to place undue reliance on such statements.

The following discussion and analysis should be read in conjunction with
the condensed consolidated financial statements and

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notes thereto in Item 1 above and with our financial statements and notes thereto for the year ended
September 30, 2002 contained in our Annual Report on Form 10-K.

Overview

We are a leading provider of yield management solutions to the flat panel
display industry. 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. We recently
acquired rapid thermal processing technology which enables manufacturers of
flat panel displays to thermally activate low temperature poly-silicon films at
temperatures that would otherwise distort or destroy underlying glass
substrates. We also offer yield management solutions for cathode ray tube
display, cathode ray tube glass and automotive glass industries, collectively
referred to as our cathode ray tube display and high quality glass products.
Through December 31, 2002, we have also offered yield management solutions for the printed circuit board
assembly industry. In January 2003, we implemented a plan to exit the printed
circuit board assembly inspection business. Beginning in our second quarter of fiscal
2003, this business segment will be reported as a discontinued operation and
we will operate in two segments.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have
been prepared in accordance with accounting principles generally accepted in
the United States for interim financial information. The preparation of these
financial statements requires us to make estimates and judgments that affect
the reported amounts of assets, liabilities, revenue and expenses, and related
disclosure of contingent assets and liabilities. On an ongoing basis, we
evaluate our estimates, including those related to accounts receivable,
inventories, purchase order commitments, warranty obligations, intangible
assets and contingencies and litigation. We base our estimates on historical
experience and on various other assumptions that are believed to be reasonable
under the circumstances, the results of which form the basis for making
judgments about the carrying values of assets and liabilities that are not
readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions.

We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our consolidated
financial statements.

Revenue Recognition

We recognize revenue when persuasive evidence of an arrangement exists,
delivery has occurred or services have been rendered, the selling price is
fixed or determinable and collectibility is reasonably assured.

We account for certain of our product sales, including sales to a value
added reseller, in our flat panel display and cathode ray tube display and high
quality glass inspection product segments as arrangements with multiple
deliverables. For arrangements with multiple
deliverables, we recognize revenue for the delivered items if the delivered
items have value to the customer on a standalone basis, and the
amount of revenue for delivered elements is not subject to refund, we
have met defined customer acceptance experience levels for the
delivered items, and the fair value of
undelivered items, such as installation and system upgrade rights, can be
reliably determined. We allocate revenue to the delivered items based
on the amount due and billable upon shipment, with the remaining
amount recognized after installation and acceptance when the final
amount becomes due. We recognize all other product sales upon customer acceptance. We recognize
revenue from the sale of spare parts upon shipment. We generally
recognize revenue from the sale of out printed circuit board assembly
inspection products upon shipment, as such product sales are not
subject to customer acceptance provisions.

We record a provision for estimated sales returns in the same period as
the related revenue is recorded, which is netted against revenue. These
estimates are based on historical sales returns and other known factors. If the
historical data we use to calculate these estimates does not properly reflect
future returns, additional provisions may be required.

Accounts Receivable

We maintain an allowance for the inability of our customers to make
required payments. These estimates are based on historical data, the length of
time the receivables are past due and other known factors. If a single customer
returned a product or was unable or unwilling to make payments, additional
allowances may be required as certain of our products have selling prices in
excess of $1.5 million per unit. Accordingly, a single customer could have a
material adverse effect on our results of operations.

Inventories

We make purchase commitments for inventory based upon existing backlog and
sales forecasts. To mitigate supply constraints and to fulfill orders for
non-standard configurations, we maintain certain inventory levels especially
for parts with long lead times.

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Inventories consist of raw materials, work-in-process and finished goods and are stated at the lower of cost or
market. Cost is computed using currently adjusted standards which approximate
actual costs on a first-in, first-out basis. We assess the recoverability of
all inventory and purchase commitments to determine whether write-downs are
required. Inventory which is obsolete (defined as inventory that will no longer
be used in the manufacturing process) or in excess of the forecasted usage is
written down to its estimated market value based on projected demand,
historical usage and other known factors. If actual demand is lower than our
forecast, additional inventory write-downs may be required.

Warranty Obligations

Our warranty policy generally states that we will provide warranty
coverage for a period of one year from final acceptance. We record the
estimated cost of warranty coverage, primarily material and labor to repair and
service the equipment, upon product shipment. Our warranty obligation is
affected by the number of installed units under warranty, product failure
rates, material usage rates and the efficiency by which the product failure is corrected. Should
actual product failure rates, material usage and labor efficiencies differ from
our estimates, revisions to the estimated warranty liability would be required.

Goodwill

We have accounted for goodwill and other intangible assets resulting from
our acquisitions in accordance with Statement of Financial Accounting Standards
(FAS 142 Goodwill and Other Intangible Assets). FAS 142 prohibits the
amortization of goodwill and intangible assets with indefinite useful lives.
FAS 142 requires that these assets be reviewed for impairment at least annually
and more frequently if indicators of impairment exist. The process for
evaluating the potential impairment of goodwill is highly subjective and
requires significant judgment at many points during the analysis. In estimating
the fair value of the reporting unit with recognized goodwill, we make
estimates and judgments about the future cash flows of the reporting unit. Our
cashflow forecasts are based on assumptions that are consistent with the plans
and estimates we are using to manage the underlying business. We also consider
our market capitalization (adjusted for unallocated monetary assets such as
cash, marketable debt securities and debt) in determining the fair value of the
respective businesses. Should actual results differ from our estimates,
revisions to the recorded amount of goodwill could be reported.

Long-Lived Assets and Intangible Assets

Intangible assets with finite lives and other long-lived assets are
amortized over their estimated useful lives and subject to evaluation for
impairment. We review long-lived assets including intangible assets for
impairment whenever events or changes in business circumstances indicate that
the carrying amount of the assets may not be fully recoverable, such as a
significant industry downturn, significant decline in the market value of the
Company, or significant reductions in projected future cash flows. An
impairment loss would be recognized when estimated undiscounted future cash
flows expected to result from the use of the asset and its eventual disposition
is less than its carrying amount. Impairment, if any, is assessed using
discounted cash flows. In assessing the recoverability of long-lived assets
including intangible assets we must make assumptions regarding estimated future
cash flows and other factors to determine the fair value of the respective
assets. If these estimates or their related assumptions change in the future,
we may be required to record impairment charges for these assets.

