##### Table of Contents



UNITED STATES SECURITIES AND
    EXCHANGE COMMISSIONWashington, D.C.
    20549
      Form 10-K
  þ

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended
    September 30, 2006oro

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934For the transition period
    from          
    to   Commission File Number 0-27234
      Photon Dynamics, Inc.
 (Exact name of registrant as
    specified in its charter)
  California

94-3007502(State or other jurisdiction
    of
    incorporation or organization)

(I.R.S. Employer
    Identification No.)   5970 Optical Court
    San Jose, CA 95138 (Address of principal
    executive offices, including zip code)
  (408) 226-9900 (Registrants telephone
    number, including area code)
      Securities registered pursuant to Section 12(b) of the
    Act:
 None
  Securities registered pursuant to Section 12(g) of the
    Act:
    Common Stock, no par value per share (Title of class)
      o þ
  o þ
  þ o
  Regulation S-K Form 10-K Form 10-K. o
  Rule 12b-2
 o þ o
  Rule 12b-2 o þ
      DOCUMENTS
    INCORPORATED BY REFERENCE
  Form 10-K, Items 10-14 Form 10-K.




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##### 



PHOTON
    DYNAMICS, INC.
  ANNUAL
    REPORT ON
    FORM 10-K
 FOR THE
    FISCAL YEAR ENDED SEPTEMBER 30, 2006
  TABLE OF
    CONTENTS
  
  PagePART IItem 1.

Business


3Item 1A.

Risk
    Factors


12Item 2.

Properties


21Item 3.

Legal
    Proceedings


21Item 4.

Submission of
    Matters to a Vote of Security Holders


21PART IIItem 5.

Market for the
    Registrants Common Equity, Related Stockholder Matters and
    Issuer Purchases of Equity Securities


22Item 6.

Selected Financial
    Data


23Item 7.

Managements
    Discussion and Analysis of Financial Condition and Results of
    Operations


24Item 7A.

Quantitative and
    Qualitative Disclosures About Market Risk


46Item 8.

Financial
    Statements and Supplementary Data


48Item 9.

Changes in and
    Disagreements With Accountants on Accounting and Financial
    Disclosure


89Item 9A.

Controls and
    Procedures


89Item 9B.

Other
    Information.


90PART IIIItem 10.

Directors and
    Executive Officers of the Registrant


90Item 11.

Executive
    Compensation


91Item 12.

Security Ownership
    of Certain Beneficial Owners and Management and Related
    Stockholder Matters


91Item 13.

Certain
    Relationships and Related Transactions


91Item 14.

Principal
    Accounting Fees and Services


91PART IVItem 15.

Exhibits and
    Financial Statement Schedules


91Signatures


93EXHIBIT 21.1EXHIBIT 23.1EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1   1




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SPECIAL
    NOTE REGARDING FORWARD-LOOKING STATEMENTS
  This Annual Report on
    Form 10-K
    contains certain forward-looking statements within the meaning
    of Section 27A of the Securities Act of 1933 and
    Section 21E of the Securities Exchange Act of 1934. All
    statements included or incorporated by reference in this Annual
    Report on
    Form 10-K
    other than statements of historical fact may be forward-looking
    statements. You can identify these and other forward-looking
    statements by the use of words such as may,
    will, could, would,
    should, plans, anticipates,
    relies, expects, intends,
    believes, estimates,
    predicts, potential,
    continue or the negative of such terms, or other
    comparable terminology. Forward-looking statements also include
    the assumptions underlying or relating to any such statements.
    These forward-looking statements are based on current
    expectations as of the filing date of this Annual Report on
    Form 10-K
    and involve a number of uncertainties and risks. These
    uncertainties and risks include, but are not limited to: the
    adoption of new technology by our existing and potential
    customers, the current economic uncertainty, which may cause
    consumers to purchase products containing flat panel displays at
    a rate lower than we and our customers expect, and therefore
    that could lead our customers to reduce investments in our
    products below that which we project until the markets become
    more certain; the current economic conditions, which may cause
    an increase in competitive pricing pressures; and the risk of
    the introduction of competing products having technological
    and/or
    pricing advantages, which would reduce the demand for our
    products. As a result, our actual results and end user demand
    may differ substantially from expectations.
  Our actual results could differ materially from those
    projected in the forward-looking statements included herein as a
    result of a number of factors, risks and uncertainties,
    including the risk factors set forth in Part I
    Item 1A. Risk Factors in this Annual Report on
    Form 10-K
    and elsewhere in this Annual Report on
    Form 10-K.
    The information included in this Annual Report on
    Form 10-K
    is as of the filing date with the Securities and Exchange
    Commission and future events or circumstances could differ
    significantly from the forward-looking statements included
    herein. Accordingly, we caution readers not to place undue
    reliance on such statements and we expressly assume no
    obligation to update the forward-looking statements included in
    this report after the date hereof except as required by law.
 2




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PART I  Item 1.
    Business  Introduction
    tm tm tm tm
    www.photondynamics.com. Form 10-K, Form 10-Q, Form 8-K, Form 10-K
  Industry
  Flat
    Panel Display Industry Background
   3




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work-in-progress
        Manufacture of Active Matrix Liquid Crystal
    Displays.
        Array Phase. sub-pixel, sub-pixels sub-pixels
  Cell Assembly Phase.
  Module Assembly Phase.
 4




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Challenges Faced by Flat Panel Display
    Manufacturers.
  
    Demand for Higher Quality.  Increased
    competition among flat panel display manufacturers, improvements
    in the manufacturing process and higher consumer expectations
    are moving the flat panel display industry towards a zero defect
    standard. The manufacturing challenges presented by the goal of
    zero defect products have been compounded by the increasing
    demand for higher resolution and larger displays.
    Increasing Display Resolutions.  Resolutions of
    advanced flat panel displays now involve several million pixels,
    presenting a challenge when test and inspection equipment must
    exercise each pixel. Traditional methods of physically
    contacting each row and column of pixels with probe cards have
    difficulty handling current advanced displays. Manufacturers
    require new techniques, such as non-contact pixel-addressing
    mechanisms, to more effectively handle these displays.
    High Cost of Materials.  Materials costs
    comprise approximately 50% to 70% of flat panel display costs,
    in contrast to only approximately 10% for semiconductors,
    according to industry sources. Higher material costs expose the
    flat panel display manufacturer to higher costs due to yield
    loss throughout the manufacturing process. High performance LCDs
    for television applications further increase the complexities
    associated with LCD manufacturing. Because of the high cost of
    materials used in the manufacture of LCDs, defective LCDs,
    especially larger displays, represent a substantial cost to LCD
    manufacturers, and can ultimately drive up both panel and end
    product costs. Therefore, it is important to test, repair and
    inspect early in the manufacturing process before expensive
    materials are added to the display in the latter assembly phases.
    Need for Increased Yield and Greater
    Throughput.  Greater yields are realized in part
    through more effective test, repair and inspection. In order to
    maintain or improve profitability, flat panel display
    manufacturers need test, repair and inspection equipment that
    will allow them to increase process speed while using larger
    panels.
    Need for Flexibility.  The flat panel display
    industry is producing a larger number of different panel sizes
    as the variety of applications incorporating flat panel displays
    has increased. Manufacturers are seeking test, repair and
    inspection equipment that can be reconfigured quickly and
    accurately for different panel sizes, with minimal production
    downtime. 5




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Products
    Yield
    Management Products
    Flat Panel Display Array Test Systems. tm tm
  Flat Panel Display Array Repair Systems. tm tm
  tm
  Flat Panel Display Inspection Systems. tm tm tm
  Customer
    Service and Support
   6




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Customers
  Form 10-K
    Sales,
    Service and Marketing
        Form 10-K. Form 10-K
 7




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Research
    and Development
  Form 10-K,
    Manufacturing
    tm
    build-up
    Suppliers
   8




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Intellectual
    Property
  non-U.S. patents non-U.S. pending
    Patents in ForceU.S.


