---

---

UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549

---

FORM 10-Q

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

For the quarterly period ended March 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

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

California(State or other jurisdiction of
incorporation or organization)

94-3007502(I.R.S. Employer Identification No.)


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

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

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

As
of April 30, 2002, there were 16,994,354 shares outstanding of the Registrant's Common Stock, no par value.

---

---

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INDEX

|           |  |                                                                                                                   |  | Page
|---------- |  | ----------------------------------------------------------------------------------------------------------------- |  | ----
|PART I     |  | FINANCIAL INFORMATION                                                                                             |  |     
|Item 1.    |  | Financial Statements (unaudited)                                                                                  |  |     
|           |  | Condensed Consolidated Balance Sheets as of March 31, 2002 and September 30, 2001                                 |  | 2   
|           |  | Condensed Consolidated Statements of Operations for the Three and Six Month Periods Ended March 31, 2002 and 2001 |  | 3   
|           |  | Condensed Consolidated Statements of Cash Flows for the Six Month Periods Ended March 31, 2002 and 2001           |  | 4   
|           |  | Notes to Condensed Consolidated Financial Statements                                                              |  | 5   
|Item 2.    |  | Management's Discussion and Analysis of Financial Condition and Results of Operations                             |  | 12  
|Item 3.    |  | Quantitative and Qualitative Disclosures About Market Risk                                                        |  | 24  
|PART II    |  | OTHER INFORMATION                                                                                                 |  |     
|Item 1.    |  | Legal Proceedings                                                                                                 |  | 25  
|Item 2.    |  | Changes in Securities                                                                                             |  | 25  
|Item 3.    |  | Defaults Upon Senior Securities                                                                                   |  | 25  
|Item 4.    |  | Submission of Matters to a Vote of Security Holders                                                               |  | 25  
|Item 5.    |  | Other Information                                                                                                 |  | 26  
|Item 6.    |  | Exhibits and Reports on Form 8-K                                                                                  |  | 27  
|Signatures |  | 28                                                                                                               

1

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

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

|                                     |                                        | March 31,
2002                             |        | September 30,
2001 |        
|------------------------------------ | -------------------------------------- | ------------------------------------------ | ------ | ------------------ | -------
|
|ASSETS                               |                                        |                                            |        |                    |        
|Current assets:                      |                                        |                                            |        |                    |        
|                                     | Cash and cash equivalents              |                                            | $      | 154,292            |        
|                                     | Short-term investments                 |                                            |        | 34,563             |        
|                                     | Accounts receivable, net               |                                            |        | 16,144             |        
|                                     | Inventories                            |                                            |        | 13,238             |        
|                                     | Other current assets                   |                                            |        | 4,565              |        
|                                     |                                        |                                            |        |                    |        
|                                     |                                        | Total current assets                       |        |                    | 222,802
|Land, property and equipment, net    |                                        |                                            | 12,558 |                    |        
|Other assets                         |                                        |                                            | 2,419  |                    |        
|Intangible assets, net               |                                        |                                            | 3,928  |                    |        
|Goodwill                             |                                        |                                            | 22,724 |                    |        
|                                     |                                        |                                            |        |                    |        
|                                     |                                        | Total assets                               |        | $                  | 264,431
|                                     |                                        |                                            |        |                    |        
|LIABILITIES AND SHAREHOLDERS' EQUITY |                                        |                                            |        |                    |        
|Current liabilities:                 |                                        |                                            |        |                    |        
|                                     | Accounts payable                       |                                            | $      | 6,446              |        
|                                     | Other current liabilities              |                                            |        | 7,961              |        
|                                     | Deferred revenue                       |                                            |        | 740                |        
|                                     |                                        |                                            |        |                    |        
|                                     |                                        | Total current liabilities                  |        |                    | 15,147 
|Other liabilities                    |                                        |                                            | 333    |                    |        
|Commitments and contingencies        |                                        |                                            |        |                    |        
|Shareholders' equity:                |                                        |                                            |        |                    |        
|                                     | Common stock, no par value             |                                            |        | 295,271            |        
|                                     | Accumulated deficit                    |                                            |        | (46,674            | )      
|                                     | Accumulated other comprehensive income |                                            |        | 354                |        
|                                     |                                        |                                            |        |                    |        
|                                     |                                        | Total shareholders' equity                 |        |                    | 248,951
|                                     |                                        |                                            |        |                    |        
|                                     |                                        | Total liabilities and shareholders' equity |        | $                  | 264,431
|                                     |                                        |                                            |        |                    |        

See
accompanying notes to condensed consolidated financial statements.

