##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 
 FORM 10-Q
 
 (Mark One)
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended June 30, 2008
 OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION
13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
 For the transition period from  to
 Commission file number: 000-27234
 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.)
 5970 Optical Court
San Jose, California 95138-1400  (Address of principal executive offices including zip code)
 (408) 226-9900  (Registrants telephone number, including area code)
 þ o
  Large accelerated filer oAccelerated filer þNon-accelerated filer o(Do not check if a smaller reporting company)Smaller reporting company o o þ




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##### 



INDEX
 PagePART I FINANCIAL INFORMATIONItem 1
    
    Financial Statements (unaudited)
    
    
    3Condensed Consolidated Balance Sheets as of June 30, 2008 and September 30, 2007
    
    
    3Condensed Consolidated Statements of Operations for the Three and Nine Months Ended June 30, 2008 and 2007
    
    
    4Condensed Consolidated Statements of Cash Flows for the Nine Months Ended June 30, 2008 and 2007
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    23Item 3
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    41Item 4
    
    Controls and Procedures
    
    
    42PART II OTHER INFORMATIONItem 1
    
    Legal Proceedings
    
    
    44Item 1A
    
    Risk Factors
    
    
    45Item 2
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    57Item 3
    
    Defaults Upon Senior Securities
    
    
    57Item 4
    
    Submission of Matters to a Vote of Security Holders
    
    
    58Item 5
    
    Other Information
    
    
    58Item 6
    
    Exhibits
    
    
    58Signatures
    
    
    
    
    59EXHIBIT 10.60EXHIBIT 10.61EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1
  2




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##### Table of Contents



PART I. FINANCIAL INFORMATION
 
 ITEM 1. Financial Statements
 
 PHOTON DYNAMICS, INC.
 CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
 June 30,
    
    
    September 30,2008
    
    
    2007(in thousands)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    60,672
    
    
    $
    41,170Short-term investments
    
    
    10,156
    
    
    
    42,640Accounts receivable, net of allowance for doubtful accounts of $52 and
$239 at June 30, 2008 and September 30, 2007, respectively
    
    
    36,894
    
    
    
    11,934Inventories
    
    
    21,409
    
    
    
    13,292Refundable customs obligations
    
    
    632
    
    
    
    560Other current assets
    
    
    5,066
    
    
    
    3,661Total current assets
    
    
    134,829
    
    
    
    113,257Long-term investments
    
    
    1,000
    
    
    
    1,176Land, property and equipment, net
    
    
    9,725
    
    
    
    10,583Other assets
    
    
    6,174
    
    
    
    5,365Intangible assets, net
    
    
    8,348
    
    
    
    11,023Goodwill
    
    
    6,857
    
    
    
    6,857Total assets
    
    $
    166,933
    
    
    $
    148,261LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    22,112
    
    
    $
    4,217Warranty
    
    
    5,823
    
    
    
    3,217Employee note payable
    
    
    2,733
    
    
    
    Customs obligations
    
    
    438
    
    
    
    4,114Other current liabilities
    
    
    11,963
    
    
    
    9,874Deferred gross margin
    
    
    1,699
    
    
    
    3,236Total current liabilities
    
    
    44,768
    
    
    
    24,658Non-current liabilities:Long-term employee note payable
    
    
    2,667
    
    
    
    5,381Other non-current liabilities
    
    
    
    
    
    
    38Total non-current liabilities
    
    
    2,667
    
    
    
    5,419Commitments and contingenciesShareholders equity:Common stock, no par value
    
    
    302,413
    
    
    
    300,290Accumulated deficit
    
    
    (182,352
    )
    
    
    (181,503
    )Accumulated other comprehensive loss
    
    
    (563
    )
    
    
    (603
    )Total shareholders equity
    
    
    119,498
    
    
    
    118,184Total liabilities and shareholders equity
    
    $
    166,933
    
    
    $
    148,261
  3




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##### Table of Contents



PHOTON DYNAMICS, INC.
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
 Three Months Ended
    
    
    Nine Months EndedJune 30,
    
    
    June 30,2008
    
    
    2007
    
    
    2008
    
    
    2007(in thousands, except per share data)Product revenue
    
    $
    41,387
    
    
    $
    11,356
    
    
    $
    94,884
    
    
    $
    39,462Customer support and spare parts revenue
    
    
    4,734
    
    
    
    3,074
    
    
    
    12,506
    
    
    
    10,331Total revenue
    
    
    46,121
    
    
    
    14,430
    
    
    
    107,390
    
    
    
    49,793Product cost of revenue
    
    
    23,157
    
    
    
    10,027
    
    
    
    58,438
    
    
    
    36,272Customer support and spare parts cost of revenue
    
    
    1,829
    
    
    
    1,188
    
    
    
    5,383
    
    
    
    4,497Total cost of revenue
    
    
    24,986
    
    
    
    11,215
    
    
    
    63,821
    
    
    
    40,769Gross margin
    
    
    21,135
    
    
    
    3,215
    
    
    
    43,569
    
    
    
    9,024Operating expenses:Research and development
    
    
    7,309
    
    
    
    6,213
    
    
    
    18,681
    
    
    
    21,343Selling, general and administrative
    
    
    9,216
    
    
    
    5,831
    
    
    
    24,072
    
    
    
    17,197Restructuring charge (benefit)
    
    
    
    
    
    
    (95
    )
    
    
    
    
    
    
    1,368Impairment of property and equipment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,834Gain on sale of property and equipment
    
    
    
    
    
    
    
    
    
    
    (49
    )
    
    
    Amortization of intangible assets
    
    
    892
    
    
    
    254
    
    
    
    2,675
    
    
    
    999Total operating expenses
    
    
    17,417
    
    
    
    12,203
    
    
    
    45,379
    
    
    
    43,741Income (loss) from operations
    
    
    3,718
    
    
    
    (8,988
    )
    
    
    (1,810
    )
    
    
    (34,717
    )Interest income and other, net
    
    
    423
    
    
    
    327
    
    
    
    1,886
    
    
    
    3,337Income (loss) before income taxes
    
    
    4,141
    
    
    
    (8,661
    )
    
    
    76
    
    
    
    (31,380
    )Provision for income taxes
    
    
    255
    
    
    
    72
    
    
    
    559
    
    
    
    278Net income (loss)
    
    $
    3,886
    
    
    $
    (8,733
    )
    
    $
    (483
    )
    
    $
    (31,658
    )Net income (loss) per share:Basic
    
    $
    0.22
    
    
    $
    (0.52
    )
    
    $
    (0.03
    )
    
    $
    (1.91
    )Diluted
    
    $
    0.21
    
    
    $
    (0.52
    )
    
    $
    (0.03
    )
    
    $
    (1.91
    )Weighted average number of shares:Basic
    
    
    17,786
    
    
    
    16,635
    
    
    
    17,759
    
    
    
    16,605Diluted
    
    
    18,624
    
    
    
    16,635
    
    
    
    17,759
    
    
    
    16,605
  4




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##### Table of Contents



PHOTON DYNAMICS, INC.
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 Nine Months EndedJune 30,2008
    
    
    2007(in thousands)Cash flows from operating activities:Net loss
    
    $
    (483
    )
    
    $
    (31,658
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation
    
    
    2,333
    
    
    
    3,653Amortization of intangible assets
    
    
    2,675
    
    
    
    999Stock-based compensation
    
    
    1,982
    
    
    
    1,513Restructuring charge
    
    
    
    
    
    
    178Impairment of property and equipment
    
    
    
    
    
    
    2,834Foreign currency translation adjustment gain recognized upon liquidation of a subsidiary
    
    
    
    
    
    
    (928
    )Gain on sale of property and equipment
    
    
    (49
    )
    
    
    Accretion of non-interest bearing notes payable
    
    
    
    
    
    
    23Changes in operating assets and liabilities:Accounts receivable
    
    
    (24,960
    )
    
    
    10,414Inventories
    
    
    (6,840
    )
    
    
    428Other current assets
    
    
    (1,477
    )
    