Non-U.S.Yield Management Products


45



27Other


29



25Total


74



52     Backlog
  Form 10-K.
  Competition
   9




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easy-to-use
      Employees
      Business
    Combinations
      and/or
   10




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##### Table of Contents



Form 10-K.
  Executive
    Officers of the Registrant
    Name

Age

PositionMalcolm J. Thompson


61



Chairman of the Board of
    Directors, DirectorJeffrey A. Hawthorne


49



Chief Executive Officer, President
    and DirectorMichael Schradle


61



Chief Financial OfficerSteve Song


51



Vice President, Worldwide SalesMark Merrill


43



Vice President, Marketing   Malcolm J. Thompson
  Jeffrey A. Hawthorne
 11




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##### Table of Contents



Michael Schradle
  Steve Song
  Mark Merrill start-up
  Item 1A.
    Risk
    Factors  We
    have sustained losses and we may sustain losses in the
    future.
  Form 10-K.
    Our
    operating results are difficult to predict and may vary from
    investors expectations, which could cause our stock price
    to fall.
   12




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##### Table of Contents




    the timing of the receipt of orders from major customers;
    the delay or extension of firm orders;
    the receipt of final acceptance on new products;
    our product mix;
    competitive pricing pressures;
    our ability to obtain components from our single or limited
    source suppliers in a timely manner;
    our ability to effectively implement our strategy of domestic
    and offshore manufacturing;
    global economic uncertainty;
    changing international economic conditions;
    the outcome of the appeal of litigation with a former executive
    officer;
    worldwide political instability;
    our ability to design, manufacture and introduce new products on
    a cost-effective and timely basis;
    the delay between expenses to further develop marketing and
    service capabilities and the realization of benefits from those
    improved capabilities; and
    the introduction of new products by our competitors.    If our
    products experience performance, reliability or quality
    problems, our customers may reduce their orders.
  tm tm
  
    delays in receiving final acceptance, which in turn delays
    recognition of the associated revenue;
    delays in collecting accounts receivable;
    reduced orders;
    additional warranty and service expenses; and
    higher manufacturing costs. 13




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tm
  Capital
    investment by manufacturers of flat panel display products can
    be highly cyclical and may decline in the future.
      We
    depend on sales to a few large customers in the flat panel
    display industry, and if we lose any of our large customers our
    revenue could decrease significantly.
    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.
   14




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##### Table of Contents



tm tm tm tm tm tm tm tm tm tm tm tm tm
  We may
    not be able to develop and introduce new products that respond
    to evolving industry requirements in a timely manner, which
    could reduce our ability to compete effectively.
        If we
    are not able to obtain critical components from our single or
    limited source suppliers, we may experience significant delays
    in producing our products, which could decrease our revenue for
    an extended period of time.
    All of
    our revenue is derived from sales to companies located outside
    the United States, which exposes us to risks that we would not
    experience with domestic sales.
    
    political instability and the possibility of hostilities,
    terrorist attacks, or war;
    imposition of governmental controls; 15




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
    fluctuations in interest and currency exchange rates;
    export license requirements;
    restrictions on the export of technology;
    limited foreign protection of intellectual property rights;
    trade restrictions;
    periodic or local international downturns;
    decreases in productivity, temporary plant shutdowns or
    infrastructure service disruptions resulting from widespread
    health alerts including Severe Acute Respiratory Syndrome
    (SARS) and warnings of an Avian Flu pandemic;
    changes in tariffs; and
    difficulties in staffing and managing international operations.    Our
    ability to efficiently and effectively implement our strategy of
    using both domestic and offshore manufacturing may impact our
    profitability.
      
    political instability and the possibility of hostilities,
    terrorist attacks, or war;
    imposition of governmental controls;
    fluctuations in interest and currency exchange rates;
    limited foreign protection of intellectual property rights;
    trade restrictions;
    periodic or local international downturns;
    decreases in productivity, temporary plant shutdowns or
    infrastructure service disruptions resulting from widespread
    health alerts including SARS and warnings of an Avian Flu
    pandemic; and
    difficulties in staffing and managing international
    manufacturing.    Any
    failure of, or other problems at or with, our third party
    manufacturers could delay shipments of our flat panel display
    products, harm our relationships with our customers or otherwise
    negatively impact our business.
   16




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If we
    do not compete effectively in our target markets, we will lose
    market share.
    Our
    success depends in large part on the strength of the active
    matrix liquid crystal display in the flat panel display
    industry.
    We may
    have difficulty integrating the businesses or assets we have
    acquired and may acquire in the future, and we may not realize
    the benefits that we expect from these
    acquisitions.
  and/or
  
    difficulty in the assimilation of the technologies and products
    of the acquired company;
    entering markets in which we have no or limited direct prior
    experience;
    loss of key customers of the acquired company;
    diversion of management resources from the business of the
    combined company;
    incompatibility of business cultures or practices;
    loss of key employees of the acquired company;
    costs and delays in implementing common systems and procedures;
    potential inefficiencies in delivering services to the customers
    of the combined company; and
    assumption of unknown or undisclosed liabilities. 17




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Compliance
    with new reporting requirements may strain our resources and we
    may be unable to implement in a timely manner additional finance
    and accounting systems, procedures and controls in the future to
    satisfy new reporting requirements, which could cause our stock
    price to fall.
  Form 10-K.
    Our
    business could be harmed if we fail to properly protect our
    intellectual property.
   18




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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.
      We
    must attract and retain key employees and our management team
    and employees must work effectively together to maintain and
    grow our business.
    Terrorism
    and international political instability may negatively affect
    our operations.
      Our
    manufacturing facilities and our customers manufacturing
    facilities may be subject to disruption from natural
    disasters.
   19




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We
    have exposure to various risks related to the regulatory
    environment.
  and/or
  Computer
    viruses may disrupt our operations.
    Additional
    Risks in Owning our Common Stock
  Our
    stock price may fluctuate significantly.
    
    announcements of technological innovations or new products by us
    or by our competitors;
    government regulations;
    developments in patent or other property rights; and
    developments in our relationships with our customers.    Some
    anti-takeover provisions may affect the price of our common
    stock.
    We do
    not anticipate paying cash dividends.
   20




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Item 2.
    Properties    Location

Type

Principal Use

Footage


OwnershipSan Jose, California

Office and plant

Manufacturing


22,000


OwnedSan Jose, California

Office and plant

Headquarters, marketing, sales,
    administration, manufacturing, research, engineering


128,520


LeasedMarkham, Ontario, Canada

Office

Sublet


50,000


LeasedHsin Chu, Taiwan

Office

Sales, service, marketing,
    administration, research


10,236


Leased     Item 3.
    Legal
    Proceedings      Item 4.
    Submission
    of Matters to a Vote of Security Holders   21




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PART II  Item 5.
    Market
    for the Registrants Common Equity, Related Stockholder
    Matters and Issuer Purchase of Equity Securities  Common
    Stock Market Price
    December 31,


March 31,


June 30,


September 30,Fiscal 2006 Quarter Ended

2005


2006


2006


2006High

$
19.26


$
22.72


$
19.75


$
13.48Low

$
16.74


$
17.47


$
12.52


$
10.30   December 31,


March 31,


June 30,


September 30,Fiscal 2005 Quarter Ended

2004


2005


2005


2005High

$
24.90


$
25.52


$
22.00


$
24.67Low

$
16.71


$
18.73


$
17.47


$
17.84         Total SharesAverage

Purchased

Shares YetTotal Shares

Price Paid

as Part

to be PurchasedPurchased

per Share

of the Plan

Under the PlanAugust 1 through
    August 31, 2006


503,581


$
13.17



503,581



596,419September 1 through
    September 30, 2006


26,020


$
13.35



529,601



570,399  22




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Item 6.
    Selected
    Financial Data  Form 10-K.
    Year Ended September 30,2006


2005


2004


2003


2002(In thousands, except per share data)Consolidated Statements of
    Operations:Revenue

$
172,872


$
125,813


$
141,870


$
67,196


$
49,342Income (loss) from operations


1,412



(21,161
)


6,860



(30,692
)


3,402Income (loss) from continuing
    operations before discontinued operations


4,207
(1)


(19,567
)(2)


11,085
(3)


(27,780
)(4)


6,230
(5)Income (loss) from discontinued
    operations


(127
)


256



(1,391
)


(44,592
)


(28,032
)Net income (loss)

$
4,080


$
(19,311
)

$
9,694


$
(72,372
)

$
(21,802
)Income (loss) per share from
    continuing operations before discontinued operations:Basic

$
0.25
(1)

$
(1.16
)(2)

$
0.67
(3)

$
(1.73
)(4)

$
0.39
(5)Diluted

$
0.25
(1)

$
(1.16
)(2)

$
0.65
(3)

$
(1.73
)(4)

$
0.37
(5)Income (loss) per share from
    discontinued operations:Basic

$
(0.01
)

$
0.02


$
(0.08
)

$
(2.77
)

$
(1.76
)Diluted

$
(0.01
)

$
0.02


$
(0.08
)

$
(2.77
)

$
(1.67
)Net income (loss) per share:Basic

$
0.24
(1)

$
(1.14
)(2)

$
0.58
(3)

$
(4.50
)(4)

$
(1.37
)(5)Diluted

$
0.24
(1)

$
(1.14
)(2)

$
0.57
(3)

$
(4.50
)(4)

$
(1.30
)(5)   2006


2005


2004


2003


2002(In thousands)Consolidated Balance
    Sheets:Cash, cash equivalents and
    short-term investments

$
102,769


$
93,026


$
84,155


$
116,469


$
170,143Working capital


121,411



116,488



132,335



125,624



190,188Total assets


177,613



183,684



207,900



161,919



249,159Other non-current liabilities


119



1,008



1,528



193



1,465Shareholders equity


144,381



142,594



159,959



144,143



226,143     (1)
    
    Includes a restructuring charge of approximately $30,000 related
    to the restructuring of the Companys Markham, Canada
    location, an impairment charge of approximately $81,000 related
    to the impairment of 23