2

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

|                                                                                                |                                     | Three months ended
March 31, |        | Six months ended
March 31, |      
|----------------------------------------------------------------------------------------------- | ----------------------------------- | ---------------------------- | ------ | -------------------------- | -----
|
|
|
|Revenue                                                                                         |                                     | $                            | 17,297 |                            | $    
|Cost of revenue                                                                                 |                                     |                              | 10,068 |                            |      
|                                                                                                |                                     |                              |        |                            |      
|Gross margin                                                                                    |                                     |                              | 7,229  |                            |      
|Operating expenses:                                                                             |                                     |                              |        |                            |      
|                                                                                                | Research and development            |                              |        | 4,201                      |      
|                                                                                                | Selling, general and administrative |                              |        | 4,994                      |      
|                                                                                                | Non-recurring acquisition charges   |                              |        |                           |      
|                                                                                                | Amortization of intangible assets   |                              |        | 286                        |      
|                                                                                                |                                     |                              |        |                            |      
|                                                                                                |                                     | Total operating expenses     |        |                            | 9,481
|Loss from operations                                                                            |                                     |                              | (2,252 | )                          |      
|Interest income and other, net                                                                  |                                     |                              | 639    |                            |      
|                                                                                                |                                     |                              |        |                            |      
|Income (loss) before income taxes and cumulative effect of change in accounting principle       |                                     |                              | (1,613 | )                          |      
|Provision for income taxes                                                                      |                                     |                              |       |                            |      
|                                                                                                |                                     |                              |        |                            |      
|Income (loss) before cumulative effect of change in accounting principle                        |                                     |                              | (1,613 | )                          |      
|Cumulative effect of change in accounting principle                                             |                                     |                              |       |                            |      
|                                                                                                |                                     |                              |        |                            |      
|Net income (loss)                                                                               |                                     | $                            | (1,613 | )                          | $    
|                                                                                                |                                     |                              |        |                            |      
|Net income (loss) per share before cumulative effect of change in accounting principle:         |                                     |                              |        |                            |      
|Basic                                                                                           |                                     | $                            | (0.10  | )                          | $    
|                                                                                                |                                     |                              |        |                            |      
|Diluted                                                                                         |                                     | $                            | (0.10  | )                          | $    
|                                                                                                |                                     |                              |        |                            |      
|Loss per share from the cumulative effect of change in accounting principle, net of tax benefit |                                     |                              |        |                            |      
|Basic                                                                                           |                                     | $                            |       |                            | $    
|                                                                                                |                                     |                              |        |                            |      
|Diluted                                                                                         |                                     | $                            |       |                            | $    
|                                                                                                |                                     |                              |        |                            |      
|Net income (loss) per share                                                                     |                                     |                              |        |                            |      
|Basic                                                                                           |                                     | $                            | (0.10  | )                          | $    
|                                                                                                |                                     |                              |        |                            |      
|Diluted                                                                                         |                                     | $                            | (0.10  | )                          | $    
|                                                                                                |                                     |                              |        |                            |      
|Weighted average number of shares:                                                              |                                     |                              |        |                            |      
|Basic                                                                                           |                                     |                              | 15,746 |                            |      
|Diluted                                                                                         |                                     |                              | 15,746 |                            |      

See
accompanying notes to condensed consolidated financial statements.

3

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

|                                                             |                                                                                           | Six months ended
March 31,                |                                                    
|------------------------------------------------------------ | ----------------------------------------------------------------------------------------- | ----------------------------------------- | ---------------------------------------------------
|
|
|
|Cash flows from operating activities:                        |                                                                                           |                                           |                                                    
|                                                             | Net loss                                                                                  |                                           | $                                                  
|                                                             | Adjustments to reconcile net loss to net cash provided by (used in) operating activities: |                                           |                                                    
|                                                             |                                                                                           | Depreciation                              |                                                    
|                                                             |                                                                                           | Amortization of intangibles               |                                                    
|                                                             |                                                                                           | Stock based compensation expense          |                                                    
|                                                             |                                                                                           | Changes in assets and liabilities:        |                                                    
|                                                             |                                                                                           |                                           | Accounts receivable                                
|                                                             |                                                                                           |                                           | Inventories                                        
|                                                             |                                                                                           |                                           | Other current assets                               
|                                                             |                                                                                           |                                           | Other assets                                       
|                                                             |                                                                                           |                                           | Accounts payable                                   
|                                                             |                                                                                           |                                           | Other current liabilities                          
|                                                             |                                                                                           |                                           | Deferred revenue                                   
|                                                             |                                                                                           |                                           |                                                    
|                                                             |                                                                                           |                                           | Net cash provided by (used in) operating activities
|                                                             |                                                                                           |                                           |                                                    
|Cash flows from investing activities:                        |                                                                                           |                                           |                                                    
|                                                             |                                                                                           | Purchase of property and equipment        |                                                    
|                                                             |                                                                                           | Purchase of short-term investments        |                                                    
|                                                             |                                                                                           | Redemption of short-term investments      |                                                    
|                                                             |                                                                                           |                                           |                                                    
|                                                             |                                                                                           |                                           | Net cash provided by (used in) investing activities
|                                                             |                                                                                           |                                           |                                                    
|Cash flows from financing activities:                        |                                                                                           |                                           |                                                    
|                                                             | Issuance of common stock, net                                                             |                                           |                                                    
|                                                             | Repayment of lease obligations                                                            |                                           |                                                    
|                                                             |                                                                                           |                                           |                                                    
|                                                             |                                                                                           | Net cash provided by financing activities |                                                    
|                                                             |                                                                                           |                                           |                                                    
|Effect of exchange rate changes on cash and cash equivalents |                                                                                           |                                           | (39                                                
|                                                             |                                                                                           |                                           |                                                    
|Net increase in cash and cash equivalents                    |                                                                                           |                                           | 137,764                                            
|Cash and cash equivalents at beginning of period             |                                                                                           |                                           | 16,528                                             
|                                                             |                                                                                           |                                           |                                                    
|Cash and cash equivalents at end of period                   |                                                                                           | $                                         | 154,292                                            
|                                                             |                                                                                           |                                           |                                                    

See
accompanying notes to condensed consolidated financial statements.

4

---



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 and six month periods ended March 31, 2002 are
not necessarily indicative of the results that may be expected for the year ending September 30, 2002. 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, 2001.

The
condensed consolidated balance sheet as of September 30, 2001 is derived from the Company's audited consolidated financial statements as of September 30, 2001, 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.