    
    (471
    )Other assets
    
    
    (1,010
    )
    
    
    (284
    )Accounts payable
    
    
    17,895
    
    
    
    (224
    )Other current liabilities
    
    
    752
    
    
    
    (1,022
    )Deferred gross margin
    
    
    (1,537
    )
    
    
    (851
    )Other liabilities
    
    
    (38
    )
    
    
    (23
    )Net cash used in operating activities
    
    
    (10,757
    )
    
    
    (15,419
    )Cash flows from investing activities:Purchase of property and equipment
    
    
    (2,823
    )
    
    
    (1,040
    )Proceeds from sale of property and equipment
    
    
    250
    
    
    
    Purchase of short-term investments
    
    
    (13,621
    )
    
    
    (82,711
    )Maturities and sales of short-term investments
    
    
    46,290
    
    
    
    78,264Net cash provided by (used in) investing activities
    
    
    30,096
    
    
    
    (5,487
    )Cash flows from financing activities:Issuance of common stock
    
    
    161
    
    
    
    1,364Capital lease payments
    
    
    (80
    )
    
    
    (68
    )Net cash provided by financing activities
    
    
    81
    
    
    
    1,296Effect of exchange rate changes on cash and cash equivalents
    
    
    82
    
    
    
    (72
    )Net increase (decrease) in cash and cash equivalents
    
    
    19,502
    
    
    
    (19,682
    )Cash and cash equivalents at beginning of period
    
    
    41,170
    
    
    
    47,935Cash and cash equivalents at end of period
    
    $
    60,672
    
    
    $
    25,253
  5




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##### Table of Contents



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




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




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##### Table of Contents



PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
   .
 NOTE 2  MERGER WITH ORBOTECH LTD.
   
    
    Following the termination by the Company to accept a superior proposal (as defined in
the Merger Agreement);
    
    Following the termination by Orbotech, if the Companys Board of Directors changes
its recommendation or recommends a competing proposal, or fails to reaffirm its
recommendation following the public announcement of a competing proposal;
    
    Following the public announcement of a competing proposal that is not withdrawn prior
to the special meeting, if (i) such termination results from a failure to obtain the
required shareholder vote and (ii) within twelve months after such termination, the
Company enters into a definitive agreement relating to an alternative acquisition or
consummates an alternative acquisition; or
 8




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PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
 
    
    Following the receipt by the Company of a competing proposal that is not withdrawn on
or prior to the outside date, if (i) the required shareholder vote is not obtained and
(ii) within twelve months after such termination, the Company enters into a definitive
agreement relating to an alternative acquisition or consummates an alternative
acquisition.
    NOTE 3  FINANCIAL STATEMENT COMPONENTS
 June 30,
    
    
    September 30,2008
    
    
    2007(in thousands)Inventories:Raw materials
    
    $
    10,402
    
    
    $
    7,465Work-in-process
    
    
    10,281
    
    
    
    4,491Finished goods
    
    
    726
    
    
    
    1,336Total
    
    $
    21,409
    
    
    $
    13,292Other current liabilities:Compensation
    
    $
    5,696
    
    
    $
    4,897Professional fees
    
    
    3,082
    
    
    
    2,441Other accrued expenses
    
    
    3,185
    
    
    
    2,536Total
    
    $
    11,963
    
    
    $
    9,874Deferred gross margin:Deferred system revenue
    
    $
    17,007
    
    
    $
    10,269Deferred cost of revenue
    
    
    (15,308
    )
    
    
    (7,033
    )Total
    
    $
    1,699
    
    
    $
    3,236Accumulated other comprehensive loss:Foreign currency translation adjustments
    
    $
    (512
    )
    
    $
    (543
    )Unrealized losses on availablefor-sale securities
    
    
    (51
    )
    
    
    (60
    )Total
    
    $
    (563
    )
    
    $
    (603
    )
 NOTE 4  GOODWILL AND OTHER PURCHASED INTANGIBLE ASSETS
 Goodwill
  9




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##### Table of Contents



PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
  Intangible Assets
  NonDeveloped
    
    
    Core
    
    
    Compete
    
    
    Customer
    
    
    TradeTechnology
    
    
    Technology
    
    
    Contract
    
    
    Relations
    
    
    Name
    
    
    Backlog
    
    
    Total(in thousands)Gross carrying amount at June 30, 2008
    
    $
    7,346
    
    
    $
    3,988
    
    
    $
    2,348
    
    
    $
    910
    
    
    $
    640
    
    
    $
    110
    
    
    $
    15,342Accumulated amortization
    
    
    (2,470
    )
    
    
    (2,753
    )
    
    
    (1,368
    )
    
    
    (209
    )
    
    
    (147
    )
    
    
    (47
    )
    
    
    (6,994
    )Net carrying amount at June 30, 2008
    
    $
    4,876
    
    
    $
    1,235
    
    
    $
    980
    
    
    $
    701
    
    
    $
    493
    
    
    $
    63
    
    
    $
    8,348
  NonDeveloped
    
    
    Core
    
    
    Compete
    
    
    Customer
    
    
    TradeTechnology
    
    
    Technology
    
    
    Contract
    
    
    Relations
    
    
    Name
    
    
    Backlog
    
    
    Total(in thousands)Gross carrying amount at September 30, 2007
    
    $
    7,346
    
    
    $
    3,988
    
    
    $
    2,348
    
    
    $
    910
    
    
    $
    640
    
    
    $
    110
    
    
    $
    15,342Accumulated amortization
    
    
    (1,094
    )
    
    
    (2,111
    )
    
    
    (1,041
    )
    
    
    (38
    )
    
    
    (27
    )
    
    
    (8
    )
    
    
    (4,319
    )Net carrying amount at September 30, 2007
    
    $
    6,252
    
    
    $
    1,877
    
    
    $
    1,307
    
    
    $
    872
    
    
    $
    613
    
    
    $
    102
    
    
    $
    11,023
  NonDeveloped
    
    
    Core
    
    
    Compete
    
    
    Customer
    
    
    TradeTechnology
    
    
    Technology
    
    
    Contract
    
    
    Relations
    
    
    Name
    
    
    Backlog
    
    
    Total(in thousands)Balance as of September 30, 2007
    
    $
    6,252
    
    
    $
    1,877
    
    
    $
    1,307
    
    
    $
    872
    
    
    $
    613
    
    
    $
    102
    
    
    $
    11,023Amortization during the period
    
    
    (1,376
    )
    
    
    (642
    )
    
    
    (327
    )
    
    
    (171
    )
    
    
    (120
    )
    
    
    (39
    )
    
    
    (2,675
    )Balance as of June 30, 2008
    
    $
    4,876
    
    
    $
    1,235
    
    
    $
    980
    
    
    $
    701
    
    
    $
    493
    
    
    $
    63
    
    
    $
    8,348
   NOTE 5  RESTRUCTURING AND OTHER CHARGES
 March 2007 Impairment of Property and Equipment
   10




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PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
  February 2007 Restructure
    November 2006 Restructure
 TM
 NOTE 6  COMPREHENSIVE INCOME (LOSS)
  Three Months Ended
    
    
    Nine Months EndedJune 30,
    
    
    June 30,2008
    
    
    2007
    
    
    2008
    
    
    2007(in thousands)Net income (loss)
    
    $
    3,886
    
    
    $
    (8,733
    )
    
    $
    (483
    )
    
    $
    (31,658
    )Other comprehensive income (loss):Net change in unrealized gain (loss) on investments
    
    
    32
    
    
    
    (8
    )
    
    
    9
    
    
    
    (3
    )Change in foreign currency translation
    
    
    (157
    )
    
    
    6
    
    
    
    31
    
    
    
    (87
    )(1)Other comprehensive income (loss)
    
    
    (125
    )
    
    
    (2
    )
    
    
    40
    
    
    
    (90
    )Total comprehensive income (loss)
    
    $
    3,761
    
    
    $
    (8,735
    )
    
    $
    (443
    )
    
    $
    (31,748
    )
 