Restructuring Costs

We have accounted for restructuring costs incurred prior to December 31,
2002, in accordance with the provisions of Emerging Issues Task Force (EITF)
Issue No. 94-3, Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred
in a Restructuring). These accruals include estimates pertaining to employee
separation costs and related abandonment of excess equipment and facilities.
Actual costs may differ from these estimates. Future restructuring costs will
be accounted for under the Statement of Financial Accounting Standards No. 146
Accounting for Costs Associated with Exit or Disposal Activites.

Contingencies and Litigation

We make an assessment of the probability of an adverse judgment resulting
from current and threatened litigation. We accrue the cost of an adverse
judgment if, in our estimation, the adverse settlement is probable and we can
reasonably estimate the ultimate cost of such litigation. We have made no such
accruals at December 31, 2002.

Results of Operations

The percentage of net revenue represented by certain line items in our
consolidated statement of operations for the periods indicated, are set forth
in the table below.

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|                               |                                                          |                          |        |                    |       |      |       |      |      | 
|------------------------------ | -------------------------------------------------------- | ------------------------ | ------ | ------------------ | ----- | ---- | ----- | ---- | ---- | 
|                               |                                                          |                          |        | Three months ended
|                               |                                                          |                          |        | December 31,      
|                               |                                                          |                          |        |                   
|                               |                                                          |                          |        | 2002               |       | 2001
|                               |                                                          |                          |        |                    |       |     
|Revenue                        |                                                          |                          | 100    | %                  |       |      | 100   | %   
|Cost of revenue                |                                                          |                          | 64.2   |                    |       |      | 64.8  |     
|                               |                                                          |                          |        |                    |       |      |       |      |      | 
|Gross margin                   |                                                          |                          | 35.8   |                    |       |      | 35.2  |     
|Operating expenses:            |                                                          |                          |        |                    |       |      |       |     
|                               | Research and development                                 |                          |        | 26.3               |       |      |       | 27.6 |     
|                               | Selling, general and administrative                      |                          |        | 22.1               |       |      |       | 32.9 |     
|                               | Goodwill impairment charge                               |                          |        | 69.4               |       |      |       |     |     
|                               | Impairment of purchased intangible and long-lived
assets |                          |        | 26.3               |       |      |       |     |     
|                               | Acquired in-process research and development             |                          |        | 8.5                |       |      |       |     |     
|                               | Amortization of intangible assets                        |                          |        | 2.1                |       |      |       | 2.0  |     
|                               |                                                          |                          |        |                    |       |      |       |      |      | 
|                               |                                                          | Total operating expenses |        |                    | 154.7 |      |       |      | 62.5 | 
|                               |                                                          |                          |        |                    |       |      |       |      |      | 
|Loss from operations           |                                                          |                          | (118.9 | )                  |       |      | (27.3 | )   
|Interest income and other, net |                                                          |                          | 3.7    |                    |       |      | 3.7   |     
|                               |                                                          |                          |        |                    |       |      |       |      |      | 
|Net loss                       |                                                          |                          | (115.2 | )%                 |       |      | (23.6 | )%  
|                               |                                                          |                          |        |                    |       |      |       |      |      | 

Revenue

Revenue for the first quarter of fiscal 2003 was $21.7 million, an
increase of $7.5 million or approximately 53% from revenue of $14.2 million for
the same quarter of fiscal 2002. The increase is due to an increase of $10.0
million of revenue from flat panel display products resulting from current
period customer expansion of manufacturing capacity in the flat panel display
segment versus the prior year in which the general economic slowdown impacted
all product segments. Included in the $10.0 million increase in flat panel
display revenue is $2.1 million of revenue contributed by the rapid thermal
processing products acquired in November, 2002 from Intevac Inc., representing
approximately 9% of the total flat panel display segment revenue in the first
quarter of fiscal 2003. The increase in flat panel display revenue was offset
in part by decreases in revenue from printed circuit board assembly
inspection and cathode ray tube display and high quality glass products, which continue to be impacted
by the general economic slowdown, and for cathode ray tube display, continued
displacement by flat panel display products. Sales of flat panel display
products were $19.2 million and $9.2 million, or 88% and 65%, of revenue in the
three months ended December 31, 2002 and 2001, respectively. Sales of printed
circuit board assembly inspection products were $1.9 million and $2.8 million, or 9% and
20%, of revenue in the three months ended December 31, 2002 and 2001,
respectively. Sales of cathode ray tube display and high quality glass
products were $710,000 and $2.2 million, or 3% and 15%, of revenue in the three
months ended December 31, 2002 and 2001, respectively. As a
result of our exit from the printed circuit board assembly inspection
business, our revenue beginning in the second quarter of fiscal 2003
will not reflect sales of our printed circuit board assembly
inspections products.

International revenue for the first quarter of fiscal 2003 was $19.8
million or 91% of net revenue, compared to $12.3 million or 86% of net revenue
for the same quarter of fiscal 2002. The increase in international revenue was
primarily from sales of flat panel display products in Korea and Taiwan.
International revenue is derived primarily from customers in Korea, Taiwan and
Japan.

Gross Margin

Gross margin increased slightly to 36% in the first quarter of fiscal 2003 as
compared to 35% in the same quarter of fiscal 2002. Gross margin from flat
panel display products increased to 40% for the three months ended December
31, 2002 from 38% for the same period of fiscal 2002. This improvement was
the result of increased manufacturing efficiencies attributable to higher
sales volumes of flat panel display products and favorable product mix offset
in part by lower margin on the rapid thermal processing product as a result
of amortization of backlog of $300,000. Gross margin from printed circuit
board assembly inspection products decreased to (1%) for the three month period ended
December 31, 2002 from 18% for the same period of fiscal year 2002. The
decrease in printed circuit board assembly inspection products gross margin is the
result of lower sales, combined with lower average selling prices brought on
by the sluggish economy, pricing pressures and competition. Gross margin from
cathode ray tube display and high quality glass products decreased to 24% for
the three months ended December 31, 2002 from 47% for the same period of
fiscal 2002. The decrease in cathode ray tube display and high quality glass
products gross margin is the result of lower sales and manufacturing volumes,
resulting in under-absorption of manufacturing overhead. Based on
generally lower gross margins with respect to our printed circuit
board assembly inspection products, compared to our other products,
we expect a positive impact with respect to our overall gross margin
due to our exit from the printed circuit board assembly inspection
business.