The Company changed its revenue recognition policy effective October 1, 2000 based on guidance provided in SEC Staff Accounting Bulletin No. 101,
Revenue Recognition in Financial Statements ("SAB 101"). 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 in its flat panel display ("FPD") products and cathode ray tube ("CRT") display and high quality glass inspection product segments
as multiple-element arrangements. If the Company has met defined customer acceptance experience levels with the specific type of equipment, the Company recognizes revenue for a portion of the total
contract price due and billable upon shipment, with the remainder recognized when it becomes due (generally upon acceptance). The Company recognizes all other product sales with the customer
acceptance provisions upon customer acceptance. The Company generally recognizes revenue from the sale of its surface mount technology products upon shipment, as such product sales are not subject to
customer acceptance holdbacks. The Company recognizes revenue from the sale of spare parts upon shipment.

In
accordance with guidance provided in SAB 101, the Company recorded a non-cash charge of $6.6 million, or $0.50 per share, to reflect the cumulative effect of the
accounting change as of October 1, 2000 and accordingly, has restated the condensed consolidated statement of operations for the three and six month periods ended March 31, 2001 and cash
flows for the six months ended March 31, 2001, presented herein.

The
deferred revenue balance as of October 1, 2000 was $8.4 million. This amount is comprised of final holdback amounts comprised of certain portions of the total sales
prices that became due on final acceptances, which had not occurred as of October 1, 2000. Of this amount, the Company recognized as revenue $519,000 and $1.2 million, which increased
net income by $444,000 and $975,000 in the three month periods ended March 31, 2002 and March 31, 2001, respectively. The Company recognized

5

---

as revenue $2.6 million and $1.6 million, which increased net income by $2.0 million and $1.1 million in the six month periods ended March 31, 2002 and
March 31, 2001, respectively.

Prior
to fiscal year 2001, the Company's revenue recognition policy was to recognize revenue when the customer took title to the equipment, generally at the time of shipment, which
generally preceded installation and final customer acceptance.

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:

March 31,
2002

September 30,
2001(in thousands)Raw materials

$
5,444

$
9,686Work-in-process


4,221


3,493Finished goods


3,573


2,828Total

$
13,238

$
16,007


NOTE 3Other Current Liabilities

The components of other current liabilities were as follows:

March 31,
2002

September 30,
2001(in thousands)Warranty

$
2,157

$
2,760Compensation


3,486


3,160Commissions


978


694Acquisition charges





451Income taxes


503


494Other accrued expenses


837


802Total

$
7,961

$
8,361


NOTE 4Earnings Per Share

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

6

---

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
March 31,

Six months ended
March 31,2002

2001

2002

2001(in thousands, except per share data)Numerator:Net income (loss) for basic and diluted earnings per share:

$
(1,613
)
$
1,203

$
(4,976
)
$
(4,687
)Weighted average shares for basic earnings per share


15,746


12,972


14,831


12,968Effect of dilutive securities:Employee stock options





681





693Warrants





6





8Weighted average shares for diluted earnings per share


15,746
(1)

13,659


14,831
(1)

13,669Basic net income (loss) per share

$
(0.10
)
$
0.09

$
(0.34
)
$
(0.36
)Diluted net income (loss) per share

$
(0.10
)
$
0.09

$
(0.34
)
$
(0.36
)


---

NOTE 5Operations by Industry Segment

The Company conducts business in three operating segments: flat panel display ("FPD") products, printed circuit board ("PCB") assembly and advanced semiconductor
packaging inspection products (collectively, "surface mount technology products") and cathode ray tube ("CRT") display and glass inspection products. The Company's FPD products include test, repair
and inspection equipment. The Company's FPD test and inspection equipment identifies and characterizes defects at early stages of the manufacturing process so that the panels may be repaired before
the next stage, or, if necessary, discarded, minimizing the loss of time and materials. The Company's FPD products gather comprehensive data that enable FPD manufacturers to control and refine their
manufacturing processes. The Company's surface mount technology products enable PCB assembly and advanced semiconductor packaging manufacturers to detect and identify defects, thereby increasing
yields and quality and reducing costs. The Company's CRT display and glass inspection products allow CRT 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 management has determined the operating segments based upon the manner in which the business is managed and operated. There are no significant intersegment sales or
transfers, and the majority of the Company's long-lived assets are located in the U.S. The Company's principal customers are primarily Asian-based FPD and CRT display manufacturers.

The
Company sells its products for the FPD industry directly to customers in Korea and Taiwan and through a value-added reseller, Ishikawajima-Harima Heavy Industries Co., Ltd.
("IHI"), in Japan.

7

---

The Company sells its products for the CRT display and glass industries directly except in Japan where a sales representative is used. The Company sells its products for the surface mount technology
industry primarily through sales representatives and distributors.

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
March 31,

Six months ended
March 31,2002

2001

2002

2001(restated)



(restated)(in thousands)

(in thousands)Net sales to external customers:FPD products

$
12,250

$
12,700

$
21,422

$
28,129Surface mount technology products


3,365


4,453


6,202


10,583CRT display and glass inspection products


1,682


6,232


3,878


8,542Net sales to external customers

$
17,297

$
23,385

$
31,502

$
47,254Operating income (loss):FPD products

$
756

$
410

$
(101
)
$
2,206Surface mount technology products


(2,405
)

139


(5,014
)

840CRT display and glass inspection products(1)


(603
)

(732
)

(1,022
)

(3,721
)Loss from operations

$
(2,252
)
$
(183
)
$
(6,137
)
$
(675
)


---

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

Three months ended
March 31,

Six months ended
March 31,2002

2001

2002

2001(restated)



(restated)(in thousands)

(in thousands)Quanta Display Inc.



21
%


19
%LG Philips LCD Co., Ltd.

21
%
25
%
36
%
17
%IHI

21
%
11
%
12
%
17
%Chi Mei

11
%




Samsung America, Inc.