 (1)
    
    In the quarter ended March 31, 2007, the Company substantially liquidated its net investment
in its Canadian subsidiary, Photon Dynamics Canada, Inc., for financial statement purposes. In
accordance with the provisions of Statement of Financial Accounting Standards No. 52, Foreign
Currency Translation the Company recorded a gain on liquidation of its net investment in this
subsidiary of approximately $928,000, composed of translation adjustment gains that had
accumulated in Accumulated other comprehensive income (loss) on the Consolidated Balance
Sheet. 11




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##### Table of Contents



PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 NOTE 7  STOCK-BASED COMPENSATION PLANS
   Three Months Ended
    
    
    Nine Months EndedJune 30,
    
    
    June 30,2008
    
    
    2007
    
    
    2008
    
    
    2007(in thousands)Stock-based compensation expense included in continuing
operations: :Cost of revenue
    
    $
    61
    
    
    $
    26
    
    
    $
    233
    
    
    $
    213Research and development
    
    
    242
    
    
    
    125
    
    
    
    411
    
    
    
    324Selling, general and administrative
    
    
    757
    
    
    
    274
    
    
    
    1,338
    
    
    
    976Total stock-based compensation expense after income taxes (1)
    
    $
    1,060
    
    
    $
    425
    
    
    $
    1,982
    
    
    $
    1,513Stock-based compensation expense by type of award: :Employee stock options
    
    $
    288
    
    
    $
    274
    
    
    $
    441
    
    
    $
    1,130Employee stock purchase plan
    
    
    56
    
    
    
    74
    
    
    
    56
    
    
    
    281Restricted stock awards
    
    
    696
    
    
    
    159
    
    
    
    1,465
    
    
    
    184Amounts capitalized as inventory and deferred gross margin
    
    
    20
    
    
    
    (82
    )
    
    
    20
    
    
    
    (82
    )Total stock-based compensation expense after income taxes (1)
    
    $
    1,060
    
    
    $
    425
    
    
    $
    1,982
    
    
    $
    1,513
 
 (1)
    
    The income tax benefit on stock-based compensation for all periods presented was not
material. Equity Incentive and Other Programs
  2005 Equity Incentive Plan
 2006 Non-Employee Directors Stock Incentive Plan
 12




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PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
    Valuation and Other Assumption
  Expected Volatility
 Expected Term
 Risk-Free Interest Rate
 Expected Dividends
 Forfeitures
  13




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PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 Three Months Ended
    
    Nine Months EndedJune 30,
    
    June 30,2008
    
    2007
    
    2008
    
    2007Stock option plan:Expected volatility
    
    
    52
    %
    
    
    42
    %
    
    
    51
    %
    
    
    43
    %Risk free rate
    
    
    2.4
    %
    
    
    4.5
    %
    
    
    2.5
    %
    
    
    4.6
    %Expected term (in years)
    
    
    3.8
    
    
    
    3.4
    
    
    
    4.0
    
    
    
    3.4Expected dividends
    
    None
    
    
    None
    

    
    None
    

    
    None
   Three Months Ended
    
    Nine Months EndedJune 30,
    
    June 30,2008
    
    2007
    
    2008
    
    2007Stock purchase plan:Expected volatility
    
    
    53
    %
    
    
    42
    %
    
    
    53
    %
    
    
    43
    %Risk free rate
    
    
    2.8
    %
    
    
    4.5
    %
    
    
    2.8
    %
    
    
    4.6
    %Expected term (in years)
    
    
    0.5
    
    
    
    0.5
    
    
    
    0.5
    
    
    
    0.5Expected dividends
    
    None
    

    
    None
    

    
    None
    
    
    None
   Equity Incentive Plan
  Awards
    
    
    
    
    
    
    Weighted-
    
    
    Weighted-Average
    
    
    AggregateAvailable
    
    
    Options
    
    
    Average
    
    
    Remaining Contract
    
    
    Intrinsic Valuefor Grant
    
    
    Outstanding
    
    
    Exercise Price
    
    
    Term (in years)
    
    
    (in thousands)Balances at September 30, 2007
    
    
    1,739,630
    
    
    
    1,245,582
    
    
    $
    19.29Plan shares expired (1)
    
    
    (155,479
    )
    
    
    
    
    
    
    Restricted stock units granted (2)
    
    
    (702,500
    )
    
    
    
    
    
    
    Restricted stock units cancelled (2)
    
    
    78,415
    
    
    
    
    
    
    
    Restricted stock units canceled or
withheld for taxes (2)
    
    
    27,379
    
    
    
    
    
    
    
    Options granted
    
    
    (160,750
    )
    
    
    160,750
    
    
    
    9.63Options canceled
    
    
    293,179
    
    
    
    (293,179
    )
    
    
    20.71Options exercised
    
    
    
    
    
    
    (17,018
    )
    
    
    9.44Balances at June 30, 2008
    
    
    1,119,874
    
    
    
    1,096,135
    
    
    $
    17.64
    
    
    
    5.63
    
    
    $
    2,259Vested and expected to vest at June 30, 2008
    
    
    
    
    
    
    921,266
    
    
    $
    18.75
    
    
    
    5.53
    
    
    $
    1,616Exercisable at June 30, 2008
    
    
    
    
    
    
    688,017
    
    
    $
    21.22
    
    
    
    5.18
    
    
    $
    677
 14




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##### Table of Contents



PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 
 (1)
    
    The Companys 1995 Amended and Restated Stock Option Plan expired in November 2005. Option
shares that were available for grant at the time of cancellation and all outstanding option
shares that subsequently are cancelled or expire are no longer available for grant.(2)
    
    Any restricted stock units granted under the 2005 Equity Incentive Plan or 2006 Non-Employee
Directors Stock Incentive Plan shall be counted against the total number of shares issuable
under the Plans. Additional detail of issued restricted stock units are shown below.     Restricted Stock Units
  Weighted-AverageNumber
    
    
    Grant Dateof Shares
    
    
    Fair ValueUnvested restricted stock units at September 30, 2007
    
    
    284,196
    
    
    $
    10.44Restricted stock units granted
    
    
    702,500
    
    
    $
    9.97Restricted stock units released
    
    
    (83,573
    )
    
    $
    10.40Unvested restricted stock units cancelled
    
    
    (78,415
    )
    
    $
    10.26Unvested restricted stock units at June 30, 2008
    
    
    824,708
    
    
    $
    10.06
  Employee Stock Purchase Plan
    NOTE 8  EARNINGS (LOSS) PER SHARE
 15




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##### Table of Contents



PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
   Three Months Ended
    
    
    Nine Months EndedJune 30,
    
    
    June 30,2008
    
    
    2007
    
    
    2008
    
    
    2007(in thousands, except per share data)Numerator:Net income (loss)
    
    $
    3,886
    
    
    $
    (8,733
    )
    
    $
    (483
    )
    
    $
    (31,658
    )Denominator:Weighted average shares outstanding,
excluding unvested restricted stock,
for basic net income (loss) per
share
    
    
    17,786
    
    
    
    16,635
    
    
    
    17,759
    
    
    
    16,605Effect of dilutive securities:Employee stock options and
restricted stock (1)
    
    
    838
    
    
    
    
    
    
    
    
    
    
    
    Weighted average shares for
diluted net income (loss) per
share
    
    
    18,624
    
    
    
    16,635
    
    
    
    17,759
    
    
    
    16,605Earnings (loss) per share:Basic
    
    $
    0.22
    
    
    $
    (0.52
    )
    
    $
    (0.03
    )
    
    $
    (1.91
    )Diluted
    
    $
    0.21
    
    
    $
    (0.52
    )
    
    $
    (0.03
    )
    
    $
    (1.91
    )Potentially anti-dilutive securities (2)
    
    
    1,090
    
    
    
    1,622
    
    
    
    1,148
    
    
    
    1,878
 
 (1)
    
    The effect of potentially dilutive securities to purchase 834,892 shares of common stock for
the nine months ended June 30, 2008, and 318,823 and 320,321 shares of common stock for the
three and nine months ended June 30, 2007, respectively, were not included in the computation
of diluted net loss per share as the effect is anti-dilutive.(2)
    