Research and Development

Our research and development expenses consist primarily of salaries and
related personnel costs, depreciation, non-recurring engineering charges and
prototype costs, patent filing costs and fees paid to consultants and outside
service providers, all of which relate to the design, development, testing,
pre-manufacturing and significant improvement of our products. Research and
development expenses for the first quarter of fiscal 2003 were $5.7 million, or
approximately 26% of net revenue, as compared to $3.9 million, or

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approximately 28% of net revenue, in the first quarter of fiscal 2002. The increase in
research and development in absolute dollars is primarily attributable to
higher spending related to our efforts to complete development of the array
checker 3500 in the flat panel display segment and salaries and related
expenses incurred after the acquisitions of Akcron in September 2002 and
certain assets from Intevac, Inc. in November 2002. Beginning in the
second quarter of fiscal 2003, we expect our total research and
development expenses will be offset by a decrease in research and
development expenses related to the printed circuit board assembly
inspection business due to our exit from this business.

Selling, General and Administrative

Our selling, general and administrative expenses consist primarily of
salaries and commissions and related expenses for executive, sales, finance,
accounting, and human resources personnel, professional fees, insurance and
other corporate expenses. Selling, general and administrative expenses for the
first quarter of fiscal quarter 2003 were $4.8 million or approximately 22% of
net revenue as compared to $4.7 million or 33% of net revenue in the first
quarter of fiscal 2002. Selling, general and administrative expenses for the
first quarter of fiscal 2003 have remained relatively flat in absolute dollars as compared to the first quarter of
fiscal 2002. Additional headcount and other expenses related to the
acquisitions of Akcron in September 2002 and certain assets of Intevac, Inc. in
November 2002 have been mostly offset by reduced headcount and other expenses
resulting from the restructuring in the fourth quarter of fiscal
2002. Beginning in the second quarter of fiscal 2003, we expect our
total selling, general and administrative expenses will be offset by
a decrease in selling, general and administrative expenses related to
the printed circuit board assembly inspection business due to our exit
from this business.

Impairment of Goodwill

In the first quarter of fiscal 2003, based on further deterioration of
business conditions from the fourth quarter of fiscal 2002 when we recorded impairment of goodwill, we performed an interim analysis of the fair
value of the printed circuit board assembly inspection reporting unit. As a result of
this analysis, we determined that the remaining goodwill of $15.1 million was
impaired. The valuation was done as of December 31, 2002, using established
valuation techniques, specifically, the income and market approaches.

Impairment of Purchased Intangible Assets and Long-lived Assets

In the first quarter of fiscal 2003, based on certain indicators of
impairment in the printed circuit board assembly inspection division, we performed an
impairment analysis of purchased intangible assets and certain other long-lived
assets associated with the printed circuit board assembly inspection reporting unit. As a
result, we recorded impairment charges of approximately $2.9 million related to
the un-amortized portion of the acquired developed and core technology
intangible assets and approximately $2.9 million related to certain other
long-lived assets to reduce the carrying values of purchased intangible assets
and other long-lived assets to their respective estimated values.

Acquired InProcess Research and Development

In November 2002, we completed our acquisition of certain assets from
Intevac, Inc. related to Intevacs rapid thermal processing technology used for
activating low temperature poly-silicon during the manufacturing process for
flat panel displays. The purchase price has been allocated in accordance with
FAS 141. including inprocess research and development charges of approximately
$1.9 million. This was expensed on the acquisition date as it represents
ongoing research and development projects that had not yet reached
technological feasibility and had no alternative future uses.

Acquired in-process research and development was identified and valued
through interviews with acquired company executives, analysis of data
concerning developmental products and their stage of development, the time and
resources needed to complete the projects, their expected income generating
ability, target markets and associated risks. The income approach, which
includes an analysis of the markets, cash flows and risks associated with
achieving such cash flows, was the primary technique utilized in valuing
in-process research and development. Projected incremental cash flows were
discounted back to their present value using a discount rate of 25%, which was
determined after consideration of our weighted average cost of capital and the
weighted average return on assets. Associated risks include the inherent
difficulties and uncertainties in completing each project and thereby achieving
technological feasibility, anticipated levels of market acceptance and
penetration, market growth rates and risks related to the impact of potential
changes in future target markets. The nature of the efforts required to develop
the acquired in-process research and development into commercially viable
products principally relate to the completion of all planning, designing,
prototyping, verification and testing activities that are necessary to
establish that the products can be produced to meet their design
specifications, including functions, features and technical performance
requirements. As such, the timing of completion and ultimate commercial
application are affected by the successful completion of these activities and
ultimately, market acceptance. In-process research and development projects
include a new transport system for more efficient handling of larger glass,
redesign of the lamphouse for selective heating of the film and enhancement of
low oxygen technology. The current percentage of completion on these projects
is approximately 5%, with approximately $500,000 of additional expenditures
anticipated to complete this development.

Amortization of Intangibles

The identified intangible assets (other than goodwill) are being amortized
over a two to five year period, commencing on the

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date of the acquisitions. We have recorded related amortization expense of $455,000 and $287,000 for the
three-months ended December 31, 2002 and 2001, respectively.

Interest Income and Other, Net

Interest income and other, net consists primarily of interest income,
foreign currency exchange gains and losses and other miscellaneous income and
expense. Interest income and other, net was $813,000 and $522,000 for the
three-months ended December 31, 2002 and 2001, respectively. The increase in
interest income and other, net for the three months ended December 31, 2002,
was primarily attributable to higher average cash balances.

Liquidity and Capital Resources

We have financed our growth primarily by a combination of cash flows from
operations, public stock offerings, lines of credit and loans. At December 31,
2002, we had approximately $126.1 million in cash, cash equivalents and
short-term investments. This is a decrease of approximately $44.0 million from
$170.1 million at September 30, 2002. We had approximately $157.6 million in
working capital at December 31, 2002, a decrease of approximately $32.6 million
from $190.2 million at September 30, 2002.

Operating Activities. During the first three months of fiscal 2003, net
cash used in operating activities was $11.0 million. The primary components of
this use in cash were a reduction in accounts payable of $3.2 million and an
increase in accounts receivable of $7.1 million. Also impacting the cash used
in operating activities was the net loss, excluding the charges for goodwill
impairment, and impairment of purchased intangibles and long-lived assets,
acquired in-process research and development and amortization and depreciation.

During the first three months of fiscal 2002, net cash used in operating
activities was $4.2 million. This was primarily the result of the net loss of
$3.4 million, decreases in accounts payable, other current liabilities and
deferred revenue, partially offset by a decrease in receivables and the impact
of non-cash related items such as depreciation and amortization.