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manufacturing capital equipment and charges for amortization of
    intangibles of approximately $1.5 million. Effective
    October 1, 2005, we adopted the provisions of
    SFAS No. 123R, Share-Based Payments, and
    as a result, fiscal 2006 includes net stock-based compensation
    of approximately $4.1 million related to our stock option
    plans and our employee stock purchase plan. There were no
    comparable charges in previous fiscal years.(2)
    
    Includes a restructuring charge of approximately
    $1.2 million related to the restructure of the
    Companys Markham, Canada location, an impairment charge of
    approximately $637,000 related primarily to impairment of
    manufacturing capital equipment and charges for amortization of
    intangibles of approximately $1.5 million.(3)
    
    Includes a goodwill impairment charge of approximately $665,000,
    purchased intangible asset write-off of approximately
    $2.1 million and property and equipment impairment charges
    of approximately $234,000, all related to the suspension of the
    low-temperature poly-silicon (LTPS) and inverter
    product lines; acquired in-process research and development
    charge of approximately $210,000 in connection with the
    acquisition of certain assets from Quantum Composers, Inc.; gain
    on fixed assets of approximately $427,000 related to the sale of
    the TFT-LCD Backlight Inverter Business, and charges for
    amortization of intangibles of approximately $789,000.(4)
    
    Includes a goodwill impairment charge of approximately
    $10.0 million related to the Akcron and RTP Assets,
    purchased intangible asset write-off of approximately
    $3.5 million related to the Akcron and RTP Assets, and an
    acquired in-process research and development charge of
    approximately $2.5 million related to the acquisition of
    certain assets from Intevac related to Intevacs Rapid
    Thermal Processing Division and the acquisition of substantially
    all the assets of Summit Imaging, and charges for amortization
    of intangibles of approximately $1.2 million.(5)
    
    Includes an acquired in-process research and development charge
    of approximately $410,000 in connection with the acquisition of
    Akcron.  Item 7.
    Managements
    Discussion and Analysis of Financial Condition and Results of
    Operations  The following discussion of our financial condition and
    results of operations should be read in conjunction with our
    Consolidated Financial Statements and the related Notes to
    Consolidated Financial Statements in Part II, Item 8,
    Financial Statements and Supplementary Data in this
    Annual Report on
    Form 10-K.
    This discussion 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
    Part I Item 1A. Risk Factors, and
    elsewhere in this Annual Report on
    Form 10-K.
    Generally, the use of words such as may,
    will, could, would,
    should, plans, anticipates,
    relies, expects, intends,
    believes, estimates,
    predicts, potential,
    continue or the negative of such terms, or other
    comparable terminology and similar expressions identify
    forward-looking statements. The information included in this
    Annual Report on
    Form 10-K
    is as of the filing date with the Securities and Exchange
    Commission and future events or circumstances could differ
    significantly from the forward-looking statements included
    herein. Accordingly, we caution readers not to place undue
    reliance on such statements.
  Overview
  Our
    Company
    tm tm tm
 24




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tm
      tm tm Form 10-K.
    
    The level of capital expenditures of flat panel display
    manufacturers, which in turn depends on the current and
    anticipated market demand for products utilizing flat panel
    displays; and
    The relative competitiveness of our products and services.      Focus
    on Flat Panel Display Industry
     25




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
    Product Focus:  We continue to improve our
    product performance in defect detection, repair success, cost of
    ownership, ease of use and throughput for each of our product
    generations. We seek to couple this improved system performance
    with our expert applications engineering services to provide the
    best possible business solutions to our customers.
    Quality Focus:  We continue to implement
    processes to drive product quality improvement and ease of use
    for our customers.
    Technology Leadership:  We continue to
    emphasize our research and development to maintain our
    technology leadership in our products.
    Financial Improvement:  We continue our efforts
    to improve financial performance. To achieve these goals, we
    will continue to look for vertical integration opportunities,
    source certain raw materials and certain system integration in
    Asia, and expand sales and marketing of our service product
    offerings.      
    Continued investment in research and development, with a focus
    on Generation 10 products and new repair product applications;
    Grow our service and upgrade revenue as a percentage of overall
    revenue;
    Gross margin improvement;
    New product introduction execution; and
    Reduce our overall operating expenses through continued emphasis
    on operational efficiency and discipline.  Acquisitions
    and Dispositions
  and/or
  Acquisition of TORC Assets.
  Acquisition of Quantum Composers Assets.
     26




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Form 10-K
  Industry
           27




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tm tm tm tm
  Backlog
      Critical
    Accounting Policies and Estimates
  Form 10-K
    Form 10-K.
 28




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Revenue
    Recognition
  Form 10-K
      Allowance
    for Doubtful Accounts
      Inventories
    part-by-part
 29




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Warranty
    tm
  Goodwill
    and Intangible Assets
       30




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Stock-Based
    Compensation
      Contingencies
    and Litigation
  Form 10-K.
 31




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Results
    of Operations
  Fiscal
    Years Ended September 30, 2006, 2005 and 2004
    Year EndedSeptember 30,2006


2005


2004Revenue


100.0
%


100.0
%


100.0
%Cost of revenue


65.2



65.8



59.2Gross margin


34.8



34.2



40.8Operating expenses:Research and development


18.8



28.8



20.9Selling, general and administrative


14.2



19.6



12.5Restructuring charge


0.0



1.0



Goodwill impairment charge










0.5Impairment of purchased intangibles










1.5Impairment of property and
    equipment


0.0



0.5



0.2Loss (gain) on sale of property
    and equipment


0.0



(0.1
)


(0.3
)Acquired in-process research and
    development










0.1Amortization of intangible assets


0.9



1.2



0.6Total operating expenses


33.9



51.0



36.0Income (loss) from operations


0.9



(16.8
)


4.8Interest income and other, net


1.9



1.8



3.4Income (loss) from continuing
    operations before income taxes and discontinued operations


2.8



(15.0
)


8.2Provision for income taxes


0.3



0.5



0.4Income (loss) from continuing
    operations before discontinued operations


2.5



(15.5
)


7.8Income (loss) from discontinued
    operations


(0.1
)


0.2



(1.0
)Net income (loss)


2.4
%


(15.3
)%


6.8
%   Revenue
  Fiscal Year Ended

Fiscal Year EndedSeptember 30,

September 30,2006

Change

2005

2005

Change

2004(Dollars in thousands)Revenue

$
172,872



37
%

$
125,813


$
125,813



(11.3
)%

$
141,870    32




---



##### Table of Contents



tm tm tm
  ArrayCheckertm and
    ArraySavertm Product Revenue
  Fiscal 2006 v 2005: tm tm period-over-period tm tm
  tm tm
  tm tm
  tm tm
  Fiscal 2005 v 2004:
  tm
  tm
 33




---



##### Table of Contents



tm tm
  PanelMastertmProduct Revenue
  tm tm
  Fiscal 2006 v 2005: tm
  tm tm tm
  Fiscal 2005 v 2004: tm
  Customer
    Support and Spare Parts Revenue
  Fiscal 2006 v 2005:
  Fiscal 2005 v 2004:
  Rapid
    Thermal Processing Revenue
   34




---



##### Table of Contents



International
    Revenue
    Fiscal Year Ended


Fiscal Year EndedSeptember 30,


September 30,2006


Change


2005


2005


Change


2004(Dollars in millions)South Korea

$
113.3



173
%

$
41.5


$
41.5



(39
)%

$
68.5Taiwan


41.1



(23
)


53.2



53.2



(13
)


60.8Japan


7.7



(55
)


17.0



17.0



55



11.0China


10.8



(24
)


14.1



14.1



778



1.6$
172.9



37
%

$
125.8


$
125.8



(11
)%

$
141.9       Revenue
    Outlook
  Form 10-K
  Gross
    Margin
  Fiscal Year Ended

Fiscal Year EndedSeptember 30,

September 30,2006

Change

2005

2005

Change

2004Gross Margin

$
60,101



40
%

$
43,081


$
43,081



(26
)%

$
57,901Percent of Revenue


35
%






34
%


34
%






41
%   tm
  
    Lower revenue related to the receipt of final customer
    acceptances following completed installation, which have higher
    margins associated with this portion of the sales price, as
    compared to the same period in the prior year;
    Costs associated with SFAS No. 123R for which there
    were no comparable charges in the same period of the prior
    fiscal year;
    An additional write-down of excess inventory in our third
    quarter as a result of anticipated lower bookings and revenues;
    A one-time warranty charge for the replacement of two of our
    Generation 7
    ArrayCheckertm
    systems.    
    Higher percentage sales of lower-margin products, including our
    ArraySavertm
    and
    PanelMastertm
    products; 35