    These securities are excluded from the computation of diluted earnings per share because the
exercise price, including unamortized stock-based compensation net of tax benefits, was
greater than the average market price of common shares for the periods presented. As a result,
their effect would have been anti-dilutive. NOTE 9  COMMITMENTS AND CONTINGENCIES
 Purchase Agreements
   16




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##### Table of Contents



PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 Warranty Obligations
   Nine Months EndedJune 30,2008
    
    
    2007(in thousands)Beginning balance
    
    $
    3,217
    
    
    $
    8,058Estimated warranty cost of new shipments during the period
    
    
    6,639
    
    
    
    3,755Warranty costs during the period
    
    
    (4,351
    )
    
    
    (7,819
    )Changes in liability for pre-existing warranties, including expirations
    
    
    318
    
    
    
    697Ending balance
    
    $
    5,823
    
    
    $
    4,691
 TM
 Contingent Termination Fee Related to Merger with Orbotech
  Legal Proceedings
 Capital Partners v. Dr. Malcolm J. Thompson, et al Capital Partners
v. Dr. Malcolm J. Thompson, et al.
  Amtower v. Photon Dynamics, Inc
 17




---



##### Table of Contents



PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
  Customs and Duties Liability.
 Security and Exchange Commission Inquiry
 General Litigation
 NOTE 10  SEGMENT REPORTING AND GEOGRAPHIC INFORMATION
   
    
    Flat Panel Display Segment. Includes test and repair equipment used in the flat panel
display industry to collect and analyze data from the liquid crystal display production
lines and to diagnose and repair defects in the production line.
    
    High-Performance Digital Imaging Segment. Includes high-performance digital cameras used
in the defense, industrial and scientific/medical industries for a variety of applications.
 18




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##### Table of Contents



PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
     Three Months
    
    
    Nine MonthsEnded
    
    
    EndedJune 30,
    
    
    June 30,2008
    
    
    2007
    
    
    2008
    
    
    2007(in thousands)Revenue:Flat panel display segment
    
    $
    44,470
    
    
    $
    14,430
    
    
    $
    103,544
    
    
    $
    49,793High-performance digital imaging segment
    
    
    1,651
    
    
    
    
    
    
    
    3,846
    
    
    
    Consolidated revenue
    
    $
    46,121
    
    
    $
    14,430
    
    
    $
    107,390
    
    
    $
    49,793Operating income (loss):Flat panel display segment
    
    $
    6,234
    
    
    $
    (8,455
    )
    
    $
    4,491
    
    
    $
    (28,799
    )High-performance digital imaging segment
    
    
    (1,456
    )
    
    
    
    
    
    
    (4,367
    )
    
    
    Total segment operating income (loss)
    
    $
    4,778
    
    
    $
    (8,455
    )
    
    $
    124
    
    
    $
    (28,799
    )
   Three Months
    
    
    Nine MonthsEnded
    
    
    EndedJune 30,
    
    
    June 30,2008
    
    
    2007
    
    
    2008
    
    
    2007(in thousands)Operating loss:Total segment operating income (loss)
    
    $
    4,778
    
    
    $
    (8,455
    )
    
    $
    124
    
    
    $
    (28,799
    )Unallocated costs
    
    
    (1,060
    )
    
    
    (628
    )
    
    
    (1,983
    )
    
    
    (1,716
    )Restructuring costs (benefit)
    
    
    
    
    
    
    95
    
    
    
    
    
    
    
    (1,368
    )Impairment of property and equipment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,834
    )Gain on sale of property and equipment
    
    
    
    
    
    
    
    
    
    
    49
    
    
    
    Consolidated income (loss) from operations
    
    $
    3,718
    
    
    $
    (8,988
    )
    
    $
    (1,810
    )
    
    $
    (34,717
    )
 19




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##### Table of Contents



PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
  Three Months
    
    
    Nine MonthsEnded
    
    
    EndedJune 30,
    
    
    June 30,2008
    
    
    2007
    
    
    2008
    
    
    2007(in thousands)Revenue:South Korea
    
    $
    27,906
    
    
    $
    6,921
    
    
    $
    52,781
    
    
    $
    16,995Taiwan
    
    
    12,964
    
    
    
    3,493
    
    
    
    36,716
    
    
    
    17,123Japan
    
    
    1,022
    
    
    
    3,936
    
    
    
    10,717
    
    
    
    14,476Germany
    
    
    2,324
    
    
    
    
    
    
    
    2,323
    
    
    
    United States
    
    
    1,651
    
    
    
    
    
    
    
    3,846
    
    
    
    China
    
    
    254
    
    
    
    80
    
    
    
    1,007
    
    
    
    1,199Total
    
    $
    46,121
    
    
    $
    14,430
    
    
    $
    107,390
    
    
    $
    49,793
  Three Months
    
    Nine MonthsEnded
    
    EndedJune 30,
    
    June 30,2008
    
    2007
    
    2008
    
    2007Customer A
    
    
    43
    %
    
    
    39
    %
    
    
    25
    %
    
    
    25
    %Customer B
    
    
    14
    %
    
    
    *
    
    
    
    23
    %
    
    
    *Customer C
    
    
    14
    %
    
    
    14
    %
    
    
    22
    %
    
    
    18
    %Customer D
    
    
    13
    
    
    
    *
    
    
    
    11
    %
    
    
    13
    %Customer E
    
    
    *
    
    
    
    25
    %
    
    
    *
    
    
    
    27
    %
 
 *
    
    Customer accounted for less than 10% of total revenue for the period.   June 30,
    
    September 30,2008
    
    2007Customer A
    
    
    32
    %
    
    
    *Customer B
    
    
    22
    %
    
    
    28
    %Customer C
    
    
    14
    %
    
    
    *Customer D
    
    
    12
    %
    
    
    *Customer E
    
    
    *
    
    
    
    26
    %Customer F
    
    
    *
    
    
    
    19
    %
 
 *
    
    Customer accounted for less than 10% of total accounts receivable.   June 30,
    
    
    September 30,2008
    
    
    2007(In thousands)United States
    
    $
    24,365
    
    
    $
    27,518South Korea
    
    
    364
    
    
    
    756Other
    
    
    201
    
    
    
    189Total
    
    $
    24,930
    
    
    $
    28,463
 20




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##### Table of Contents



PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 NOTE 11  FINANCIAL INSTRUMENTS
     NOTE 12  NOTES PAYABLE
  NOTE 13  INCOME TAXES
 Tax Provision
 21




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PHOTON DYNAMICS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
   Adoption of FIN 48
    22




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##### Table of Contents



ITEM 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
 This Quarterly Report on Form 10-Q contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
of 1934. All statements included or incorporated by reference in this Quarterly Report on Form 10-Q
other than statements of historical fact may be forward-looking statements. You can identify these
and other forward-looking statements by the use of words such as may, will, could, would,
should, plans, anticipates, relies, expects, intends, believes, estimates,
predicts, potential, continue or the negative of such terms, or other comparable terminology.
Forward-looking statements also include the assumptions underlying or relating to any such
statements. These forward-looking statements are based on current expectations as of the filing
date of this Quarterly Report on Form 10-Q and involve a number of uncertainties and risks. These
uncertainties and risks include, but are not limited to: our ability to complete the proposed
acquisition by Orbotech; our ability to remediate material weaknesses in our internal controls; our
ability to attract and retain qualified employees; possible further changes in our customs duty
liability; possible civil and criminal liability in connection with customs duty issues; the
adoption of new technology by our existing and potential customers; our customers response to
prevailing economic and market conditions; the changing customer investment climate, which could
lead to the impairment of our assets; our ability to successfully migrate our manufacturing
operations offshore; our ability to maintain competitive pricing; the introduction of competing
products having technological and/or pricing advantages, which would reduce the demand for our
products; our ability to operate and integrate our newly acquired subsidiary; and failure to comply
with a variety of Untied States and foreign federal, state and local laws and regulation, which
could lead to the Company incurring additional penalties, interest and other expenses. As a result,
our actual results and end user demand may differ substantially from expectations.
 Our actual results could differ materially from those projected in the forward-looking
statements included herein as a result of a number of factors, risks and uncertainties, including
the risk factors set forth in Part I Item 1A. Risk Factors in our Annual Report on Form 10-K for
our fiscal year ended September 30, 2007. The information included in this Quarterly Report on Form
10-Q is as of the filing date with the Securities and Exchange Commission and future events or
circumstances could differ significantly from the forward-looking statements included herein.
Accordingly, we caution readers not to place undue reliance on such statements and we expressly
assume no obligation to update the forward-looking statements included in this report after the
date hereof except as required by law.
 The following discussion and analysis should be read in conjunction with the condensed
consolidated financial statements and notes thereto in Item 1 above and with our financial
statements and notes thereto for the year ended September 30, 2007, contained in our Annual Report
on Form 10-K , as filed with the SEC on January 24, 2008.
 MERGER WITH ORBOTECH, LTD.
   