Investing Activities. Investing activities provided cash of $15.9
million during the first three months of fiscal 2003. This was primarily the
result of the redemption of short-term investments of $171.3 million, offset in
part by the purchase of short-term investments of $134.8 million, the
acquisition of certain assets from Intevac, Inc. for
$20.0 million and $666,000
in purchases of capital equipment.

During the first three months of fiscal 2002, investing activities used cash of
$1.4 million. This was primarily the result of net purchase and redemption
activities of short-term investments of approximately $626,000. In addition, we
purchased $738,000 in capital equipment.

Financing Activities. Cash used in financing activities was $12.5
million in the first three months of fiscal 2003. This was the result of
repurchases of common stock of $13.4 million, offset in part by employee
exercises of stock options of $868,000.

During the first three months of fiscal 2002, financing activities provided
cash of $1.2. million. This was the result of employee exercises of stock
options of $802,000 and an exercise of warrants to purchase 21,285 shares,
providing cash proceeds of $360,000.

In August 2002, our Board of Directors approved a stock repurchase program
authorizing us to repurchase up to an aggregate of $25.0 million of our common
stock. The repurchases are made from time to time on the open market at
prevailing prices, in negotiated transactions off the market or pursuant to a
10b5-1 plan adopted by us. The 10b5-1 plan, allows us to repurchase our shares
during a period in which we are in possession of material non-public
information, provided that we communicated share repurchase instructions to the
broker at a time when we were not in possession of such material non-public
information. As of January 31, 2003 we have repurchased 1,253,932 shares for an
aggregate of approximately $24.6 million.

The following table summarizes the approximate contractual obligations
that we have at December 31, 2002. Such obligations include both non-cancelable
obligations and other obligations that are generally non-cancelable except
under certain limited conditions.

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|                            |       |       |        |        |  |       |                        |         |     |   |       |       |  |   |     |     | 
|--------------------------- | ----- | ----- | ------ | ------ |  | ----- | ---------------------- | ------- | --- | - | ----- | ----- |  | - | --- | --- | 
|                            |       |       |        |        |  |       | Payments Due by Period |         |     |   |      
|                            |       |       |        |        |  |       |                        |         |     |   |      
|                            |       |       |        |        |  |       | Less than              |         | 1-4 |   | After
|Contract Obligations        |       | Total |        | 1 Year |  | Years |                        | 4 Years
|                            |       |       |        |        |  |       |                        |        
|                            |       |       |        |        |  |       | (in thousands)         |         |     |   |      
|Operating lease obligations |       | $     | 10,219 |        |  | $     | 2,517                  |         |     | $ | 7,507 |       |  | $ | 195 |    
|Capital lease obligations   |       |       | 37     |        |  |       | 33                     |         |     |   | 4     |       |  |   |    |    
|Purchase obligations        |       |       | 17,523 |        |  |       | 17,523                 |         |     |   |      |       |  |   |    |    
|                            |       |       |        |        |  |       |                        |         |     |   |       |       |  |   |     |    
|                            | Total |       | $      | 27,779 |  |       | $                      | 20,073  |     |   | $     | 7,511 |  |   | $   | 195 | 
|                            |       |       |        |        |  |       |                        |         |     |   |       |       |  |   |     |    

The table above includes purchase orders that we have placed with
Sanmina-SCI under the terms of our agreement, which requires us to place orders
covering a minimum period of 90 days.

We believe that existing liquid capital resources and funds generated from
operations combined with the ability, if necessary, to borrow up to $4.0
million under our line of credit, 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, if at all, and if we were to proceed with acquisitions
without this funding or with limited funding it would decrease our capital
resources. The sale of additional equity or convertible debt securities could
result in dilution to our shareholders.

New Accounting Pronouncements

In December 2002, the Financial Accounting Standards Board (FASB) issued
FASB Statement No. 148 Accounting for Stock-Based Compensation  Transition
and Disclosure (FAS 148), which provides for alternative methods to
transition to the fair value method of accounting for stock options in
accordance with the provisions of FASB Statement No. 123 Accounting for Stock
Based Compensation. In addition, FAS 148 requires disclosure of the effects
of an entitys accounting policy with respect to stock-based compensation on
reported net income and earnings per share in annual and interim financial
statements. As permitted by FAS 148, the Company is adopting the disclosure
provisions of FAS 148 beginning with the second quarter of fiscal 2003.

Factors Affecting Operating Results

We have recently sustained losses and we may not be able to return to
profitability.

We reported a decrease in revenue for the fiscal year ended September 30,
2002 as compared to the prior year comparable period, and losses for the three
months ended December 31, 2002 and for the fiscal year ended September 30,
2002. In the future, our revenue may decline, remain flat or grow at a rate
slower than expected, especially in light of the recent economic slowdown. Our
ability to regain profitability on an annual basis is dependent in part on our
customers recovery from this slowdown and the success of our efforts to reduce
operating expenses as a percentage of revenue through our ongoing cost-cutting
measures in connection with our recent restructuring and discontinued
operations. In addition, if we determine that the goodwill, intangible assets
and other long-lived assets of one of the businesses we acquired has been
impaired, then we would need to decrease the carrying value of these assets,
which would decrease our net income, or increase our net loss, during the
period in which we determined that the assets were impaired. Our operating
results are difficult to predict, as described below, and there is no assurance
that we will be successful in achieving increased revenue, positive cash flows
or profitability.

Capital investment by manufacturers of flat panel display products can be
highly cyclical and may decline in the future.

Our business depends in large part on capital expenditures by
manufacturers of flat panel display products, which in turn depend on the
current and anticipated market demand for the end products in that industry.
The market for flat panel display products is highly cyclical and has
experienced periods of oversupply resulting in significantly reduced demand for
capital equipment. For example, the flat panel display industry experienced a
downturn in 1998, which led many flat panel display manufacturers to delay or
cancel capital expenditures. Additionally, in 2001, due to the general
deteriorating economic environment, flat panel display and electronics
manufacturers reduced capital expenditures resulting in a decrease in revenue
for all segments of our business. Although flat panel display revenues
increased for the three months ended December 31, 2002 compared to the prior
year, this was not enough to offset the decline in revenue from our other
segments.If the flat panel display and other markets in which we sell our
products do not recover sufficiently or experience further slowdowns in the
future, it could cause our revenue to decrease significantly. 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 these
downturns.