---



##### Table of Contents




    High warranty costs, higher rework costs and expedite fees
    incurred as a result of the execution issues surrounding the
    production ramp up in our Generation 7
    ArrayCheckertm
    and
    ArraySavertm
    systems and in our
    PanelMastertm
    products;
    The under-utilization of our San Jose facilities; and
    Increased manufacturing and support headcount and travel costs
    to support our growing installed product base.      
    Our revenue mix between higher-margin
    ArrayCheckertm
    systems and lower-margin
    ArraySavertm
    systems;
    The costs of increasing customer service staff to support
    potential increased demands from new and existing customers;
    The additional costs in connection with inefficiencies of
    manufacturing newly introduced products;
    Competitive pricing pressures, particularly in the array repair
    market;
    The success of our strategy of using both domestic and offshore
    manufacturing as we begin limited manufacturing of certain of
    our
    ArraySavertm
    systems in South Korea;
    Reduced production levels as a consequence of either industry
    slowdown, order cancellations or rescheduled product shipments
    requested by our customers; and
    Fluctuations in the level of revenue due to the cyclical nature
    of our customers capital expenditures.  Research
    and Development
  Fiscal Year Ended

Fiscal Year EndedSeptember 30,

September 30,2006

Change

2005

2005

Change

2004(Dollars in thousands)Expense

$
32,420



(11
)%

$
36,275


$
36,275



22
%

$
29,701Percent of Revenue


19
%






29
%


29
%






21
%          36




---



##### Table of Contents




    Focus on product enhancements and improving cost of ownership on
    our Generation 7, 7.5 and 8 products;
    Begin Generation 10 product development programs; and
    Continue our reliability and cost reduction initiatives.    Selling,
    General and Administrative
  Fiscal Year Ended

Fiscal Year EndedSeptember 30,

September 30,2006

Change

2005

2005

Change

2004(Dollars in thousands)Expense

$
24,611



(0
)%

$
24,678


$
24,678



39
%

$
17,780Percent of Revenue


14
%






20
%


20
%






13
%     Form 10-K Form 10-Q
    
    Amounts spent on the internal investigation discussed above;
    Amounts spent on preparation work for compliance with
    Section 404 of the Sarbanes-Oxley Act of 2002; and
    Additional investments in marketing.    Stock-Based
    Compensation
     37




---



##### Table of Contents



Year EndedSeptember 30,2006(In thousands)Stock-based compensation expense
    included in continuing operations:Cost of revenue

$
401Research and development


676Selling, general and administrative


3,002Total stock-based compensation
    expense after income taxes(1)

$
4,079     (1)
    
    The income tax benefit on stock-based compensation was not
    material.    Restructuring
    Charges
  Fiscal Year Ended September 30,

Fiscal Year Ended September 30,2006

Change

2005

2005

Change

2004(Dollars in thousands)Expense

$
30



(97
)%

$
1,197


$
1,197



100
%

$
0Percent of Revenue


0
%






1
%


1
%






0
%    38




---



##### Table of Contents



Impairment
    of Goodwill, Purchased Intangibles and Property and
    Equipment
  Fiscal Year Ended

Fiscal Year EndedSeptember 30,

September 30,2006

Change

2005

2005

Change

2004(Dollars in thousands)Expense

$
81



(87
)%

$
637


$
637



(79
)%

$
2,988Percent of Revenue


0
%






0.5
%


0.5
%






2
%     Loss
    (gain) on Sale of Property and Equipment
  Fiscal Year Ended

Fiscal Year EndedSeptember 30,

September 30,2006

Change

2005

2005

Change

2004(Dollars in thousands)Loss (Gain)

$
58



(162
)%

$
(93
)

$
(93
)


(78
)%

$
(427
)Percent of Revenue


0
%






0
%


0
%






0
%        39




---



##### Table of Contents



Acquired
    In-Process Research and Development
  Fiscal Year Ended

Fiscal Year EndedSeptember 30,

September 30,2006

Change

2005

2005

Change

2004(Dollars in thousands)Expense

$
0



0
%

$
0


$
0



(100
)%

$
210Percent of Revenue


0
%






0
%


0
%






0
%           Amortization
    of Intangible Assets
  Fiscal Year Ended

Fiscal Year EndedSeptember 30,

September 30,2006

Change

2005

2005

Change

2004(Dollars in thousands)Expense

$
1,489



(4
)%

$
1,548


$
1,548



96
%

$
789Percent of Revenue


1
%






1
%


1
%






1
%      40




---



##### Table of Contents



Interest
    Income and Other, Net
  Fiscal Year Ended

Fiscal Year EndedSeptember 30,

September 30,2006

Change

2005

2005

Change

2004(Dollars in thousands)Interest Income and Other, Net

$
3,356



51
%

$
2,218


$
2,218



54
%

$
4,802Percent of Revenue


2
%






2
%


2
%






3
%         Provision
    for Income Taxes
  Fiscal Year Ended

Fiscal Year EndedSeptember 30,

September 30,2006

Change

2005

2005

Change

2004(Dollars in thousands)Expense

$
561



(10
)%

$
624


$
624



8
%

$
577Percent of Revenue


0
%






0
%


0
%






0
%          41




---



##### Table of Contents



Discontinued
    Operations
    Printed
    Circuit Board Assembly Inspection Business
  Fiscal Year EndedSeptember 30,2006

2005

2004(In thousands)Net Loss

$
(154
)

$
(56
)

$
(1,562
)         Cathode
    Ray Tube Display and High Quality Glass Inspection
    Business
  Fiscal Year EndedSeptember 30,2006

2005

2004(In thousands)Net Income

$
27


$
312


$
171         Outlook
    Liquidity
    and Capital Resources
   42




---



##### Table of Contents



Operating Activities of Continuing
    Operations.
        Investing Activities of Continuing
    Operations.
        Financing Activities of Continuing
    Operations.
         43




---



##### Table of Contents



Operating, Investing and Financing Activities of Discontinued
    Operations.
  Fiscal Year Ended2006


2005


2004(In thousands)Cash flows from operating
    activities:Printed circuit board business

$
(1,242
)

$
(543
)

$
(1,387
)Cathode ray tube display and high
    quality glass inspection business


(29
)


(97
)


(47
)Net cash used in operating
    activities from discontinued operations


(1,271
)


(640
)


(1,434
)Cash flows from financing
    activities:Cathode ray tube display and high
    quality glass inspection business






(313
)


Net cash used in financing
    activities from discontinued operations






(313
)


Net decrease in cash and cash
    equivalents from discontinued operations:Printed circuit board business


(1,242
)


(543
)


(1,387
)Cathode ray tube display and high
    quality glass inspection business


(29
)


(410
)


(47
)Net decrease in cash and cash
    equivalents from discontinued operations

$
(1,271
)

$
(953
)

$
(1,434
)      44




---



##### Table of Contents



Contractual
    Obligations
    Payments Due by Fiscal YearTotal


2007


2008


2009


2010


2011


Thereafter(In thousands)Operating lease obligations

$
12,372


$
3,326


$
2,833


$
2,727


$
2,785


$
701


$
Capital lease obligations


196



65



71



60











Purchase obligations


27,002



26,389



613















Total

$
39,570


$
29,780


$
3,517


$
2,787


$
2,785


$
701


$
         Working
    Capital
    Off-Balance
    Sheet Arrangements
  Regulation S-K.
  Transactions
    with Related Parties
   45




---



##### Table of Contents



Impact of
    Accounting Pronouncements
  .
        Item 7A.
    Quantitative
    and Qualitative Disclosures about Market Risk  Foreign
    Currency Exchange Rate Risk
   46




---



##### Table of Contents



Interest
    Rate Risk
      There





FairSeptember 30, 2006

2007


2008


2009


2010


2011


after


Total


Value(Dollars in thousands)Cash and cash equivalents
    (variable rate)

$
47,941






















$
47,941


$
47,935Average interest rate


3.98
%Short-term investments (variable
    rate)





















$
46,765


$
46,765


$
46,765Average interest rate






















5.25
%Short-term investments (fixed rate)

$
8,102






















$
8,102


$
8,069Average interest rate


4.37
%Long-term investments (fixed rate)





$
800


















$
800


$
787Average interest rate






3.67
%   There





FairSeptember 30, 2005

2006


2007


2008


2009


2010


after


Total


Value(Dollars in thousands)Cash and cash equivalents
    (variable rate)

$
20,288






















$
20,288


$
20,288Average interest rate


1.30
%Short-term investments (variable
    rate)

$
1,000










$
2,300


$
3,200


$
23,575


$
30,075


$
30,071Average interest rate


2.62
%










3.60
%


3.72
%


3.76
%Short-term investments (fixed rate)

$
40,503


$
2,484


















$
42,987


$
42,667Average interest rate


2.56
%


3.46
%    47




---



##### Table of Contents



Item 8.
    Financial
    Statements and Supplementary Data  Index to
    Consolidated Financial Statements
  Description

PageReports of
    Independent Registered Public Accounting Firm


49Consolidated
    Balance Sheets


51Consolidated
    Statements of Operations


52Consolidated
    Statements of Shareholders Equity


53Consolidated
    Statements of Cash Flows


54Notes to
    Consolidated Financial Statements


55  48




---



##### Table of Contents



REPORT OF
    INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM             Internal Control 
    Integrated Framework
  
    49




---



##### Table of Contents



REPORT OF
    INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
     Internal Control  Integrated
    Framework
            