    
    Following the termination by the Company to accept a superior proposal (as defined in
the Merger Agreement);
    
    Following the termination by Orbotech, if the Companys Board of Directors changes
its recommendation or recommends a competing proposal, or fails to reaffirm its
recommendation following the public announcement of a competing proposal;
    
    Following the public announcement of a competing proposal that is not withdrawn prior
to the special meeting, if (i) such termination results from a failure to obtain the
required shareholder vote and (ii) within twelve months after such
termination, the
Company enters into a definitive agreement relating to an alternative acquisition or
consummates an alternative acquisition; or
 23




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##### Table of Contents




    
    Following the receipt by the Company of a competing proposal that is not withdrawn on
or prior to the outside date, if (i) the required shareholder vote is not obtained and
(ii) within twelve months after such termination, the Company enters into a definitive
agreement relating to an alternative acquisition or consummates an alternative
acquisition.
    BUSINESS AND COMPANY OVERVIEW
 Our Company
  Flat Panel Display Segment
 Flat Panel Display Market
    24




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##### Table of Contents



TM TM TM TM
    Flat Panel Display Industry Trends
    25




---



##### Table of Contents



High-Performance Digital Imaging Segment
 High-Performance Digital Imaging Market
      High-Performance Digital Imaging Industry Trends
   26




---



##### Table of Contents



Backlog
  CRITICAL ACCOUNTING POLICIES AND ESTIMATES
     Revenue Recognition
     27




---



##### Table of Contents



Allowance for Doubtful Account
   Fair value of financial instruments
    Inventories
   28




---



##### Table of Contents



Warranty
  Goodwill and Intangible Assets
   Stock-Based Compensation
    Contingencies and Litigation
  29




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##### Table of Contents



Capital Partners v. Dr.
Malcolm J. Thompson, et al.
  RESULTS OF OPERATIONS
 Selected Financial Data
  Three Months Ended
    
    Nine Months EndedJune 30,
    
    June 30,2008
    
    2007
    
    2008
    
    2007Product revenue
    
    
    90
    %
    
    
    79
    %
    
    
    88
    %
    
    
    79
    %Customer support and spare parts revenue
    
    
    10
    
    
    
    21
    
    
    
    12
    
    
    
    21Total revenue
    
    
    100
    
    
    
    100
    
    
    
    100
    
    
    
    100Product cost of revenue
    
    
    50
    
    
    
    70
    
    
    
    54
    
    
    
    73Customer support and spare parts cost of revenue
    
    
    4
    
    
    
    8
    
    
    
    5
    
    
    
    9Total cost of revenue
    
    
    54
    
    
    
    78
    
    
    
    59
    
    
    
    82Gross Margin
    
    
    46
    
    
    
    22
    
    
    
    41
    
    
    
    18Operating expenses:Research and development
    
    
    16
    
    
    
    43
    
    
    
    17
    
    
    
    43Selling, general and administrative
    
    
    20
    
    
    
    40
    
    
    
    22
    
    
    
    34Restructuring charge (benefit)
    
    
    
    
    
    
    (1
    )
    
    
    
    
    
    
    3Impairment of property and equipment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6Gain on sale of property and equipment
    
    
    
    
    
    
    
    
    
    
    0
    
    
    
    Amortization of intangible assets
    
    
    2
    
    
    
    2
    
    
    
    3
    
    
    
    2Total operating expenses
    
    
    38
    
    
    
    84
    
    
    
    42
    
    
    
    88Income (loss) from operations
    
    
    8
    
    
    
    (62
    )
    
    
    (2
    )
    
    
    (70
    )Interest income and other, net
    
    
    1
    
    
    
    2
    
    
    
    2
    
    
    
    7Income (loss) before income taxes
    
    
    9
    
    
    
    (60
    )
    
    
    (0
    )
    
    
    (63
    )Provision for income taxes
    
    
    1
    
    
    
    1
    
    
    
    1
    
    
    
    1Net income (loss)
    
    
    8
    %
    
    
    (61
    )%
    
    
    (1
    )%
    
    
    (64
    )%
   30




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##### Table of Contents



Three Months Ended
    
    
    Nine Months EndedJune 30,
    
    
    June 30,2008
    
    
    Change
    
    
    2007
    
    
    2008
    
    
    Change
    
    
    2007(dollars in millions)Korea
    
    $
    27.9
    
    
    
    303
    %
    
    $
    6.9
    
    
    $
    52.8
    
    
    
    211
    %
    
    $
    17.0Taiwan
    
    
    13.0
    
    
    
    271
    %
    
    
    3.5
    
    
    
    36.7
    
    
    
    114
    %
    
    
    17.1Japan
    
    
    1.0
    
    
    
    (74
    )%
    
    
    4.0
    
    
    
    10.7
    
    
    
    (26
    )%
    
    
    14.5Germany
    
    
    2.3
    
    
    
    100
    %
    
    
    
    
    
    
    2.3
    
    
    
    100
    %
    
    
    United States
    
    
    1.7
    
    
    
    100
    %
    
    
    
    
    
    
    3.8
    
    
    
    100
    %
    
    
    China
    
    
    0.3
    
    
    
    217
    %
    
    
    0.1
    
    
    
    1.0
    
    
    
    (16
    )%
    
    
    1.2Total Revenue
    
    $
    46.1
    
    
    
    220
    %
    
    $
    14.4
    
    
    $
    107.4
    
    
    
    116
    %
    
    $
    49.8
  Operating Segments
   Flat Panel Display Segment
 TM TM
  Three Months Ended
    
    Nine Months EndedJune 30,
    
    June 30,2008
    
    Change
    
    2007
    
    2008
    
    Change
    
    2007(dollars in millions)Revenues:Product
    
    $
    39.7
    
    
    
    250
    %
    
    $
    11.4
    
    
    $
    91.0
    
    
    
    131
    %
    
    $
    39.5Customer support and spare parts
    
    $
    4.7
    
    
    
    54
    %
    
    $
    3.1
    
    
    $
    12.5
    
    
    
    21
    %
    
    $
    10.3Cost of revenue:Product
    
    $
    21.9
    
    
    
    120
    %
    
    $
    10.0
    
    
    $
    55.4
    
    
    
    54
    %
    
    $
    36.1Customer support and spare parts
    
    $
    1.8
    
    
    
    54
    %
    
    $
    1.2
    
    
    $
    5.4
    
    
    
    20
    %
    
    $
    4.5Operating expenses:Research and development
    
    $
    6.6
    
    
    
    8
    %
    
    $
    6.1
    
    
    $
    17.5
    
    
    
    (17
    )%
    
    $
    21.0Selling, general and administrative
    
    $
    7.7
    
    
    
    44
    %
    
    $
    5.4
    
    
    $
    20.4
    
    
    
    27
    %
    
    $
    16.0Amortization of intangible assets
    
    $
    0.2
    
    
    
    (29
    )%
    
    $
    0.3
    
    
    $
    0.5
    
    
    