16
%


13
%


8

---

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

Three months ended
March 31,

Six months ended
March 31,2002

2001

2002

2001(restated)



(restated)(in thousands)

(in thousands)Revenue:Taiwan

$
4,853

$
5,247

$
6,117

$
12,630United States


2,598


3,845


4,533


8,314Korea


4,308


5,689


12,643


8,784Japan


3,604


2,477


3,800


8,021China


605


4,340


1,204


6,017Europe


180


1,060


1,694


1,528Canada


124


605


135


1,613Other


1,025


122


1,376


347Total

$
17,297

$
23,385

$
31,502

$
47,254


NOTE 6Comprehensive Income

The components of comprehensive income were as follows:

Three months ended
March 31,

Six months ended
March 31,2002

2001

2002

2001(restated)



(restated)(in thousands)

(in thousands)Net income (loss)

$
(1,613
)
$
1,203

$
(4,976
)
$
(4,687
)Other comprehensive income (loss):Change in unrealized gain on investments


(52
)

32


(113
)

52Currency translation adjustments


(189
)

(162
)

(39
)

(264
)Other comprehensive loss


(241
)

(130
)

(152
)

(212
)Total comprehensive income (loss)

$
(1,854
)
$
1,073

$
(5,128
)
$
(4,899
)


NOTE 7Outsourced Manufacturing Arrangement

In December, 2001, the Company entered into a Manufacturing Services Agreement with Sanmina-SCI Corporation ("Sanmina-SCI"), pursuant to
which Sanmina-SCI has agreed to provide a significant portion of the manufacturing, assembly and test operations for the Company's flat panel display and surface mount technology optical
products. Under the terms of the three year agreement and related agreements, Sanmina-SCI has agreed to lease a portion of the Company's San Jose facility, lease and operate the equipment
required to manufacture a substantial portion of the Company's flat panel display products, expand the Company's San Jose clean room facility and purchase a portion of the Company's existing flat
panel display and surface mount technology raw material inventory.

NOTE 8Restructure Charges

During the fourth quarter of fiscal year 2001, the Company implemented a restructuring plan (the "Restructuring Plan") to control spending and reduced its
workforce. Prior to September 30, 2001, management approved and implemented the Restructuring Plan and determined the benefits that would be offered to the employees being terminated. The
benefits package was explained in sufficient detail such that each affected employee was able to determine the type and amount of benefits he or

9

---

she was entitled to receive. The reductions occurred primarily in manufacturing and operational locations in North America. The Company recorded a restructuring charge in the fourth quarter of fiscal
year 2001 of $1.2 million for employee-related costs and other expenses. As of March 31, 2002, the remaining liability associated with the Restructuring Plan is approximately $600,000.
There have been no adjustments to the liability and management expects to complete all payments under the Restructuring Plan by the end of the fourth quarter of fiscal 2002, except for contract
employment payments.

NOTE 9Income Taxes

The provision for income taxes was $0 for both the three and six month periods ended March 31, 2002, and $191,000 and $709,000 for the three and six month
periods ended March 31, 2001, respectively. The effective tax rate for both the three and six month periods ended March 31, 2001 was 14%, before non-recurring acquisition
expenses and cumulative effect of change in accounting principle, and was lower than the statutory U.S. tax rate of 35% due to realization of net operating loss carry forwards.

NOTE 10Shareholders' Equity

On February 6, 2002, the Company completed an underwritten public offering of shares of its common stock. The offering related to 2,500,000 shares of
common stock at a price of $40.14 per share, all of which were sold by the Company. Additionally, the underwriters exercised their option to purchase an additional 375,000 shares to cover
over-allotments. The net proceeds to the Company, after the underwriters' discount and expenses of the offering, aggregated approximately $107.0 million.

On
January 21, 2002, the Company held its Annual Meeting of Shareholders. At that meeting, the Company's shareholders approved an amendment to the Company's Articles of
Incorporation to increase the authorized number of shares of Common Stock from 20,000,000 shares to 30,000,000 shares.

On
December 17, 1999, in connection with services rendered in a private placement offering, Photon Dynamics Canada Inc., formerly known as Image Processing
Systems Inc. ("IPS"), issued special warrants to the placement agent for the right to purchase IPS common shares. Upon acquisition of IPS by the Company, the warrants issued to the placement
agent were converted into a replacement warrant to purchase 21,285 exchangeable shares of IPS at an exercise price of $26.40 (Canadian dollars) each, which were exchangeable for the Company's common
stock on a one to one ratio. This replacement warrant was fully exercised in December 2001.

On
April 1, 2002, the remaining 51,951 exchangeable shares of IPS that were not owned by the Company or its affiliates were automatically exchanged for shares of the Company's
common stock. In connection with the exchange of the remaining exchangeable shares of IPS, the one share of the
Company's Series A Preferred Stock issued to Computershare Trust Company of Canada as trustee for the exchangeable shares was cancelled.

NOTE 11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 to assert that he was wrongly not allowed to exercise certain stock options and is
seeking damages of approximately $900,000. 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.

10

---

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 in this action has asserted several causes of action under state law arising out of alleged
misrepresentation and enforcement of the Company's insider trading policy and is seeking damages of approximately $17.7 million, plus undetermined damages resulting from emotional distress and
punitive damages. On December 6, 2001, the court dismissed the complaint for failure to allege facts sufficient to state a cause of action, with leave to amend. On January 17, 2002, the
plaintiff filed an amended complaint and the Company has answered such complaint. While the Company intends to vigorously contest this action, the Company 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 the Company's financial condition or results of operations.

NOTE 12Subsequent Events

In March 2002, the Company extended its existing bank line of credit until May 2002. In April 2002, the Company entered into a new bank line
of credit, expiring in April 2003, that provides a borrowing capacity of $4.0 million. The line of credit is secured by substantially all of the Company's assets and contains financial
and other covenants. As of March 31, 2002, no amounts were outstanding under the line of credit.