    50




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  CONSOLIDATED BALANCE SHEETS
  September 30,2006


2005(In thousands except share data)ASSETSCurrent assets:Cash and cash equivalents

$
47,935


$
20,288Short-term investments


54,834



72,738Accounts receivable, net of
    allowance for doubtful accounts of $406 and $153, respectively


29,341



27,067Inventories


18,442



32,545Other current assets


3,972



3,932Total current assets


154,524



156,570Long-term investments


787



Land, property and equipment, net


15,891



19,366Other assets


4,542



4,390Intangible assets, net


1,716



3,205Goodwill


153



153Total assets

$
177,613


$
183,684LIABILITIES AND
    SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable

$
7,657


$
13,005Warranty


8,058



5,346Employee notes payable


977



490Other current liabilities


8,967



8,128Deferred gross margin


7,454



13,113Total current liabilities


33,113



40,082Other non-current liabilities


119



1,008Commitments and contingencies
    (Note 12)Shareholders equity:Preferred stock, no par value,
    5,000,000 shares authorized, none outstanding, as of
    September 30, 2006 and 2005, respectively






Common stock, no par value,
    30,000,000 shares authorized, 16,526,782 and
    16,989,940 shares issued and outstanding, as of
    September 30, 2006 and 2005, respectively


285,510



287,765Accumulated deficit


(141,409
)


(145,489
)Accumulated other comprehensive
    income


280



318Total shareholders equity


144,381



142,594Total liabilities and
    shareholders equity

$
177,613


$
183,684    51




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  CONSOLIDATED STATEMENTS OF OPERATIONS
  Year Ended September 30,2006


2005


2004(In thousands, except per share data)Revenue

$
172,872


$
125,813


$
141,870Cost of revenue


112,771



82,732



83,969Gross margin


60,101



43,081



57,901Operating expenses:Research and development


32,420



36,275



29,701Selling, general and administrative


24,611



24,678



17,780Restructuring charge


30



1,197



Goodwill impairment charge










665Impairment of purchased intangibles










2,089Impairment of property and
    equipment


81



637



234Loss (gain) on sale of property
    and equipment


58



(93
)


(427
)Acquired in-process research and
    development










210Amortization of intangible assets


1,489



1,548



789Total operating expenses


58,689



64,242



51,041Income (loss) from operations


1,412



(21,161
)


6,860Interest income and other, net


3,356



2,218



4,802Income (loss) from continuing
    operations before income taxes and discontinued operations


4,768



(18,943
)


11,662Provision for income taxes


561



624



577Income (loss) from continuing
    operations before discontinued operations


4,207



(19,567
)


11,085Income (loss) from discontinued
    operations


(127
)


256



(1,391
)Net income (loss)

$
4,080


$
(19,311
)

$
9,694Income (loss) per share from
    continuing operations:Basic

$
0.25


$
(1.16
)

$
0.67Diluted

$
0.25


$
(1.16
)

$
0.65Income (loss) per share from
    discontinued operations:Basic

$
(0.01
)

$
0.02


$
(0.08
)Diluted

$
(0.01
)

$
0.02


$
(0.08
)Net income (loss) per share:Basic

$
0.24


$
(1.14
)

$
0.58Diluted

$
0.24


$
(1.14
)

$
0.57Weighted average number of shares:Basic


16,978



16,890



16,631Diluted


17,011



16,890



17,087    52




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  CONSOLIDATED STATEMENTS OF SHAREHOLDERS
    EQUITY
  Common Stock and





AccumulatedCapital in Excess of





OtherPar Value


Accumulated


ComprehensiveShare


Amount


Deficit


Income


Total(In thousands)Balances at September 30, 2003


16,390


$
279,417


$
(135,872
)

$
598


$
144,143Components of comprehensive income:Net income










9,694







9,694Change in unrealized gain on
    investments














(377
)


(377
)Currency translation adjustments














126



126Total comprehensive income


















9,443Net issuance of common stock


469



6,167











6,167Stock ownership expense






206











206Balances at September 30, 2004


16,859



285,790



(126,178
)


347



159,959Components of comprehensive loss:Net loss










(19,311
)






(19,311
)Change in unrealized gain on
    investments














(138
)


(138
)Currency translation adjustments














109



109Total comprehensive loss


















(19,340
)Net issuance of common stock


131



1,797











1,797Tax benefits of stock option
    transactions






126











126Stock ownership expense






52











52Balances at September 30, 2005


16,990



287,765



(145,489
)


318



142,594Components of comprehensive income:Net income










4,080







4,080Change in unrealized loss on
    investments














273



273Currency translation adjustments














(311
)


(311
)Total comprehensive income


















4,042Net issuance of common stock


116



1,788











1,788Repurchase of common stock, net


(529
)


(6,993
)










(6,993
)Cancellation of escrow shares


(50
)


(1,258
)










(1,258
)Stock-based compensation






4,194











4,194Stock ownership expense






14











14Balances at September 30, 2006


16,527


$
285,510


$
(141,409
)

$
280


$
144,381    53




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  CONSOLIDATED STATEMENTS OF CASH FLOWS
  Year Ended September 30,2006


2005


2004(In thousands)Cash flows from operating
    activities:Net income (loss) from continuing
    operations

$
4,207


$
(19,567
)

$
11,085Adjustments to reconcile net income
    (loss) from continuing operations to net cash used in operating
    activities from continuing operations:Depreciation


5,720



5,037



2,898Amortization of intangible assets


1,489



1,548



789Stock-based compensation


4,079







Acquired in process research and
    development










210Impairment of goodwill










665Impairment of purchased intangibles










2,089Impairment of property and equipment


81



637



234Stock ownership expense


14



52



206Restructuring expense


30



171



Loss (gain) on sale of property and
    equipment


58



(93
)


(427
)Accretion of non-interest bearing
    notes payable


39



64



17Changes in assets and liabilities:Accounts receivable


(2,274
)


31,274



(48,074
)Inventories


14,218



(829
)


(22,720
)Other current assets


383



(130
)


1,553Related party receivable










250Other assets


(1,168
)


536



(1,157
)Accounts payable


(5,269
)


(5,475
)


14,448Other current liabilities


4,010



(999
)


4,808Deferred gross margin


(5,659
)


1,610



8,764Other liabilities


79



(91
)


(49
)Net cash provided by (used in)
    operating activities from continuing operations


20,037



13,745



(24,411
)Net cash used in operating
    activities from discontinued operations


(1,271
)


(640
)


(1,434
)Net cash provided by (used in)
    operating activities


18,766



13,105



(25,845
)Cash flows from investing
    activities:Purchase of property and equipment


(2,343
)


(4,880
)


(9,803
)Proceeds from sale of fixed assets


50



270



481Acquisition of Rapid Thermal
    Processing Division from Intevac, Inc.










(300
)Acquisition of Quantum Composers,
    Inc.










(1,000
)Acquisition of Tucson Optical
    Research Corporation










(625
)Acquisition of certain intangible
    assets upon termination of a distributor agreement










(1,138
)Purchase of short-term investments


(125,928
)


(56,380
)


(420,296
)Maturities and sales of short-term
    investments


143,319



42,175



459,411Net cash provided by (used in)
    investing activities from continuing operations


15,098



(18,815
)


26,730Cash flows from financing
    activities:Issuance of common stock, net


1,788



1,923



6,167Repurchase of common stock


(6,993
)






Repayment of short-term notes


(609
)


(1,205
)


Net cash provided by (used in)
    financing activities from continuing operations


(5,814
)


718



6,167Net cash used in financing
    activities from discontinued operations






(313
)


Net cash provided by (used in)
    financing activities


(5,814
)


405



6,167Effect of exchange rate changes on
    cash and cash equivalents


(403
)


110



126Net increase (decrease) in cash and
    cash equivalents from continuing operations


28,918



(4,242
)


8,612Net decrease in cash and cash
    equivalents from discontinued operations


(1,271
)


(953
)


(1,434
)Net increase (decrease) in cash and
    cash equivalents


27,647



(5,195
)


7,178Cash and cash equivalents at
    beginning of year


20,288



25,483



18,305Cash and cash equivalents at end of
    year

$
47,935


$
20,288


$
25,483Supplemental cash flow disclosures:Income taxes paid

$
768


$
498


$
59Interest paid






1



6Supplemental non-cash financing and
    investing activities disclosure:Assumed liabilities from
    acquisition of Quantum Composers, Inc. assets










155Note payable issued in acquisition
    of Quantum Composers, Inc. assets










2,000Note payable issued in acquisition
    of TORC assets










625    54




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS
  Note 1 
    Summary of Significant Accounting Policies
  Description of Operations and Principles of
    Consolidation.
    Management Estimates and Assumptions.
  Fair Value of Financial Instruments. and/or
  Cash Equivalents and Short-Term
    Investments. available-for-sale
 55




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  other-than-temporarily other-than-temporary
  Inventories. (first-in,
  Land, Property and Equipment.
    Goodwill and Intangible Assets.
    Accumulated Other Comprehensive Income
    (Loss). available-for-sale
  Concentrations and Other Risk.
   56