    (47
    )%
    
    $
    1.0Operating income (loss)
    
    $
    6.2
    
    
    
    
    
    
    $
    (8.5
    )
    
    $
    4.5
    
    
    
    
    
    
    $
    (28.8
    )
 31




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##### Table of Contents



Revenue
  ArrayChecker TM and ArraySaver TM Product Revenue. TM TM
 Three Months Ended
    
    Nine Months EndedJune 30,
    
    June 30,2008
    
    2007
    
    2008
    
    2007Revenue by generation:Generation 6 and earlier
    
    
    57
    %
    
    
    17
    %
    
    
    45
    %
    
    
    16
    %Generation 7 and 8
    
    
    32
    %
    
    
    42
    %
    
    
    43
    %
    
    
    52
    %Revenue by product:ArrayCheckerTM
    
    
    82
    %
    
    
    52
    %
    
    
    82
    %
    
    
    52
    %ArraySaverTM
    
    
    7
    %
    
    
    7
    %
    
    
    6
    %
    
    
    16
    %
 TM TM
 TM TM
 TM TM
 Customer Support and Spare Parts Revenue. TM TM
 Gross Margin
 TM
 32




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##### Table of Contents



Research and Development
   Selling, General and Administrative
   Amortization of Intangible Assets
   Operating Income/Loss
  
    
    The costs of increasing customer service staff to support potential increased demands from new
and existing customers;
 33




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
    
    The additional costs in connection with inefficiencies of manufacturing newly-introduced
products;
    
    The success of our strategy of using both domestic and offshore manufacturing;
    
    The success of outsourcing certain manufacturing to third-party vendors;
    
    The under-utilization of manufacturing facilities as a consequence of industry slowdown,
order cancellations or changes in delivery schedules by our customers;
    
    The unanticipated need for additional warranty charges;
    
    The level of spending required on developing new Generations of our ArrayCheckerTM
and ArraySaverTM products; and
    
    The inability to reduce our expense levels quickly in the event of market downturns, due to the
fact that a high percentage of our expenses, including those related to manufacturing,
engineering, research and development, sales and marketing and general and administrative
functions, is fixed in the short term.
  High-Performance Digital Imaging Segment
   Three Months Ended
    
    Nine Months EndedJune 30, 2008
    
    June 30, 2008(dollars in millions)Revenue
    
    $
    1.7
    
    
    $
    3.9Cost of revenue
    
    $
    1.1
    
    
    $
    2.8Operating expenses:Research and development
    
    $
    0.5
    
    
    $
    0.9Selling, general and administrative
    
    $
    0.8
    
    
    $
    2.4Amortization of intangible assets
    
    $
    0.7
    
    
    $
    2.2Operating loss
    
    $
    (1.5
    )
    
    $
    (4.4
    )
  Revenue
   34




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##### Table of Contents



Gross Margin
  Research and Development
   Selling, General and Administrative
   Amortization of Intangible Assets
   Operating Loss
  
    
    The costs of increasing marketing and customer service staff to increase market share and
support potential increased demands from new and existing customers;
    
    The additional costs in connection with inefficiencies of manufacturing newly-introduced
products;
    
    The modification, cancellation or termination of contracts and subcontracts by the U.S.
government;
    
    The unanticipated need for additional warranty charges; and
 35




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
    
    The inability to reduce our expense levels quickly in the event of market downturns, due to the
fact that a high percentage of our expenses, including those related to manufacturing,
engineering, research and development, sales and marketing and general and administrative
functions, is fixed in the short term.
 Restructuring Charge (Benefit)
 Three Months Ended
    
    Nine Months EndedJune 30,
    
    June 30,2008
    
    Change
    
    2007
    
    2008
    
    Change
    
    2007(dollars in millions)Expense (benefit)
    
    $
    0.0
    
    
    
    (100
    )%
    
    $
    (1.0
    )
    
    $
    0.0
    
    
    
    (100
    )%
    
    $
    1.4Percent of Revenue
    
    
    0
    %
    
    
    
    
    
    
    1
    %
    
    
    0
    %
    
    
    
    
    
    
    3
    %
  February 2007 Restructure
   November 2006 Restructure
 TM
  Impairment of Property and Equipment
 Three Months Ended
    
    Nine Months EndedJune 30,
    
    June 302008
    
    Change
    
    2007
    
    2008
    
    Change
    
    2007(dollars in millions)Expense
    
    $
    0.0
    
    
    
    0
    %
    
    $
    0.0
    
    
    $
    0.0
    
    
    
    (100
    )%
    
    $
    2.8Percent of Revenue
    
    
    0
    %
    
    
    
    
    
    
    0
    %
    
    
    0
    %
    
    
    
    
    
    
    6
    %
  36




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##### Table of Contents



Gain on Sale of Property and Equipment
 Three Months Ended
    
    Nine Months EndedJune 30,
    
    June 30,2008
    
    Change
    
    2007
    
    2008
    
    Change
    
    2007(dollars in thousands)Gain (loss)
    
    $
    0.0
    
    
    
    100
    %
    
    $
    0.0
    
    
    $
    49
    
    
    
    100
    %
    
    $
    0.0Percent of Revenue
    
    
    0
    %
    
    
    
    
    
    
    0
    %
    
    
    0
    %
    
    
    
    
    
    
    0
    %
  Interest Income and Other, Net
 Three Months Ended
    
    Nine Months EndedJune 30,
    
    June 30,2008
    
    Change
    
    2007
    
    2008
    
    Change
    
    2007(dollars in millions)Income
    
    $
    0.4
    
    
    
    29
    %
    
    $
    0.3
    
    
    $
    1.9
    
    
    
    (43
    )%
    
    $
    3.4Percent of Revenue
    
    
    1
    %
    
    
    
    
    
    
    2
    %
    
    
    2
    %
    
    
    
    
    
    
    7
    %
   Provision for Income Taxes
 Three Months Ended
    
    Nine Months EndedJune 30,
    
    June 30,2008
    
    Change
    
    2007
    
    2008
    
    Change
    
    2007(dollars in millions)Expense
    
    $
    0.3
    
    
    
    254
    %
    
    $
    0.1
    
    
    $
    0.6
    
    
    
    101
    %
    
    $
    0.3Percent of Revenue
    
    
    1
    %
    
    
    
    
    
    
    1
    %
    
    
    1
    %
    
    
    
    
    
    
    1
    %
   37




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Stock-Based Compensation
   Three Months Ended
    
    
    Nine Months EndedJune 30,
    
    
    June 30,2008
    
    
    2007
    
    
    2008
    
    
    2007(in thousands, except per share data)Stock-based compensation expense included in continuing
operations:Cost of revenue
    
    $
    61
    
    
    $
    26
    
    
    $
    233
    
    
    $
    213Research and development
    
    
    242
    
    
    
    125
    
    
    
    411
    
    
    
    324Selling, general and administrative
    
    
    757
    
    
    
    274
    
    
    
    1,338
    
    
    
    976Total stock-based compensation expense after income taxes (1)
    
    $
    1,060
    
    
    $
    425
    
    
    $
    1,982
    
    
    $
    1,513Stock-based compensation expense by type of award:Employee stock options
    
    $
    288
    
    
    $
    274
    
    
    $
    441
    
    
    $
    1,130Employee stock purchase plan
    
    
    56
    
    
    
    74
    
    
    
    56
    
    
    
    281Restricted stock awards
    
    
    696
    
    
    
    159
    
    
    
    1,465
    
    
    
    184Amounts capitalized as inventory and deferred gross margin
    
    
    20
    
    
    
    (82
    )
    
    
    20
    
    
    
    (82
    )Total stock-based compensation expense after income taxes (1)
    
    $
    1,060
    
    
    $
    425
    
    
    $
    1,982
    
    
    $
    1,513
 
 (1)
    
    The income tax benefit on stock-based compensation for all periods presented was not
material.  LIQUIDITY AND CAPITAL RESOURCES
  Operating Activities
  38