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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.

The
following discussion should be read in conjunction with the condensed consolidated financial statements and notes thereto included in Item 1 above and with our financial statements
and notes thereto for the year ended September 30, 2001 contained in our Annual Report on Form 10-K filed with the Securities and Exchange Commission.

Overview

We are a leading provider of yield management solutions to the flat panel display industry. Our flat panel display systems are designed to collect data, analyze
product quality and identify and repair product defects at critical steps in the flat panel display manufacturing process. We also offer yield management solutions for the printed circuit board
assembly and advanced semiconductor packaging industry (collectively referred to as our surface mount technology products) and the cathode ray tube display and high quality glass industries. Our
optical and X-ray inspection systems are used to detect and identify defects on printed circuit board assemblies with advanced semiconductor packages mounted on the surfaces of these
assemblies. Our optical inspection systems use high-resolution cameras and proprietary software to locate and characterize defects in cathode ray tube displays, cathode ray tube glass and
automotive glass panels. Our systems are designed to help manufacturers maximize factory output with reduced material input and error, a practice know as yield management.

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, deferred tax assets, intangible assets, restructuring 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 changed our revenue recognition policy effective October 1, 2000 based on guidance provided in The Securities and Exchange Commission Staff Accounting
Bulletin No. 101, Revenue Recognition in Financial Statements, or SAB 101. We recognize revenue when persuasive evidence of an

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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 product sales in the FPD and CRT display and high quality glass inspection product segments as multiple-element arrangements. If we have met defined customer
acceptance experience levels with the specific type of equipment, we recognize revenue for a portion of the total contract price due and billable upon shipment, with the remainder recognized when it
becomes due (generally upon acceptance). We recognize all other product sales with the customer acceptance provisions upon customer acceptance. We generally recognize revenue from the sale of our
surface mount technology products upon shipment, as such product sales are not subject to customer acceptance holdbacks. We recognize revenue from the sale of spare parts upon shipment.

Accounts Receivable

We maintain an allowance for estimated losses resulting from product returns, allowances or the inability of our customers to make required payments. If a single
customer 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. Accordingly, a single customer
could have a material adverse effect on our results of operations.

Inventories

We assess the recoverability of all inventory, including raw materials, work-in-process, finished goods, spare parts and purchase
commitments to determine whether adjustments for impairment are required. Inventory which is obsolete or in excess of the forecasted usage is written down to its estimated market value based on
assumptions about future demand and market conditions. 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 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 and Intangible Assets

We have goodwill and other intangible assets resulting from an acquisition accounted for under the purchase method of accounting. The purchase price was allocated
based on available information with respect to the fair value of the assets acquired and liabilities assumed. The intangible assets are being amortized over a three to five year life. Goodwill is not
being amortized, but we perform an impairment test on an annual basis and between annual tests in certain circumstances. In response to changes in the industry and market conditions, we may
strategically realign our resources and consider restructuring, disposing of, or otherwise exiting businesses, which could result in an impairment of goodwill or a revision to the value or estimated
life of intangible assets.

Contingencies and Litigation

We make an assessment of the probability of an adverse judgment resulting from current and threatened litigation. We would 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 March 31, 2002.

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Results of Operations

Revenue.Revenue for the three months ended March 31, 2002 was $17.3 million compared to $23.4 million
in the same period of the prior fiscal year, representing a decrease of $6.1 million, or 26%. Revenue for the six months ended March 31, 2002 was $31.5 million compared with
$47.3 million for the six months ended March 31, 2001, representing a decrease of $15.8 million, or 33%. The decrease is due primarily to the general economic slowdown and reduced
capital spending by our customers, which affected all of our product segments. Sales of flat panel display products represented $12.3 million and $12.7 million, or 71% and 54%, of
revenue in the three month periods ended March 31, 2002 and 2001, respectively. Sales of surface mount technology products represented $3.4 million and $4.5 million, or 19% and
19%, of revenue in the three month periods ended March 31, 2002 and 2001, respectively. Sales of cathode ray tube display and high quality glass products represented $1.7 million and
$6.2 million, or 10% and 27%, of revenue in the three month periods ended March 31, 2002 and 2001, respectively. For the six month periods ended March 31, 2002 and 2001, sales of
flat panel display products represented $21.4 million and $28.1 million, or 68% and 60%, of revenue, respectively. Sales of surface mount technology products represented
$6.2 million and $10.6 million, or 20% and 22%, of revenue in the six month periods ended March 31, 2002 and 2001, respectively. Sales of cathode ray tube display and high quality
glass products represented $3.9 million and $8.5 million, or 12% and 18%, of revenue in the six month periods ended March 31, 2002 and 2001, respectively.

Gross Margin.Gross margin increased to 42% in the three month period ended March 31, 2002 from 39% in the three month
period ended March 31, 2001. The overall increase in gross margin for the most recent quarter is attributable to a favorable mix of product sales and lower expenses resulting from the
restructuring in the fourth quarter of fiscal 2001. For the six month period ended March 31, 2002 the gross margin was 39% as compared to 43% for the same period of the prior fiscal year. The
overall decrease in gross margin is primarily due to manufacturing inefficiencies resulting from decreased revenue and lower manufacturing volumes across all product segments for the six months of
2002. Gross margin from flat panel display products was 49% and 45% in the three month periods ended March 31, 2002 and 2001 and 44% and 46% in the six month periods ended March 31, 2002
and 2001, respectively. The increase in FPD gross margin for the most recent quarter is attributable to a favorable mix of product sales and lower expenses resulting from the fiscal 2001 fourth
quarter restructuring. Gross margin from surface mount technology products was 19% and 44% in the three
month periods ended March 31, 2002 and 2001 and 18% and 45% for the six month periods ended March 31, 2002 and 2001, respectively. The decrease in surface mount technology gross margin
is the result of lower sales and manufacturing volumes, resulting in under-absorption of manufacturing overhead, combined with lower average selling prices. Gross margin from cathode ray tube display
and high quality glass products was 39% and 23% in the three month periods ended March 31, 2002 and 2001 and 44% and 30% for the six month periods ended March 31, 2002 and 2001,
respectively. The higher gross margins in the 2002 periods for cathode ray tube displays and high quality glass products are the result of more favorable product mix.