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
      start-up
  Foreign Currency.
  Derivative Financial Instruments.
      Warranty.
 57




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Revenue Recognition.
              Shipping Costs.
  Advertising.
  Research and Development Cost.
  Income Taxes.
 58




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Earnings Per Share.
  Stock-Based Compensation.
  Variable Interest Entity.
  Reclassifications.
  Recent Accounting Pronouncements. .
   59




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
        Note 2 
    Financial Statement Components
  September 30,2006


2005(In thousands)Balance SheetInventories:Raw materials

$
10,740


$
12,476Work-in-process


7,036



19,327Finished goods


666



742Total

$
18,442


$
32,545Land, property and equipment:Land and building

$
7,056


$
7,056Equipment


15,952



17,380Office furniture and fixtures


2,864



3,102Leasehold improvements


8,591



8,40134,463



35,939Less: accumulated depreciation and
    amortization


(18,572
)


(16,573
)Total

$
15,891


$
19,366 60




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  September 30,2006


2005(In thousands)Other current liabilities:Compensation

$
3,460


$
4,133Vendor obligation


942



286Professional fees


891



1,314Customer deposits


1,500



Other accrued expenses


2,174



2,395Total

$
8,967


$
8,128Deferred gross margin:Deferred system sales

$
12,217


$
25,481Deferred cost of revenue related
    to system sales


(4,763
)


(12,368
)Total

$
7,454


$
13,113Other non-current liabilities:Long-term portion of employee
    notes payable

$



$
966Other non-current liabilities


119



42Total

$
119


$
1,008Accumulated other comprehensive
    income Foreign currency translation adjustments

$
332


$
643Unrealized losses on
    available-for-sale
    securities


(52
)


(325
)Total

$
280


$
318   Year Ended September 30,2006


2005


2004(In thousands)Statements of
    OperationsInterest income and other, netInterest income

$
3,742


$
2,187


$
1,508Interest expense


(65
)


(74
)


(25
)Foreign exchange gain (loss)


(147
)


356



(90
)Other


(174
)


(251
)


3,409
(1)Total

$
3,356


$
2,218


$
4,802     (1)
    
    In fiscal 2004, the Company recorded a technology license fee
    resulting from a litigation settlement.  Note 3 
    Discontinued Operations
  Printed
    Circuit Board Assembly Inspection Business
   61




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
      Year Ended September 30,2006


2005


2004(In thousands)Revenue

$



$



$
83Cost of revenue






(126
)


Gross margin






126



83Operating expenses:Research and development










21Selling, general and administrative


154



182



1,624Total operating expenses


(154
)


182



1,645Loss from discontinued operations

$
(154
)

$
(56
)

$
(1,562
)        62




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    September 30,2006


2005(In thousands)ASSETSCurrent assets:Other current assets

$
597


$
175Total current assets


597



175Other assets:Other non-current assets






1,016Total assets

$
597


$
1,191LIABILITIESCurrent liabilities:Other current liabilities

$
201


$
579Total current liabilities


201



579Other liabilities:Other non-current liabilities






42Total liabilities

$
201


$
621      63




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    One-TimeTermination


OtherBenefits


Costs


Total(In thousands)Inception of liability

$
696


$
1,326


$
2,022Cash expenditures


(614
)


(652
)


(1,266
)Adjustments to the liability


(82
)


(474
)


(556
)Balance at September 30, 2005






200



200Cash expenditures










Adjustments to the liability










Balance at September 30, 2006

$



$
200


$
200     Cathode
    Ray Tube Display and High Quality Glass Inspection
    Business
      Year Ended September 30,2006


2005


2004(In thousands)Cost of revenue

$
(27
)

$
(150
)

$
Gross margin


27



150



Operating expenses:Selling, general and administrative






(162
)


38Gain on sale of fixed assets










(209
)Total operating expenses






(162
)


(171
)Income from discontinued operations

$
27


$
312


$
171    64




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
        September 30,2006

2005(In thousands)Other current liabilities

$
19


$
74         One-Time


ContractTermination


Termination


OtherBenefits


Costs


Costs


Total(In thousands)Inception of liability

$
1,116


$
771


$
11


$
1,898Cash expenditures


(1,116
)


(393
)


(61
)


(1,570
)Adjustments to the liability






(304
)


50



(254
)Balance of liability at
    September 30, 2005






74







74Cash expenditures






(21
)






(21
)Adjustments to the liability






(34
)






(34
)Balance of liability at
    September 30, 2006

$



$
19


$



$
19   Note 4 
    Acquisitions and Dispositions
  Year
    ended September 30, 2004 dispositions
    Year
    ended September 30, 2004 acquisitions
   65




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##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
      Note 5 
    Goodwill and Other Purchased Intangible Assets
  Goodwill
             66




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Intangible
    Assets
    NonDeveloped


Core


License


CompeteTechnology


Technology


Agreement


Contract


Total(In thousands)Gross carrying amount at
    September 30, 2006

$
1,006


$
2,408


$
1,138


$
968


$
5,520Accumulated amortization


(578
)


(1,504
)


(948
)


(774
)


(3,804
)Net carrying amount at
    September 30, 2006

$
428


$
904


$
190


$
194


$
1,716     NonDeveloped


Core


License


CompeteTechnology


Technology


Agreement


Contract


Total(In thousands)Gross carrying amount at
    September 30, 2005

$
1,006


$
2,408


$
1,138


$
968


$
5,520Accumulated amortization


(326
)


(902
)


(568
)


(519
)


(2,315
)Net carrying amount at
    September 30, 2005

$
680


$
1,506


$
570


$
449


$
3,205     NonDeveloped


Core


License


CompeteTechnology


Technology


Agreement


Contract


Total(In thousands)Balance as of September 30,
    2005

$
680


$
1,506


$
570


$
449


$
3,205Amortization during the period


(252
)


(602
)


(380
)


(255
)


(1,489
)Balance as of September 30,
    2006

$
428


$
904


$
190


$
194


$
1,716        67




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Note 6 
    Restructuring and Other Charges
  Restructuring
  tm
        One-Time


ContractTermination


TerminationBenefits


Costs


Total(In thousands)Inception of liability

$
430


$
246


$
676Cash payments


(526
)


(21
)


(547
)Costs incurred and charged to
    expense


521







521Adjustments to the liability


24



(166
)


(142
)Balance at September 30, 2005


449



59



508Cash payments


(492
)


(16
)


(508
)Costs incurred and charged to
    expense


114







114Adjustments to the liability


(71
)


(5
)


(76
)Balance at September 30, 2006

$



$
38


$
38    68




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Asset
    Impairment
    Note 7 
    Financial Instruments
  Short
    Term Investments
  available-for-sale,
  Gross


GrossAmortized


Unrealized


Unrealized


EstimatedCost


Gains


Losses


Fair Value(In thousands)September 30, 2006Auction rate preferred securities

$
46,765


$



$



$
46,765Corporate debt securities


20,849







(48
)


20,801Mortgage-backed securities


2,000







(4
)


1,996Money market bank deposits and
    other


22,167











22,167Total
    available-for-sale
    investments

$
91,781


$



$
(52
)

$
91,729Amounts included in:Cash equivalents

$
36,114


$



$
(6
)

$
36,108Short-term investments


54,867







(33
)


54,834Long-term investments


800







(13
)


787Total
    available-for-sale
    investments

$
91,781


$



$
(52
)

$
91,729   Gross


GrossAmortized


Unrealized


Unrealized


EstimatedCost


Gains


Losses


Fair Value(In thousands)September 30, 2005Auction rate preferred securities

$
30,075


$



$
(4
)

$
30,071Mortgage-backed securities


21,769







(164
)


21,605Commercial paper and corporate
    debt securities


21,219







(157
)


21,062Money market bank deposits and
    other


7,108











7,108Total
    available-for-sale
    investments

$
80,170


$



$
(325
)

$
79,846Amounts included in:Cash equivalents

$
7,108


$



$



$
7,108Short-term investments


73,063







(325
)


72,738Total
    available-for-sale
    investments

$
80,171


$



$
(325
)

$
79,846  69




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    EstimatedCost


Fair Value(In thousands)Due in less than one year

$
44,215


$
44,177Due in 1 to 3 years


800



787Due in 3 to 5 years






Due in 5 to 10 years






Due in greater than 10 years


46,765



46,765Total cost and estimated fair
    values

$
91,780


$
91,729         In a Loss Position


In a Loss Positionfor Less Than


for 12 Months12 Months


or Greater


TotalGross





Gross





GrossUnrealized





Unrealized





UnrealizedFMV


Losses


FMV


Losses


FMV


Losses(In thousands)Corporate debt securities

$
16,324


$
(35
)

$
2,483


$
(13
)

$
18,807


$
(48
)Mortgage-backed securities


1,996



(4
)










1,996



(4
)Total

$
18,320


$
(39
)

$
2,483


$
(13
)