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Investing Activities
  Financing Activities
    Contractual Obligations
  Payments Due by Fiscal YearContractual Obligations
    
    Total
    
    
    2008(1)
    
    
    2009
    
    
    2010
    
    
    2011
    
    
    2012
    
    
    Thereafter(In thousands)Purchase obligations
    
    $
    50,715
    
    
    $
    31,852
    
    
    $
    18,832
    
    
    $
    31
    
    
    $
    
    
    
    $
    
    
    
    $
    Operating lease obligations
    
    
    7,285
    
    
    
    851
    
    
    
    2,881
    
    
    
    2,830
    
    
    
    723
    
    
    
    
    
    
    $
    Notes payable, including interest
    
    
    5,500
    
    
    
    
    
    
    
    2,800
    
    
    
    2,700
    
    
    
    
    
    
    
    
    
    
    
    Capital lease obligations
    
    
    24
    
    
    
    24
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    63,524
    
    
    $
    32,727
    
    
    $
    24,513
    
    
    $
    5,561
    
    
    $
    723
    
    
    $
    
    
    
    $
    
 
 (1)
    
    Remaining three months    Working Capital
  39




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IMPACT OF ACCOUNTING PRONOUNCEMENTS
    .
 40




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ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
 Foreign Currency Exchange Rate Risk
      Market Risk
   41




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ITEM 4. Controls and Procedures
   
    
    The absence of adequate processes for detecting noncompliance with applicable laws and
regulations and our employee code of conduct, evaluating the effect of such noncompliance
on our financial statements on a timely and accurate basis, and communicating such
noncompliance and related evaluation to our Audit Committee;
    
    The absence of adequate processes and programs in our control environment to educate
employees on our employee code of conduct and applicable laws and regulations; and
    
    Insufficient accounting and finance personnel with the knowledge and experience required
to ensure an appropriate level of review of financial statement accounts.
  Remediation of the Material Weakness That Existed as of June 30, 2008
  
    
    Review and evaluation of our internal controls, including our internal reporting
processes, to ensure that legal, regulatory and other matters that could have a significant
financial statement effect are identified and evaluated and documented by management and
escalated on a timely basis, where appropriate, to the Audit Committee.
    
    Development, with the assistance of outside advisors, of new valuation and declaration
processes to ensure compliance with all customs regulations of each of the countries into
which we import parts, including replacing manual invoices with an automated customs
commercial invoice process that requires review by legal and finance personnel.
    
    Enhanced compliance and ethics training for employees, including implementation of an
online compliance system in four languages, increasing awareness of the employee code of
conduct through mandatory training for all employees, and reinforcing the ethics policy by
requiring an annual ethics certification for all employees.
 42




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
    
    With respect to personnel who were determined to have known, or who should have known,
that the Companys customs practices were non-compliant, certain of such personnel have
been terminated or have otherwise left the Company, and others, including a former
executive officer, have had their responsibilities and reporting relationships modified.
     Changes in Control Over Financial Reporting in the Third Quarter of Fiscal 2008
  Inherent Limitations of Disclosure Controls and Procedures and Internal Control Over Financial
Reporting.
  43




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##### Table of Contents



PART II. OTHER INFORMATION
 
 ITEM 1. Legal Proceedings
 Capital Partners v. Dr. Malcolm J. Thompson, et al Capital Partners v. Dr.
Malcolm J. Thompson, et al.
  Amtower v. Photon Dynamics, Inc
 Customs and Duties Liability.
 Security and Exchange Commission Inquiry
 General Litigation
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ITEM 1A. Risk Factors
 Our actual results could differ materially from those projected in the forward-looking
statements included in this Quarterly Report on Form 10-Q as a result of a number of factors, risks
and uncertainties, including the risk factors set forth below and elsewhere in this Quarterly
Report on Form 10-Q . You should carefully consider the risks described below before investing in
our securities. The risks described below are not the only ones facing us. Additional risks not
currently known to us or that we currently believe are immaterial may also impair our business,
results of operations, financial condition and liquidity.
 We have organized our risks into the following categories:
 
    
    Risks Relating to the Proposed Acquisition by Orbotech
    
    Risks Relating to our Business
    
    Risks Relating to Owning our Common Stock
    
    Risks Relating to Our Restatements and Related Matters
 RISKS RELATING TO THE PROPOSED ACQUISITION BY ORBOTECH
 Our business and results of operations are likely to be affected by our announced acquisition by
Orbotech.
  If the conditions to the proposed acquisition by Orbotech set forth in the Merger Agreement are
not met, the acquisition may not occur.
  45




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Failure to complete the proposed acquisition by Orbotech would negatively impact our future
business and operations.
  
    
    Activities relating to the acquisition and related uncertainties may lead to a loss of
revenue and market position, including with respect to our High-Performance Digital Imaging Segment,  that we may not be able to regain if the acquisition does not
occur;
    
    The market price of our common stock could decline following an announcement that the
acquisition has been abandoned;
    
    We could be required to pay Orbotech a termination fee and provide reimbursement to
Orbotech for costs incurred in connection with the acquisition;
    
    We would remain liable for our costs related to the acquisition, such as legal and
accounting fees and a portion of our investment banking fees;
    
    We may not be able to take advantage of alternative business opportunities or
effectively respond to competitive pressures; and
    
    We may not be able to retain key employees.
 In certain instances, the Merger Agreement requires us to pay a termination fee of $9 million to
Orbotech, a payment which could affect the decisions of a third party considering making an
alternative acquisition proposal to the proposed acquisition of the Company by Orbotech.
  RISKS RELATING TO OUR BUSINESS
 We have sustained losses and we may sustain losses in the future.
   Our customers may cancel or defer their purchases at any time and on short notice, which could
harm our operating results.
  
    
    May stop purchasing our products or defer their purchases at any time without penalty;
    
    Are free to purchase products from our competitors;
    
    Are not required to make minimum purchases; and
    
    Have cancelled, and may in the future cancel, purchase orders that they place with us
without reimbursing us for any costs incurred.
  46




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Our operating results are difficult to predict and may vary from investors expectations, which
could cause our stock price to fall.
   
    
    The result of competitive pricing pressures;
    
    The timing of the receipt of orders from major customers;
    
    The result of sudden, unanticipated changes in customer requirements;
    
    The cancellation or postponement of firm orders by a customer without compensation;
    
    The receipt of final acceptance on new products;
    
    The product mix that makes up our revenue;
    
    The incurrence of warranty expenses;
    
    Our inability to reduce our expense levels quickly in the event of market downturns, due
to the fact that a high percentage of our expenses, including those related to
manufacturing, engineering, research and development, sales and marketing and general and
administrative functions, is fixed in the short term;
    
    The ability to obtain components from our single or limited source suppliers in a timely
manner;
    
    The ability to effectively implement our strategy of migrating or outsourcing
manufacturing offshore;
    
    The ability of our offshore manufacturing operations to timely produce and deliver
products in the quantity and of the quality our customers require;
    
    The costs of operations in the global markets in which we do business;
    
    The effects of changing international economic conditions;
    
    The effects of currency exchange rate fluctuations;
    
    The outcome of current litigation;
    
    The effects of worldwide political instability;
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##### Table of Contents




    
    The 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.
  We have experienced multiple material weaknesses in our internal controls and procedures during
each of our 2003 through 2007 fiscal years, including three material weaknesses identified during
our 2007 fiscal year that have not yet been remediated. If we are unable to implement our
remediation plan effectively or if other material weaknesses or control deficiencies develop that
we are unable to address, the material weaknesses in our internal controls could have a
significant adverse effect on our business, financial condition and results of operations, result
in our failure to meet reporting obligations and adversely affect our stock price.
  We have experienced significant employee turnover, including in several key financial positions.
If we are unable to attract and retain key employees, it may disrupt our ability to improve our
financial controls, meet our reporting obligations and effectively manage our business.
  48




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We have exposure to various foreign and domestic regulatory risks. Our failure to comply with
governmental regulations could subject us to liability and additional expense.
     If our flat panel display products experience performance, reliability or quality problems, our
customers may reduce their orders.
 tm tm
 