Research and Development.Research and development expenses were $4.2 million and $4.6 million, or 24% and 20%,
of revenue in the three month periods ended March 31, 2002 and 2001, respectively. For the six month periods ended March 31, 2002 and 2001, research and development expenses were
$8.1 million and $9.1 million, or 26% and 19%, of revenue, respectively. The decrease in research and development expenses in absolute dollars is primarily attributable to lower spending
on prototype materials. As a percentage of revenue, research and development expenses are greater in the fiscal year 2002 periods than the fiscal 2001 periods primarily as a result of lower revenue.

Selling, General and Administrative.Selling, general and administrative expenses were $5.0 million and
$4.7 million, or 29% and 20% of revenue, in the three month periods ended March 31, 2002 and

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2001, respectively. For the six month periods ended March 31, 2002 and 2001, selling, general and administrative expenses were $9.7 million and $9.3 million, or 31% and 20% of
revenue, respectively. Selling, general and administrative expenses for the three and six month periods ended March 31, 2002 include costs attributable to salaries and related expenses incurred
after our acquisition of Intelligent Reasoning Systems, Inc. in July 2001. This higher level of expenses in the three and six month periods ended March 31, 2002 as compared to the
same periods ended March 31, 2001 is partially offset by reduced expenses resulting from the restructuring in the fourth quarter of fiscal 2001.

Non-Recurring Acquisition Charges.In December 2000, we acquired Image Processing Systems in exchange for
approximately 1,139,000 shares of our common stock. This acquisition was accounted for as a pooling of interests. We incurred $2.3 million in professional fees consisting of legal, accounting
and integration costs in connection with the acquisition, reflected in the six month period ended March 31, 2001.

Interest Income and Other, Net.Interest income and other, net was $639,000 and $1.6 million for the three month
periods ended March 31, 2002 and 2001 and $1.2 million and $3.3 million for the six month periods ended March 31, 2002 and 2001, respectively. The decrease in the three and
six month periods ended March 31, 2002 was primarily attributable to lower overall yields on investments as compared to the three and six month periods ended March 31, 2001.

Provision for Income Taxes.The provision for income taxes was $0 for both the three and six month periods ended
March 31, 2002, and $191,000 and $709,000 for the three and six month periods ended
March 31, 2001, respectively. The effective tax rate for both the three and six month periods ended March 31, 2001 was 14%, before non-recurring acquisition expenses and
cumulative effect of change in accounting principle, and was lower than the statutory U.S. tax rate of 35% due to realization of net operating loss carry forwards.

Liquidity and Capital Resources

We have financed our operations primarily through a combination of cash flows from operations, public stock offerings, lines of credit and loans. Working capital
was $207.7 million as of March 31, 2002 compared to $99.7 million as of September 30, 2001. Cash, cash equivalents and short-term investments of
$188.9 million at March 31, 2002 and $84.1 million at September 30, 2001, represent the largest components of working capital in both periods.

The
increase in cash, cash equivalents and short term investments and working capital resulted from our underwritten public offering of common stock in February 2002. We sold in the
offering 2,500,000 shares of our common stock at a price of $40.14 per share on February 6, 2002. Additionally, the underwriters exercised their option to purchase an additional 375,000 shares
to cover over-allotments. Our gross proceeds, after the underwriters' discount and expenses of the offering, aggregated approximately $107.0 million.

Operating Activities.Cash used in operating activities was $5.0 million for the six month period ended
March 31, 2002 as compared to cash provided by operating activities of $7.6 million for the same period in the prior fiscal year. The cash used in operating activities in the six month
period ended March 31, 2002 was primarily due to the net loss of $5.0 million and an increase in accounts receivable of $5.2 million, offset in part by depreciation of
$1.4 million, amortization of intangibles of $573,000, a reduction in inventory of $3.7 million and an increase in accounts payable of $2.2 million. Other significant components
of the cash used in operating activities included an increase in other current assets of $1.2 million and a decrease in deferred revenue of $1.6 million. For the six months ended
March 31, 2001 the primary components of cash provided by operating activities were a reduction of accounts receivable $11.5 million, partially offset by the net loss. Other significant
components in the

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cash provided by operating activities included a decrease in inventory of $1.6 million partially offset by a decrease in deferred revenue of $1.3 million.

Investing Activities.Cash provided by investing activities was $32.1 million for the six month period ended
March 31, 2002 compared to cash used in investing activities of $4.7 million for the six months ended March 31, 2001. The primary components of cash provided by investing
activities in the quarter ended March 31, 2002 was the net redemption of short term investments of $32.9 million. For the six months ended March 31, 2001, cash used in investing
activities is due to capital expenditures of $9.8 million, partially offset by a net redemption of short-term investments of $5.2 million.

Financing Activities.Cash provided by financing activities was $110.7 million and $635,000 for the six month periods
ended March 31, 2002 and 2001, respectively. In the six month period ended March 31, 2002, the primary cash provided by financing activities was approximately $107.0 million from
the public sale of common stock. Additionally, in the six months ended March 31, 2002, warrant exercises and employee stock options exercises provided approximately $3.7 million from
financing activities.