$
20,803


$
(52
)   yield-at-cost mark-to-market
  available-for-sale
 70




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Derivative
    Financial Instruments
      mark-to-market
  Note 8 
    Income Taxes
    Year EndedSeptember 30,2006


2005


2004(In thousands)Current:Federal

$
175


$
23


$
164State


2



8



3Foreign


356



678



410Deferred:Foreign


28



(85
)


Provision for income taxes

$
561


$
624


$
577  71




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Year Ended September 30,2006


2005


2004(In thousands)Domestic

$
3,418


$
(26,996
)

$
17,490Foreign


1,350



8,053



(5,828
)Income (loss) before income taxes

$
4,768


$
(18,943
)

$
11,662     September 30,2006


2005(In thousands)Deferred tax assets:Net operating loss carryforwards

$
30,267


$
31,954Research credit carryforwards


9,585



9,528Canadian research and development
    expenditures


10,884



9,242Purchased intangibles


3,004



3,083Inventory write-downs


5,198



4,229Depreciation


1,555



2,591Allowance for doubtful accounts


152



58Expenses not currently deductible


5,310



4,327Stock-based compensation


1,399



Deferred revenue


4,500



7,210Total deferred tax assets


71,854



72,222Valuation allowance


(71,796
)


(72,137
)Net deferred tax assets


58



85Deferred tax liabilities






Total net deferred tax assets

$
58


$
85          72




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
        Year Ended September 30,2006


2005


2004(In thousands)Expected provision (benefit) at
    federal statutory rate

$
1,673


$
(6,540
)

$
3,594Foreign income tax rate differences


(79
)


593



410Losses (benefited)/not benefited


(1,434
)


6,441



(3,482
)Disallowed business meals and
    entertainment


85



114



54Nondeductible stock-based
    compensation


173







Nondeductible VIE losses


143







Other individually immaterial items






16



1Provision for income taxes

$
561


$
624


$
577   Note 9 
    Shareholders Equity
  Common Stock Repurchase Program.
  Total SharesAverage


Purchased


Shares YetTotal Shares


Price Paid


as Part


to be PurchasedPurchased


per Share


of the Plan


Under the PlanAugust 1 through
    August 31, 2006


503,581


$
13.17



503,581



596,419September 1 through
    September 30, 2006


26,020


$
13.35



529,601



570,399    73




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Settlement of Escrow Shares.
  Stock Ownership Expense. No. 96-18,
  Shares Reserved.
  September 30,2006Stock options outstanding


1,950,695Stock options, available for grant


798,336Shares for employee stock purchase
    plan


954,691Exchange shares for previous
    acquisitions


32,699Total


3,736,421   Note 10 
    Stock-Based Compensation Plans and Other Employee
    Benefits
  Stock-Based
    Compensation Plans
      Prior to the Adoption of
    SFAS No. 123R.
 74




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Year Ended September 30,2005


2004(In thousands, except per share data)Net income (loss)  as
    reported

$
(19,311
)

$
9,694Less: total stock-based employee
    compensation expense determined under fair value based method
    for all awards


(9,534
)


(7,532
)Net income (loss)  pro
    forma

$
(28,845
)

$
2,162Basic net income (loss) per
    share  as reported

$
(1.14
)

$
0.58Diluted net income (loss) per
    share  as reported

$
(1.14
)

$
0.57Basic net income (loss) per
    share  pro forma

$
(1.71
)

$
0.13Diluted net income (loss) per
    share  pro forma

$
(1.71
)

$
0.13       Impact of the adoption of
    SFAS No. 123R.
 75




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Year EndedSeptember 30, 2006(In thousands,except per share data)Stock-based compensation expense
    included in continuing operations:Cost of revenue

$
401Research and development


676Selling, general and administrative


3,002Total stock-based compensation
    expense after income taxes(1)

$
4,079Stock-based compensation expense
    by type of award:Employee stock options

$
3,724Employee stock purchase plan


470Amounts capitalized as inventory
    and deferred gross margin


(115
)Net effect on net income(1)

$
4,079Effect on net income per share:Basic

$
0.24Diluted

$
0.24     (1)
    
    The income tax benefit on stock-based compensation for all
    periods presented was not material.  Equity Incentive Program.
 76




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Number of SecuritiesRemaining Available forFuture IssuanceNumber of Securities





Under Equityto be Issued Upon


Weighted-Average


Compensation PlansExercise of


Exercise Price of


(Excluding SecuritiesOutstanding Options


Outstanding Options


Reflected in Column (a))Plan Category

(a)


(b)


(c)Equity compensation plans approved
    by security holders


1,950,070


$
23.28



798,336Equity compensation plans not
    approved by security holders


625


$
16.88



Total


1,950,695


$
23.28



798,336     Expected Volatility.
  Expected Term.
  Risk-Free Interest Rate.
  Expected Dividends.
  Forfeitures.
 77




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    2006


2005


2004Stock option plan:Expected stock price volatility


44
%


69
%


83
%Risk free interest rate


4.5
%


3.4
%


2.3
%Expected life of options (years)


3.7



5.3



5.6       Weighted-


Weighted-AverageAvailable


Options


Average


Remaining Contract


Aggregatefor Grant


Outstanding


Exercise Price


Term


Intrinsic Value(In years)


(In thousands)Balances at September 30, 2003


725,147



1,750,638


$
22.14Additional shares reserved


400,000







Options granted


(618,550
)


618,550



31.72Options canceled/expired


352,407



(352,407
)


13.27Options exercised






(384,572
)


22.74Balances at September 30, 2004


859,004



1,632,209


$
27.73Additional shares reserved


1,200,000







Options granted


(797,800
)


797,800



19.37Options canceled/expired


402,104



(399,144
)


28.89Options exercised






(84,591
)


13.59Balances at September 30, 2005


1,663,308



1,946,274


$
24.64Plan shares expired(1)


(789,818
)






Options granted


(472,950
)


472,950



18.37Options canceled/expired


397,796



(397,796
)


25.36Options exercised






(70,733
)


15.06Balances at September 30, 2006


798,336



1,950,695


$
23.28



7.1


$
326Vested and expected to vest at
    September 30, 2006






1,812,954


$
23.63



7.0


$
314Exercisable at September 30,
    2006






1,293,441


$
25.54



6.6


$
280     (1)
    
    The Companys 1995 Amended and Restated Stock Option Plan
    expired in November 2005. Option shares that were available for
    grant at the time of cancellation and all outstanding option
    shares that subsequently are cancelled or expire are no longer
    available for grant. 78




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  in-the-money
    Options Outstanding


Options Vested and ExercisableNumber of Shares





Weighted-Average





Weighted-AverageOutstanding at


Weighted-Average


Exercise Price at


Number


Exercise Price atSeptember 30,


Remaining


September 30,


Vested and


September 30,Range of Exercise Price

2006


Contract Life


2006


Exercisable


2006(In years)$ 3.00 - $17.01


217,008



6.63


$
14.00



111,633


$
12.5317.36 - 17.75


205,110



7.72



17.45



112,072



17.5018.06 - 19.46


346,742



6.22



18.87



115,165



18.4519.50 - 19.50


209,600



8.92



19.50



82,440



19.5019.68 - 23.24


202,856



7.70



21.59



133,216



21.5723.50 - 27.58


296,079



6.96



26.36



265,615



26.6927.83 - 29.91


202,340



6.94



29.36



202,340



29.3631.11 - 59.00


270,960



6.18



37.06



270,960



37.06$ 3.00 - $59.00


1,950,695



7.05


$
23.28



1,293,441


$
25.54         Employee Stock Purchase Plan.
  Bulletin No. 97-1,
 79




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    2006


2005


2004Stock purchase plan:Expected stock price volatility


44
%


80
%


96
%Risk free interest rate


4.6
%


1.70
%


2.13
%Expected life of plan (years)


0.5



1.6



2.0         Other
    Employee Benefit Plans
  Retirement Savings Plan.
  Note 11 
    Net Income (Loss) Per Share
   80




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##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Year Ended September 30,2006


2005


2004(In thousand, except per share data)Numerator:Net income (loss) from continuing
    operations before discontinued operations

$
4,207


$
(19,567
)

$
11,085Net income (loss) from
    discontinued operations


(127
)


256



(1,391
)Net income (loss)

$
4,080


$
(19,311
)

$
9,694Denominator:Weighted average shares for basic
    net income (loss) per share


16,978



16,890



16,631Effect of dilutive securities:
    Employee stock options


33




(1)


456Weighted average shares for
    diluted net income per share


17,011



16,890



17,087Earnings per share:Basic net income (loss) per share:Net income (loss) from continuing
    operations

$
0.25


$
(1.16
)

$
0.67Net income (loss) from
    discontinued operations


(0.01
)


0.02



(0.08
)Net income (loss) per share

$
0.24


$
(1.14
)

$
0.58Diluted net income (loss) per
    share:Net income (loss) from continuing
    operations

$
0.25


$
(1.16
)

$
0.65Net income (loss) from
    discontinued operations


(0.01
)(2)