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.

The flat panel display industry is extremely concentrated with a small
number of manufacturers producing the majority of the worlds flat panel
displays. If one or more of our major customers ceased or significantly
curtailed their purchases, our revenue could drop significantly. We may be
unable to replace sales to these customers. Sales of flat panel display
products represented 88% of our revenue for the three months ended December 31,
2002. Sales of flat panel display products to LG Phillips LCD Co., Ltd.
represented 43% of our revenue for the three months ended December 31, 2002.
LG Phillips LCD Co., Ltd., Samsung America, Inc., and Toppoly, all customers of
our flat panel display products, collectively accounted for 78% of our total
revenue, and each in excess of 10% of our total revenue, in the three months
ended December 31, 2002.

19



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Our operating results are difficult to predict and may vary from investors
expectations, which could cause our stock price to drop.

We have experienced and expect to continue to experience significant
fluctuations in our quarterly results. Consequently, past financial results may
not be indicative of future financial results. 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 $1.85 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. For example, as we announced in December
2002, we experienced technical delays with respect to the introduction of our
next generation ArrayChecker 3500 system. We anticipate that this delay may
have a significant impact on the timing of both our revenue and net income for
the second quarter of fiscal 2003. As a result, our backlog at the beginning
of each quarter does not necessarily determine actual sales for the quarter or
any succeeding period.

Other factors which may influence our operating results in a particular
quarter include:



| |  |  | 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;                                                      
|
| |  |  | continued or worsened financial markets or economic instability in Asia or the world in general;                                                      
|
| |  |  | the relative proportions of domestic and international sales;                                                                                         
|
| |  |  | any write down in the value of acquired goodwill in the event
that we determine that the goodwill has been impaired,                                  
|
| |  |  | 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 we experience difficulties in any of these areas, our operating
results could be significantly and adversely affected and our stock price
could decline. In addition, it is possible that in some future quarter our
operating results may be below the expectations of public market analysts and
investors, which could cause our stock price to fall.

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.

The markets for our products are characterized by rapidly changing
technologies and frequent new product introductions. The failure to develop new
products and introduce them successfully and in a timely manner could harm our
competitive position and results of operations. 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 glass plates for flat panel displays and the resolution of flat panel
displays have changed frequently and may continue to change, requiring us to
redesign or reconfigure our flat panel display products.

Similarly, as the technologies for products in the cathode ray tube
display and high quality glass industries continue to become more complex, we
will be forced to continually refine our product offerings. As a result, we
expect to continue to incur significant research and development costs. 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. For example, we recently
experienced technical delays relating to the introduction of our next
generation ArrayChecker 3500 system causing us to reschedule several shipments
from the first quarter to the second quarter of fiscal 2003. We depend on
close relationships with our customers and the willingness of those

20



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customers to share information with us, and the failure to do so could harm our
development efforts.

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.

We obtain some equipment 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 flat panel display products from single source suppliers.
Although we seek to reduce dependence on our sole and limited source suppliers,
alternative sources of supply for this equipment may not be available or may be
available on unfavorable terms. The partial or complete loss of our sole and
limited source suppliers could at least temporarily delay our shipments or
otherwise harm our results of operations and damage customer relationships.
Further, a significant increase in the price of one or more of these pieces of
equipment could harm our results of operations.

A significant portion of our revenue is derived from sales to companies located
outside the United States, which exposes us to risks that we do not experience
with domestic sales.

Sales to countries other than the United States accounted for 91% of
revenue for the three months ended December 31, 2002 We expect sales to foreign
countries to continue to represent a significant percentage of our revenue. A
number of factors may adversely affect our international sales and operations,
including:



| |  |  | political instability and the possibility of hostilities or war;                                                            
| | - |  | ----------------------------------------------------------------------------------------------------------------------------
|
| |  |  | imposition of governmental controls;                                                                                        
|
| |  |  | fluctuations in the United States dollar, which could increase the foreign sales prices of our products in local currencies;
|
| |  |  | export license requirements;                                                                                                
|
| |  |  | restrictions on the export of technology;                                                                                   
|
| |  |  | limited foreign protection of intellectual property rights;                                                                 
|
| |  |  | trade restrictions;                                                                                                         
|
| |  |  | changes in tariffs; and                                                                                                     
|
| |  |  | difficulties in staffing and managing international operations.                                                             

If any of these factors occur, our operating results and revenues could be
materially and adversely affected.

We rely upon sales of a limited range of products, and if demand for one
product decreases for any reasons it could cause our revenue to decline
significantly.

A substantial percentage of our revenue has come from a limited range of
products for the flat panel display industry. We expect that these products
will continue to account for a substantial percentage of our revenue. Any
decline in demand for, or failure to achieve continued market acceptance of,
our primary products or any new version of these products could harm our
business. We currently market two primary products for the flat panel display
industry, our array test and array repair equipment. Revenue from these two
products represented 69% of our total revenue in the three months ended
December 31, 2002 and 66% of our total revenue in fiscal 2002. Moreover, we
expect that these products will account for an even greater percentage of our
revenue in the future in light of our planned exit from the printed circuit
board assembly inspection business. Continued market acceptance of these
primary products is critical to our success.

We may have difficulty integrating the businesses we recently acquired or other
businesses or assets we may acquire in the future, and we may not realize the
benefits that we expect from these acquisitions.

We have recently consummated several acquisitions, including acquisitions
of Intelligent Reasoning Systems, Inc. in July 2001, Akcron Corporation, LTD in
September 2002, and certain assets from ART Advanced Research Technologies Inc.
in July 2002 and Intevac, Inc. in November 2002. We may acquire other assets or
companies in the future. Integrating businesses can be a complex,
time-consuming and expensive process. If we are not able to do so effectively,
we will not be able to realize the benefits that we expect

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to receive from acquisitions. For each acquisition, we must integrate separate technologies,
product lines, business cultures and practices, employees and systems.
Acquisitions are subject to numerous risks, including:



| |  |  | difficulties 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 of these difficulties could increase our operating costs and harm our
financial performance. In addition, we may also elect to change our strategic
direction and may no longer have need for certain acquired businesses or
technologies. For example, we recently exited the printed circuit board
assembly inspection business. As a result, some or all of the technologies acquired in
connection with certain of our acquisitions, including ART Advanced Research
Technologies Inc. and Intelligent Reasoning Systems, Inc. have been abandoned.
Future acquisitions may also result in potentially dilutive issuances of equity
securities, incurrence of debt and contingent liabilities and amortization
expenses related to acquired intangible assets, which could harm our
profitability.