In
March 2002, we extended our existing bank line of credit until May 2002. In April 2002, we entered into a new bank line of credit, expiring in April 2003,
that provides a borrowing capacity of $4.0 million. The line of credit is secured by substantially all of our assets and contains financial and other covenants. As of March 31, 2002, no
amounts were outstanding under the line of credit.

At
March 31, 2002, we had $154.3 million in cash and cash equivalents and $34.6 million in short term investments. We lease certain facilities under
non-cancelable operating leases with terms ranging from 30 to 60 months. At March 31, 2001, we had the following approximate contractual obligations:

|                            |  | Payments Due by Period
|--------------------------- |  | ----------------------
|
|
|Operating Lease Obligations |  | $                     
|Capital Lease Obligations   |  | $                     
|Purchase Obligations        |  | $                     

We
believe that existing liquid capital resources and funds generated from operations combined with the ability, if necessary, to borrow up to $4 million under our bank 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, 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 could result in dilution to our shareholders.

Factors Affecting Operating Results

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

We reported losses for the six months ended March 31, 2002 and for the fiscal year ended September 30, 2001. In the future, our revenue may decline,
remain flat or grow at a rate slower than was experienced in prior periods, especially in light of the recent economic slowdown. Our ability to regain profitability 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 outsourcing strategy and ongoing cost-cutting
measures in connection with our recent restructuring. Our operating

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results are difficult to predict, as described below, and we cannot assure you that we will be successful in achieving increased revenue, positive cash flows or profitability.

Capital investment by manufacturers of flat panel display products and other electronics 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 and other electronics products, which in turn depend on
the current and anticipated market demand for the end products in these industries. The markets for flat panel display products and other electronics products are highly cyclical and have 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. More recently, due to the deteriorating economic environment, flat panel display manufacturers have decreased capital expenditures, resulting in
our revenues steadily declining during 2001. Further, semiconductor manufacturers have been heavily impacted by the recent economic environment, and have significantly curtailed their capital
expenditures. We had no sales to these customers in fiscal 2001 or in the six months ended March 31, 2002 and do not expect sales to such customers in the quarter ended June 30, 2002. If
the flat panel display and other markets in which we sell our products do not recover 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 also be unable to replace sales to these customers. Sales of flat panel
display products represented 68% of our revenue for the six months ended March 31, 2002 and 54% and 68% of our revenue in fiscal 2001 and 2000, respectively. LG Phillips LCD Co., Ltd.,
Quanta Display Inc., Ishikawajima-Harima Heavy Industries Co., Ltd., or IHI, and Samsung America, Inc., all customers of our flat panel display products, collectively accounted
for 50% of our revenue, in fiscal 2001 and collectively for substantially all of our revenue from sales of flat panel display products in fiscal 2001. Samsung, LG Phillips, Unipac Optoelectronics
Corporation and Hyundai Electronics Industries Co., LTD, all customers of our flat panel display products, collectively accounted for 59% of our revenue in fiscal 2000 and collectively for
approximately 80% of our revenue from sales of flat panel display products in fiscal 2000.

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, you should not expect past financial
results to 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 $150,000 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. Therefore, our backlog at the beginning of each quarter also does not necessarily determine actual sales for the quarter or any succeeding period.

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



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.

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, one of which is experiencing financial
difficulties and may cease operations, in which case we could experience shipment delays and higher materials costs, which could last for several months, as we transition to a new supplier. We also
currently obtain X-ray equipment for our printed circuit board assembly and advanced semiconductor packaging inspection products from limited 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.

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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 86% of revenue for the six months ended March 31, 2002 and 79% and 82% of revenue in fiscal 2001 and 2000,
respectively. 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:



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 reason 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 and printed circuit board assembly and advanced
semiconductor packaging industries. 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. For the printed circuit board assembly and advanced semiconductor packaging industry, our primary products include our X-ray and optical inspection systems.
Revenue from these four products represented 81% of our revenue in the six months ended March 31, 2002 and 73% of our total revenue in fiscal 2001. 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 we may acquire in the future, and we may not realize the benefits that we expect from
these acquisitions.

We have recently acquired several companies, including Image Processing Systems in December 2000 and Intelligent Reasoning Systems in July 2001, and
may acquire other 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 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:



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Any
of these difficulties could increase our operating costs and harm our financial performance. 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.

We depend on our relationship with IHI to sell our flat panel display products in Japan, and if we are not able to maintain this relationship, we may not be able to access this
important market.

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. Historically, foreign companies have found it difficult to penetrate the Japanese market and often depend upon local sales channels to sell their
products in Japan.

Since
June 1997, we have depended on IHI as our exclusive value-added reseller to sell our flat panel display products in Japan. We anticipate that this relationship will continue
in the future. In the six months ended March 31, 2002, fiscal 2001 and fiscal 2000, 12%, 13% and 7% of our revenue came from sales to IHI, respectively. If IHI reduced the resources allocated
to the development, systems construction, customization, sale and support of our flat panel display products in Japan, our business would be harmed.

In
addition, IHI's rights to continue as our exclusive value-added reseller in Japan are currently unresolved. IHI may have the right to market some or all of our products in Japan on an
exclusive basis, even 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
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.

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 or surface
mount technology 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.
In addition, we are in the process of transferring most of the manufacturing operations of our flat panel display and surface mount technology optical inspection and x-ray products to
Sanmina-SCI. During this transition period, we may encounter significant unforeseen expenses and difficulties due to reasons that may be beyond our control, including technology and
personnel incompatibility. These unforeseen expenses and difficulties

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could disrupt our ongoing business and distract management and employees. We cannot assure you 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, printed circuit board assembly and advanced semiconductor packaging, 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.

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:



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

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 fiscal 2001, we derived approximately 54% 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.