    
    Delays in receiving final acceptance from our customers, which in turn delays
recognition of the associated revenue;
    
    Cancellation of orders by customers;
    
    Assessment of penalties by customers;
    
    Delayed payment by customers;
    
    Renegotiation of our prices by customers;
    
    Reduced orders from our customers;
 49




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##### Table of Contents




    
    Additional warranty and service expenses; and
    
    Higher manufacturing costs.
  tm
 Capital investment by manufacturers of flat panel display products can be highly cyclical and may
decline in the future.
   We depend on sales to a few large customers in the flat panel display industry, and if we lose any
of our large customers our revenue could decrease significantly.
  50




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We rely upon sales of a limited range of flat panel display products, and if demand for one
product decreases for any reason it could cause our revenue to decline significantly.
  We may not be able to develop and introduce new products that respond to evolving industry
requirements in a timely manner, which could reduce our ability to compete effectively.
    If we are not able to receive sufficient parts to meet our production requirements, we may
experience significant delays in producing our products, which could decrease our revenue for an
extended period of time.
  Substantially all of our revenue from flat panel display products is derived from sales to
companies located outside the United States, which exposes us to risks that we would not
experience with domestic sales.
  
    
    Political instability and the possibility of hostilities, terrorist attacks, or war;
    
    Imposition of governmental controls;
    
    Fluctuations in interest and currency exchange rates;
 51




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
    
    Customs and export and import license requirements;
    
    Restrictions on the export of technology;
    
    Limited foreign protection of intellectual property rights;
    
    Periodic local or international downturns;
    
    Decreases in productivity, temporary plant shutdowns or infrastructure service
disruptions resulting from widespread health alerts including Severe Acute Respiratory
Syndrome (SARS) and warnings of an avian flu pandemic;
    
    Changes in tariffs; and
    
    Difficulties in staffing and managing international operations.
  Our customer qualification and sales cycle is lengthy and unpredictable and requires us to incur
substantial costs to make a sale, and if we fail to make a sale, our increased expenses may lead
to lower profit margins.
   Our ability to efficiently and effectively implement our strategy of using both domestic and
outsourced offshore manufacturing may impact our profitability.
   
    
    Political instability and the possibility of hostilities, terrorist attacks, or war;
    
    Imposition of governmental controls;
    
    Fluctuations in interest and currency exchange rates;
 52




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
    
    Limited foreign protection of intellectual property rights;
    
    Trade restrictions;
    
    Periodic or local international downturns;
    
    Decreases in productivity, temporary plant shutdowns or infrastructure service
disruptions resulting from widespread health alerts such as those relating to SARS and
avian flu outbreaks; and
    
    Difficulties in staffing and managing international manufacturing.
  Any failure of, or other problems at or with, our third party manufacturers could delay shipments
of our products, harm our relationships with our customers or otherwise negatively impact our
business.
  If we do not compete effectively in our target markets, we will lose market share.
  Our success depends in large part on the strength of active matrix liquid crystal display
technology in the flat panel display industry.
  We may have difficulty integrating businesses or assets that we have acquired or developed in new
ventures and may acquire or develop in the future, and we may not realize the benefits that we
expect from these acquisitions and new ventures.
  53




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
    
    Difficulty in the assimilation of the technologies and products;
    
    Entering markets in which we have no or limited direct prior experience;
    
    Loss of key customers;
    
    Diversion of management resources;
    
    Incompatibility of business cultures or practices;
    
    Loss of key employees;
    
    Costs and delays in implementing common systems and procedures;
    
    Potential inefficiencies in delivering services to customers; and
    
    Assumption of unknown or undisclosed liabilities.
   We may never achieve or sustain profitability in our High-Performance Digital Imaging business
segment.
  If the products developed within our High-Performance Digital Imaging segment become successful,
we may derive a significant portion of our revenue from customers that receive their funding for
our products from U.S. government contracts, which are subject to unique risks.
  54




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The funding of U.S. government programs is subject to congressional appropriations
 The U.S. government would have the ability to modify, curtail or terminate contracts.
 Our contract costs would be subject to audits by U.S. government agencies.
 Our business could be subject to potential U.S. government inquiries and investigations.
 Contracts with the U.S. government would be subject to specific procurement regulations and
other requirements affecting us or our customers.
 Certain U.S. government programs are subject to security classification restrictions on
information.
 Our business could be harmed if we fail to properly protect our intellectual property.
   55




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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.
   Our corporate offices and manufacturing facilities and our customers manufacturing facilities may
be subject to disruption from natural disasters.
   We rely upon certain critical information systems for our daily business operation. Our inability
to use or access these information systems at critical points in time could unfavorably impact the
timeliness and efficiency of our business operation.
  We may experience difficulties with our enterprise resource planning (ERP) system and other IT
systems. System failure or malfunctioning may result in disruption of operations and the inability
to process transactions, and this could adversely affect our financial results.
  56




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RISKS RELATING TO OWNING OUR COMMON STOCK
 Our stock price may fluctuate significantly.
  
    
    The need to restate our consolidated financial statements;
    
    Announcements of technological innovations or new products by us or by our competitors;
    
    Failure to comply with government regulations;
    
    Developments in patent or other property rights; and
    
    Developments in our relationships with our customers.
  Some anti-takeover provisions may affect the price of our common stock.
  We do not anticipate paying cash dividends.
  RISKS RELATING TO OUR RESTATEMENTS AND RELATED MATTERS
 Our recent restatement of our consolidated financial statements and related events, as well as
possible future restatements, may have a material adverse effect on our business.
  
 ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds
  
 ITEM 3. Defaults Upon Senior Securities
  57




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ITEM 4. Submission of Matters to a Vote of Security Holders
  
 ITEM 5. Other Information
  
 ITEM 6. Exhibits
 Exhibits
  58




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##### Table of Contents



SIGNATURES
  PHOTON DYNAMICS, INC.By:
    /s/ James P. MonizJames P. MonizChief Financial Officer
(Duly authorized and principal financial
officer)  59




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Exhibit Index
 Number
    
    Exhibit3.1(1)
    
    Amended and Restated Articles of Incorporation of the Registrant.3.2(1)
    
    Certificate of Amendment to Articles of Incorporation of the Registrant.3.3(2)
    
    Bylaws of the Registrant.4.1
    
    Reference is made to Exhibits 3.1, 3.2 and 3.3.10.59(3)
    
    Agreement and Plan of Merger and Reorganization dated as of June 26, 2008 among Orbotech Ltd., PDI
Acquisition, Inc. and Photon Dynamics, Inc.10.60
    
    Amended Change in Control Agreement between the Registrant and Jeffrey Hawthorne dated March 31, 2008.10.61
    
    Amended Change in Control Agreement between the Registrant and Wendell Blonigan dated March 31, 2008.31.1
    
    Certification required by Rule 13a-14(a) or Rule 15d-14(a).31.2
    
    Certification required by Rule 13a-14(a) or Rule 15d-14(a).32.1**
    
    Certifications required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title
18 of the United States Code (18 U.S.C. §1350).
 Key to Exhibits:
 
 (1)
    
    Previously filed as the like-numbered exhibit to the Registrants Registration Statement on
Form S-1 (Commission File No. 333-76650) as filed with the Securities and Exchange Commission
on January 14, 2002, as amended, and incorporated herein by reference.(2)
    
    Previously filed as the like-described exhibit to the Registrants Quarterly Report on Form
10-Q for the quarter ended December 31, 2005 as filed with the Securities and Exchange
Commission on February 9, 2006, and incorporated herein by reference.(3)
    
    Previously filed as the like-described exhibit to the Registrants Current Report on Form 8-K
as filed with the Securities and Exchange Commission on June 26, 2008, and incorporated herein
by reference.**
    
    The certification attached as Exhibit 32.1 accompanies the Quarterly Report on Form 10-Q
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed filed by
the Company for purposes of Section 18 of the Securities Exchange Act of 1934, as amended. 60