Any failure of, or other problems at or with, Sanmina-SCI Corporation or other
third party manufacturers could delay shipments of our flat panel display
products, harm our relationships with our customers or otherwise negatively
impact our business.

If Sanmina-SCI Corporation or any other third party that we use to
manufacture our products is unable to satisfy our quality requirements or
provide us with the products and services in a timely manner, our shipments of
these products may be delayed, our customer relationships may be harmed and our
results of operations may be adversely impacted. There can be no assurance that
our relationship with Sanmina-SCI or any other third party that we use to
manufacture our products will result in a reduction of our expenses or enable
us to satisfy our customers quality requirements or to deliver our products to
our customers in a timely manner.

If we do not compete effectively in our target markets, we will lose market
share.

The markets for yield management systems in the flat panel display,
cathode ray tube display, cathode ray tube glass, and automotive glass
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
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 and performance characteristics.
Competitive pressures may force price reductions that could harm our results of
operations. Our customers may also develop technology and equipment that 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 our competitive
advantages.

We have previously relied on our relationship with IHI to sell our flat panel
display products in Japan, and if we are not able to continue to access this
important market, either through IHI or through our own internal resources, our
business will be harmed.

We believe that Japanese companies competing with us in sales to the flat
panel display industry have a competitive advantage in Japan because of the
preference of some local customers for local equipment suppliers. Foreign
companies frequently have found it difficult to penetrate the Japanese market
and often depend upon local sales channels to sell their products in Japan.

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Historically, IHI has been a significant value added reseller with respect
to sales of our flat panel display products in Japan. In the three months
ended December 31, 2002, fiscal 2002 and fiscal 2001, 2%, 8% and 13% of our
total revenue came from sales to IHI, respectively. We are currently in
discussions with IHI regarding our on-going relationship with IHI and expect
that IHI may reduce the resources allocated to the sale and support of our flat
panel display products in Japan in the future. If we are unable to support
existing customers or develop new customers in Japan without IHI, our
business will be harmed.

In addition, IHIs rights to serve 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 exclusive as to us. If so, we
may not be able to compete effectively in Japan. Although IHI must purchase
certain critical components from us, IHI may manufacture competing array test
systems based on our technology. If this occurs, our business could be harmed.
We also 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 neither 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.

If our products experience performance, reliability or quality problems, our
customers may reduce their orders.

We believe that future orders of our products will depend in part on our
ability to satisfy the performance, reliability and quality standards required
by our customers. Particularly as customers seek increased yields, greater
throughput and higher quality end products, we must continually redesign our
products to meet the needs of our customers. If our products have performance,
reliability or quality problems, then we may experience:



| |  |  | delays in collecting accounts receivable;    
| | - |  | ---------------------------------------------
|
| |  |  | reduced orders;                              
|
| |  |  | additional warranty and service expenses; and
|
| |  |  | higher manufacturing costs.                  

If we are unable to meet the requirements of our customers, our revenue
may decrease and our business could be harmed.

In addition, we typically provide a limited warranty on our products for a
period of one year from final acceptance by customers. We may incur substantial
warranty claim expenses on our products and actual warranty claims may exceed
recorded allowances, resulting in harm to our business.

Our success depends in large part on the strength of the active matrix liquid
crystal display in the flat panel display industry.

While our technology is applicable to other flat panel display
technologies, our experience has been focused on applications for active matrix
liquid crystal displays, the most prevalent and one of the highest performance
flat panel displays available today. In the three months ended December 31,
2002 we derived approximately 88% of our revenue from sales of flat panel
display products, substantially all of which were based on the active matrix
liquid crystal display technology. An industry shift away from active matrix
liquid crystal display technology to existing or new competing technologies
could reduce the demand for our existing products and require significant
expenditures to develop new products, each of which could harm our business.

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

Our success depends largely on our ability to protect our intellectual
property. While we attempt to protect our intellectual property through
patents, copyrights and trade secrets in the United States and other countries,
there can be no assurance that we will successfully protect our technology or
that competitors will not be able to develop similar technology independently.
We cannot assure you that the claims allowed on any patents held by us will be
sufficiently broad to protect our technology against competition from third
parties with similar technologies or products. In addition, we cannot assure
you 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. Moreover, the laws of some foreign countries do not protect
intellectual property rights to the same extent as the laws of the United
States and we could experience various obstacles and high costs in protecting
our intellectual property rights in foreign countries. If we are unable to
obtain or maintain these protections, we may not be able to prevent third
parties from using our intellectual property.

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We also rely on trade secrets, proprietary know-how and continuing
technological innovation to remain competitive. We have taken measures to
protect our trade secrets and know-how, including the use of confidentiality
agreements with our employees. It is possible that these agreements may be
breached and that the available remedies for any breach will not be sufficient
to compensate us for damages incurred.

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.

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. Any litigation,
regardless of the outcome, could be costly and require significant time and
attention of key members of our management and technical personnel.

Our domestic and international competitors, many of which have
substantially greater resources and have made substantial investments in
competing technologies, may have patents that will prevent, limit or interfere
with our ability to manufacture and sell our products. We have not conducted an
independent review of patents issued to third parties. Third parties may assert
infringement claims, successful or otherwise, against us, and litigation may be
necessary to defend against claims of infringement or invalidity. An adverse
outcome in the defense of a patent suit could subject us to significant
liabilities to third parties, require disputed rights to be licensed from third
parties or require us to cease selling our products. Even successful defenses
of patent suits can be costly and time-consuming.

We must attract and retain key employees and our management team and employees
must work effectively together to maintain and grow our business.

Our future success depends in part on our ability to retain key personnel,
particularly senior management and engineers. We also need to attract
additional skilled personnel in significant 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. We generally do not
have employment contracts with our employees and do not maintain key person
life insurance on any of our employees.

In addition, our management team recently has experienced significant
personnel changes. Elwood H. Spedden recently became our President and Chief
Executive Officer when Vincent Sollitto resigned. Jeffrey A. Hawthorne,
previously Vice President of Development, recently became Senior Vice President
responsible for the flat panel display business replacing Bernard T. Clark who
resigned. In addition, Jon Hopper, Senior Vice President of our sales and
support organization recently resigned. If our management team experiences
high attrition or does not work effectively together, it could seriously harm
our business.