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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 printed circuit board assembly and advanced semiconductor packaging and 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. We depend on close relationships with our customers and the willingness of those customers to share information with us, and the failure to do so could harm our development
efforts.

We must attract and retain key employees 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, other than with Kenneth Wawrew, our Vice President, Business Development, and do not maintain key person life insurance on any of our
employees.

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.

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.

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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.

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.

Because we rely on our sales representatives and distributors, our business may be harmed if our sales representatives become unable or unwilling to sell our products.

We market and sell some of our products, such as our printed circuit board assembly and advanced semiconductor packaging products, domestically and
internationally primarily through sales representatives and distributors. If some or all of our sales representatives and distributors experience financial difficulties, or otherwise become unable or
unwilling to promote and sell our products, our business could be harmed. These sales representatives and distributors could reduce or discontinue sales of our products. They may not devote the
resources necessary to provide effective sales and marketing support to us. In addition, we depend upon the continued viability and financial resources of
these representatives and distributors, many of which are small organizations with limited working capital. These representatives and distributors, in turn, depend substantially on general economic
conditions and other factors affecting the markets for the products they sell. We believe that our success will continue to depend upon these sales representatives and distributors.

We may experience unanticipated warranty claims.

We typically provide a limited warranty on our products for a period of one year from final acceptance by customers. In addition, for some custom-designed
systems, we may need to comply with certain performance specifications for a specific application. We may incur substantial warranty claim expenses on our products or with respect to our obligations
to meet custom performance specifications. Actual warranty claims may exceed recorded allowances, resulting in harm to 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 or Southern California, 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.

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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:



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, printed circuit board assembly and advanced semiconductor
packaging and cathode ray tube display and high quality glass industries may adversely affect the market price of our common stock.

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, 2001
have not changed significantly.

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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. 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 in this action has asserted several causes of action under state law arising out of alleged misrepresentation and
enforcement of our insider trading policy and is seeking damages of approximately $17.7 million, plus undetermined damages resulting from emotional distress and punitive damages. On
December 6, 2001, the court dismissed the complaint for failure to allege facts sufficient to state a cause of action, with leave to amend. On January 17, 2002, the plaintiff filed an
amended complaint and we have answered such complaint. While we intend to vigorously contest this 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 operation.

Item 2.Changes in Securities

None.

Item 3.Defaults Upon Senior Securities

None.

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

On January 21, 2002, we held our Annual Meeting of Shareholders. At that meeting, our shareholders voted on the following five proposals:

Proposal
to elect directors to serve for the ensuing year and until their successors are elected.

|Director                 |  | FOR        |  | WITHHELD
|------------------------ |  | ---------- |  | --------
|Vincent F. Sollitto, Jr. |  | 10,142,900 |  | 611,922 
|E. Floyd Kvamme          |  | 10,701,588 |  | 53,264  
|Barry L. Cox             |  | 10,701,208 |  | 53,614  
|Michael J. Kim           |  | 10,701,508 |  | 53,314  
|Malcolm J. Thompson      |  | 10,701,608 |  | 53,214  
|Richard P. Beck          |  | 10,701,508 |  | 53,314  

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Proposal
to approve our 1995 Stock Option Plan, as amended, to increase the aggregate number of shares of Common Stock authorized for issuance under such plan by 400,000 shares from
2,190,943 shares to 2,590,943 shares.

|FOR      |  | 8,425,607
|-------- |  | ---------
|AGAINST  |  | 2,316,949
|ABSTAIN  |  | 12,266   
|NON-VOTE |  | 0        

Proposal
to approve our 1995 Employee Stock Purchase Plan, as amended, to increase the aggregate number of shares of Common Stock authorized for issuance under such plan by 250,000
shares from 750,000 shares to 1,000,000 shares.

|FOR      |  | 9,388,074
|-------- |  | ---------
|AGAINST  |  | 1,355,122
|ABSTAIN  |  | 11,621   
|NON-VOTE |  | 0        

Proposal
to approve an amendment to our Articles of Incorporation to increase the authorized number of shares of Common Stock from 20,000,000 shares to 30,000,000 shares.

|FOR      |  | 9,287,832
|-------- |  | ---------
|AGAINST  |  | 1,460,093
|ABSTAIN  |  | 6,897    
|NON-VOTE |  | 0        

Proposal
to ratify the selection of Ernst & Young LLP as our independent auditors for our fiscal year ending September 30, 2002.

|FOR      |  | 10,638,296
|-------- |  | ----------
|AGAINST  |  | 109,801   
|ABSTAIN  |  | 6,725     
|NON-VOTE |  | 0         

Item 5.Other Information

None.

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Item 6.Exhibits and Reports on Form 8-K



|Number |  | Exhibit                                                                                                                                                                             
|------ |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|2.1(1) |  | Acquisition Agreement for Plan of Arrangement by and among the Registrant, Photon Dynamics Nova Scotia Company and Image Processing Systems Inc. dated September 27, 2000.          
|2.2(2) |  | Agreement and Plan of Merger by and among the Registrant, Iris Acquisition, LLC, Intelligent Reasoning Systems Inc. and Clinton Bybee, dated July 6, 2001, amended on July 12, 2001.
|3.1(3) |  | Amended and Restated Articles of Incorporation of the Registrant.                                                                                                                   
|3.2(3) |  | Certificate of Amendment to Articles of Incorporation of the Registrant.                                                                                                            
|3.3(4) |  | Bylaws of the Registrant and amendments thereto.                                                                                                                                    
|4.1    |  | Reference is made to Exhibits 3.1, 3.2 and 3.3.                                                                                                                                     
|       |  |                                                                                                                                                                                     

Key
to Exhibits:





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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:                  

Dated:
May 8, 2002

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