Earthquakes may damage our facilities.

Our corporate and manufacturing facilities in California are located near
major earthquake faults which have experienced earthquakes in the past. In
addition, some of our customers in Asia are located near fault lines. In the
event of a major earthquake or other disaster in or near the San Francisco Bay
Area, our facilities may sustain significant damage and our operations could be
harmed. Similarly, a major earthquake in Asia, like the one that occurred in
Taiwan in September 1999, could disrupt our operations or the operations of our
customers, which could reduce demand for our products.

Our stock price may fluctuate significantly.

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



| |  |  | announcements of technological innovations or new products by us or by our competitors;
| | - |  | ---------------------------------------------------------------------------------------
|
| |  |  | government regulations;                                                                
|
| |  |  | developments in patent or other property rights; and                                   
|
| |  |  | developments in our relationships with our customers.                                  

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
flat panel display and cathode ray tube display and high quality glass
industries may adversely affect the market price of our common stock.

24



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Some anti-takeover provisions may affect the price of our common stock.

Our Amended and Restated Articles of Incorporation authorize our board of
directors to issue up to 5,000,000 shares of preferred stock. The board also
has the authority to determine the price, rights, preferences and privileges,
including voting rights, of those shares without any further vote or action by
the shareholders. The rights of our shareholders will be subject to, and may be
impaired by, the rights of the holders of any preferred stock that may be
issued in the future. These and other provisions contained in our charter
documents and applicable provisions of California law could serve to depress
our stock price or discourage a hostile bid in which shareholders could receive
a premium for their shares. In addition, these provisions could make it more
difficult for a third party to acquire a majority of our outstanding voting
stock or otherwise effect a change in control of us.

We do not anticipate paying cash dividends.

We have never declared or paid any cash dividends on our capital stock and
do not anticipate paying cash dividends in the foreseeable future. We have also
agreed not to pay cash dividends under our current bank line of credit.
Instead, we intend to apply any earnings to the expansion and development of our business.




Item 3.Quantitative and Qualitative Disclosures About Market Risk

Our market and currency risk disclosures set forth in Item 7A of our
Annual Report on Form 10-K for the year ended September 30, 2002 have not
changed significantly.




Item 4. Controls and Procedures



|(a) |  | The Companys chief executive officer and chief financial officer have
concluded, subject to the limitations on the effectiveness of the controls
described below, that the Companys disclosure controls and procedures are
sufficiently effective to ensure that the information required to be disclosed
by the Company in the reports it files under the Exchange Act is gathered,
analyzed and disclosed with adequate timeliness, accuracy and completeness,
based on an evaluation of such controls and procedures conducted within 90 days
prior to the date hereof.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(b) |  | There have been no significant changes in the Companys internal
controls or in other factors that could significantly affect these controls
subsequent to the date of the evaluation referred to above, nor were there any
significant deficiencies or material weaknesses in the Companys internal
controls. Accordingly, no corrective actions were required or undertaken.                                                                                                                                                                                             

Limitations on the Effectiveness of Controls. The Companys management,
including its chief executive officer and chief financial officer, does not
expect that the Companys disclosure controls and procedures or the Companys
internal controls will prevent all error and all fraud. A control system, no
matter how well conceived and operated, is based in part upon certain
assumptions about the likelihood of future events and can provide only
reasonable, not absolute, assurance that the objectives of the control system
are met. Further, the design of a control system must reflect the fact that
there are resource constraints, and the benefits of controls must be considered
relative to their costs. Because of the inherent limitations in all control
systems, no evaluation of controls can provide absolute assurance that all
control issues and instances of fraud, if any, within the Company have been or
will be detected.

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PART II. OTHER INFORMATION




Item 1. Legal Proceedings

We have been named as defendant in a lawsuit captioned Thomason v. Photon
Dynamics, Inc., No. 02CC03568, filed on February 28, 2002 in the Superior Court
of the State of California, County of Orange. The plaintiff in this action has
purported to assert that he was wrongly not allowed to exercise certain stock
options and is seeking damages of approximately $900,000. On March 29, 2002, we
responded to the lawsuit and filed a counterclaim against the plaintiff for
breach of a general release agreement. On December 19, 2002, we filed a motion
for summary judgment. While we intend to vigorously contest the action, we
cannot predict the outcome of this litigation. We believe that an adverse
determination in this litigation would not have a material adverse effect on
our financial condition or results of operations.

We, and certain of our directors and officers have been named as
defendants in a lawsuit captioned Amtower v. Photon Dynamics, Inc., No.
CV797876, filed on April 30, 2001 in the Superior Court of the State of
California, County of Santa Clara. The plaintiff, a former officer of Photon,
has asserted several causes of action arising out of alleged misrepresentations
made to plaintiff regarding the existence and enforcement of our insider
trading policy. Plaintiff seeks damages of approximately $17.7 million for our
alleged refusal to allow plaintiff to sell Photon stock in May of 2000, plus
unspecified emotional distress and punitive damages. On December 6, 2001, the
court granted our motion to dismiss the complaint for failure to allege facts
sufficient to state a cause of action, with leave to file an amended complaint.
On January 17, 2002, plaintiff filed his amended complaint and we again moved
to dismiss the action. On June 27, 2002, the court issued an order granting in
part and denying in part the motion, and further granted plaintiff an
opportunity to restate certain claims. On October 1, 2002, plaintiff filed his
Second Amended Complaint. Our motion to dismiss is pending and scheduled to be
heard in March of 2003. We believe plaintiffs case is without merit and intend
to defend this action vigorously. Although we cannot predict the outcome of
this litigation, we believe that any adverse judgment in this litigation would
not have a material adverse effect on our financial condition or results of
operations.

We filed a lawsuit captioned Photon Dynamics, Inc. vs. PanelVision
Technology and Guillermo Tora-Lira, No. CO202563PJH filed on May 28, 2002 in
the U.S. District Court for the Northern District of California, County of
Santa Clara. We are alleging infringement of a U.S. Patent owned by us and
seeking full compensatory damages and an injunction against the defendants. On
July 17, 2002, the defendants answered our complaint and asserted a
counterclaim alleging damages of at least $6.0 million in compensatory damages
for loss of business. We believe that the counterclaims are without merit and
intend to vigorously contest the counterclaims. On January 23, 2003 we added
Shimadzu Corporation to the complaint. Although we cannot predict the outcome
of this litigation, we believe that any adverse determination in this
litigation would not have a material adverse effect on our financial condition
or results of operations.




Item 2.Changes in Securities and Use of Proceeds

None.




Item3. Defaults Upon Senior Securities

None.




Item4. Submission of Matters to a Vote of Security Holders

None.




Item5. Other Information

In
accordance with Section 10A(i)(2) of the Securities and Exchange Act
of 1934, as added by Section 202 of the Sarbanes-Oxley Act of 2002
(the "Act"), we are required to disclose the non-audit services
approved by our Audit Committee to be performed by Ernst & Young LLP,
our external auditor. The only non-audit services approved by the Companys Audit Committee to
be performed by Ernst & Young LLP are services rendered in connection with the
formation of a subsidiary in China. Fees for such services are expected
to be less than $50,000.

In
January 2003, Elwood (Woody) H. Spedden, a director of the Company,
became our President and Chief Executive Officer, replacing Vincent
S. Sollitto in this capacity. Mr. Sollitto also resigned as a
director of the Company. Jon Hopper, the Company's Senior Vice
President of sales and support since July 2001, also resigned
accepting a Chief Executive Officer position at another company. In
addition, Bernard Clark, the Company's Vice President and President
of the Flat Panel Display Division since February 2001 resigned.
Jeffrey A. Hawthorne was named as the Company's new Senior Vice
President to manage the Flat Panel Display business in February 2003.
Mr. Hawthorne has held various management positions with the Company
since 1991.

The
Company also announced in January 2003 that it decided to exit the
printed circuit board assembly inspection business.

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Item6. Exhibits and Reports on Form 8-K

(a) Exhibits

|       |  |                                                                        
|------ |  | -----------------------------------------------------------------------
|Number |  | Exhibit                                                                
|       |  |                                                                        
|3.1(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 and amendments thereto                        
|      
|4.1    |  | Reference is made to Exhibits 3.1, 3.2 and 3.3                         
|      
|10.5   |  | 1995 Stock Option Plan, as amended                                     
|
|      

Key to Exhibits:



| | (1) |  | Previously filed as an exhibit to the Registrants Registration
Statement on Form S-1 (Commission File No. 333-76650) as filed with
the SEC on January 14, 2002, as amended, and incorporated herein by
reference.
| | --- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | (2) |  | Previously filed as an exhibit to the Registrants Annual
Report on Form 10-KSB for the fiscal year ended September 30, 1998 as
filed with the SEC on December 18, 1998, and incorporated herein by
reference.    

(b) Reports on Form 8-K

None

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SIGNATURES

Pursuant to the requirements 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: /s/ RICHARD L. DISSLY
|                         |  | By:                                             |  | Richard L. Dissly
Chief Financial Officer and Secretary
(Duly authorized and principal financial officer)
|Dated: February 14, 2003

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CERTIFICATIONS



|   |  | I, Elwood H. Spedden, certify that:                                                                                                                                                                                                                                                                                           
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  
|1. |  | I have reviewed this quarterly report on Form 10-Q of Photon Dynamics,
Inc.;                                                                                                                                                                                                                                                  
|  
|2. |  | Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this
quarterly report;
|  
|3. |  | Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;                   
|  
|4. |  | The registrants other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:                                                                                                         



| | a) |  | designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) |  | evaluated the effectiveness of the registrants disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
quarterly report (the Evaluation Date); and                                                                                                  
|
| | c) |  | presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;                                                                                                                        



|5. |  | The registrants other certifying officer and I have disclosed, based
on our most recent evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons performing the
equivalent functions):
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrants ability to record,
process, summarize and report financial data and have identified for the
registrants auditors any material weaknesses in internal controls; and
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) |  | any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrants internal
controls; and                                                                                                                                        



|6. |  | The registrants other certifying officer and I have indicated in this
quarterly report whether there were significant changes in internal controls or
in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions
with regard to significant deficiencies and material weaknesses.
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                        |  |                                      
|----------------------- |  | -------------------------------------
|                        |  | /S/ ELWOOD H. SPEDDEN                
|                        |  |                                      
|                        |  | Elwood H. Spedden                    
|                        |  | President and Chief Executive Officer
|Date: February 14, 2003 |  |                                      

29



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##### Table of Contents



|   |  | I, Richard L. Dissly, certify that:                                                                                                                                                                                                                                                                                           
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  
|1. |  | I have reviewed this quarterly report on Form 10-Q of Photon Dynamics,
Inc.;                                                                                                                                                                                                                                                  
|  
|2. |  | Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this
quarterly report;
|  
|3. |  | Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;                   
|  
|4. |  | The registrants other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:                                                                                                         



| | a) |  | designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) |  | evaluated the effectiveness of the registrants disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
quarterly report (the Evaluation Date); and                                                                                                  
|
| | c) |  | presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;                                                                                                                        



|5. |  | The registrants other certifying officer and I have disclosed, based
on our most recent evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons performing the
equivalent functions):
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrants ability to record,
process, summarize and report financial data and have identified for the
registrants auditors any material weaknesses in internal controls; and
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) |  | any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrants internal
controls; and                                                                                                                                        



|6. |  | The registrants other certifying officer and I have indicated in this
quarterly report whether there were significant changes in internal controls or
in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions
with regard to significant deficiencies and material weaknesses.
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                        |  |                                                        
|----------------------- |  | -------------------------------------------------------
|                        |  | /s/ RICHARD L. DISSLY                                  
|                        |  |                                                        
|                        |  | Richard L. Dissly
Secretary and Chief Financial Officer
|Date: February 14, 2003 |  |                                                        

30



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##### Table of Contents






Exhibit Index

|       |  |                                                                        
|------ |  | -----------------------------------------------------------------------
|Number |  | Exhibit                                                                
|       |  |                                                                        
|3.1(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 and amendments thereto                        
|      
|4.1    |  | Reference is made to Exhibits 3.1, 3.2 and 3.3                         
|      
|10.5   |  | 1995 Stock Option Plan, as amended                                     
|
|      

Key to Exhibits:



| | (1) |  | Previously filed as an exhibit to the Registrants Registration
Statement on Form S-1 (Commission File No. 333-76650) as filed with
the SEC on January 14, 2002, as amended, and incorporated herein by
reference.
| | --- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | (2) |  | Previously filed as an exhibit to the Registrants Annual
Report on Form 10-KSB for the fiscal year ended September 30, 1998 as
filed with the SEC on December 18, 1998, and incorporated herein by
reference.