0.02



(0.08
)(2)Net income (loss) per share

$
0.24


$
(1.14
)

$
0.57     (1)
    
    The effect of potentially dilutive securities from employee
    stock options to purchase 124,060 shares at
    September 30, 2005, was not included in the computation of
    diluted net loss per share as the effect is antidilutive.(2)
    
    In accordance with Statement of Accounting Standards
    No. 128 Earnings Per Share, the Company
    included the effect of dilutive securities from employee stock
    options to purchase 33,000 and 456,000 shares in its
    calculation of fiscal 2006 and 2004 diluted net loss from
    discontinued operations, respectively.    Note 12 
    Commitments and Contingencies
  Operating
    and Capital Leases
   81




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##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
        Line
    of Credit
    Purchase
    Agreements
    Retention
    Bonus
    Warranty
    Obligations
   82




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##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Fiscal


Fiscal2006


2005(In thousands)Beginning balance

$
5,346


$
6,194Estimated warranty cost of new
    shipments during the period


956



4,770Warranty charges during the period


(2,288
)


(4,651
)Changes in liability for
    pre-existing warranties, including expirations


4,044



(967
)Ending balance

$
8,058


$
5,346   tm
  Guarantees
    Legal
    Proceedings
      Note 13 
    Segment Reporting and Geographic Information
   83




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##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
        Year Ended September 30,2006


2005


2004(In thousands)Revenue:South Korea

$
113,288


$
41,474


$
68,450Taiwan


41,108



53,159



60,793Japan


7,665



17,044



11,017China


10,811



14,136



1,610Total

$
172,872


$
125,813


$
141,870     Year Ended September 30,2006


2005


2004(Percent of total revenue)Revenue:ArrayCheckertm


66
%


60
%


75
%ArraySavertm


19



24



19RTP systems










1PanelMastertm


6



6



Customer spares and other


9



10



5Total


100
%


100
%


100
%  84




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##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Year EndedSeptember 30,2006


2005


2004(Percent of total revenue)Customer A


39
%


22
%


39
%Customer B


25
%


10
%


*Customer C


12
%


*



13
%Customer D


*



11
%


*Customer E


*



12
%


*Customer F


*



12
%


*Customer G


*



*



10
%Customer H


*



*



10
%     *
    
    Customer accounted for less than 10% of total revenue for the
    period.    September 30,2006


2005(Percent of gross accounts receivable)Customer A


37
%


*Customer B


21
%


29
%Customer C


16
%


19
%Customer D


16
%


10
%Customer E


*



19
%     *
    
    Customer accounted for less than 10% of total gross accounts
    receivable for the period.    September 30,2006


2005(In thousands)United States

$
16,234


$
21,022South Korea


1,229



820Canada






519Other


297



363Total

$
17,760


$
22,724   Note 14 
    Related Party Transactions
   85




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##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Note 15 
    Notes Payable
    Note 16 
    Quarterly Consolidated Results of Operations
    (Unaudited)
    Three Months EndedDecember 31,


March 31,


June 30,


September 30,2005


2006


2006


2006(In thousands, except per share data)Revenue

$
41,633


$
50,322


$
51,658


$
29,259Cost of revenue


22,382



33,069



32,178



25,142Gross margin


19,251



17,253



19,480



4,117Operating expenses:Research and development


8,071



8,560



8,508



7,281Selling, general and administrative


6,851



6,984



6,968



3,808Restructuring charge (benefit)


62



(32
)






Impairment of property and
    equipment










50



31Loss on sale of fixed assets














58Amortization of intangible assets


372



373



372



372Total operating expenses


15,356



15,885



15,898



11,550Income (loss) from operations


3,895



1,368



3,582



(7,433
)Interest income and other, net


500



1,019



999



838Income (loss) from continuing
    operations before income taxes and discontinued operations


4,395



2,387



4,581



(6,595
)Provision (benefit) for income
    taxes


352



199



205



(195
)Income (loss) from continuing
    operations before discontinued operations


4,043



2,188



4,376



(6,400
)Income (loss) from discontinued
    operations


(680
)


334



(127
)


346Net income (loss)

$
3,363


$
2,522


$
4,249


$
(6,054
)Net income (loss) per share from
    continuing operations:Basic

$
0.24


$
0.13


$
0.26


$
(0.38
)Diluted

$
0.24


$
0.13


$
0.26


$
(0.38
) 86




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##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Three Months EndedDecember 31,


March 31,


June 30,


September 30,2005


2006


2006


2006(In thousands, except per share data)Net income (loss) per share from
    discontinued operations:Basic

$
(0.04
)

$
0.02


$
(0.01
)

$
0.02Diluted

$
(0.04
)

$
0.02


$
(0.01
)

$
0.02Net income (loss) per share:Basic

$
0.20


$
0.15


$
0.25


$
(0.36
)Diluted

$
0.20


$
0.15


$
0.25


$
(0.36
)Weighted average number of shares:Basic


16,946



17,018



17,047



16,849Diluted


17,047



17,077



17,077



16,849   Three Months EndedDecember 31,


March 31,


June 30,


September 30,2004


2005


2005


2005(In thousands, except per share data)Revenue

$
36,639


$
25,326


$
39,096


$
24,752Cost of revenue


22,781



18,768



25,966



15,217Gross margin


13,858



6,558



13,130



9,535Operating expenses:Research and development


9,470



9,818



8,618



8,369Selling, general and administrative


4,684



6,107



7,352



6,535Restructuring charges










951



246Impairment of property and
    equipment






382



174



81(Gain) loss on sale of property
    and equipment










(143
)


50Amortization of intangible assets


397



398



380



373Total operating expenses


14,551



16,705



17,332



15,654Loss from operations


(693
)


(10,147
)


(4,202
)


(6,119
)Interest income and other, net


1,255



164



472



327Income (loss) from continuing
    operations before income taxes and discontinued operations


562



(9,983
)


(3,730
)


(5,792
)Provision for income taxes


39



359



167



59Income (loss) from continuing
    operations before discontinued operations


523



(10,342
)


(3,897
)


(5,851
)Income (loss) from discontinued
    operations


(6
)


(4
)


268



(2
)Net income (loss)

$
517


$
(10,346
)

$
(3,629
)

$
(5,853
)Net income (loss) per share from
    continuing operations:Basic

$
0.03


$
(0.61
)

$
(0.23
)

$
(0.35
)Diluted

$
0.03


$
(0.61
)

$
(0.23
)

$
(0.35
) 87




---



##### Table of Contents



PHOTON
    DYNAMICS, INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Three Months EndedDecember 31,


March 31,


June 30,


September 30,2004


2005


2005


2005(In thousands, except per share data)Net income (loss) per share from
    discontinued operations:Basic

$
0.00


$
(0.00
)

$
0.02


$
(0.00
)Diluted

$
0.00


$
(0.00
)

$
0.02


$
(0.00
)Net income (loss) per share:Basic

$
0.03


$
(0.61
)

$
(0.21
)

$
(0.35
)Diluted

$
0.03


$
(0.61
)

$
(0.21
)

$
(0.35
)Weighted average number of shares:Basic


16,872



16,948



16,984



16,931Diluted


17,009



16,948



16,984



16,931   Note 17 
    Subsequent Events (Unaudited)
  tm tm
     88




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##### Table of Contents



Item 9.
    Changes
    in and Disagreements with Accountants on Accounting and
    Financial Disclosure    Item 9A.
    Controls
    and Procedures  Evaluation
    of Disclosure Controls and Procedures
  Rules 13a-15(e) 15d-15(e)
    Managements
    Report on Internal Control Over Financial
    Reporting
  Rules 13a-15(f) 15d-15(f)
      Internal Control 
    Integrated Framework.
  Form 10-K.
 89




---



##### Table of Contents



Form 10-K
  Inherent
    Limitations of Disclosure Controls and Procedures and Internal
    Control Over Financial Reporting.
    Item 9B.
    Other
    Information   PART III  Form 10-K Form 10-K,
  Item 10.
    Directors
    and Executive Officers of the Registrant  Form 10-K.
      www.photondynamcis.com Form 10-K
 90




---



##### Table of Contents



Item 11.
    Executive
    Compensation    Item 12.
    Security
    Ownership of Certain Beneficial Owners and Management and
    Related Stockholder Matters      Item 13.
    Certain
    Relationships and Related Transactions    Item 14.
    Principal
    Accountant Fees and Services   PART IV  Item 15.
    Exhibits
    and Financial Statement Schedules  Financial Statements
  Form 10-K,
  Financial Statement Schedules
  Form 10-K.
 91




---



##### Table of Contents



SCHEDULE II
  PHOTON
    DYNAMICS, INC.
  VALUATION
    AND QUALIFYING ACCOUNT
  Year Ended September 30,Balance at


Charged to


Charged to





Balance atBeginning


(Credited to)


Other





End ofof Period


Expense


Accounts


Deductions


Period(In thousands)Allowance for doubtful accounts:2006

$
153



270







(17
)

$
4062005

$
497



(324
)






(20
)

$
1532004

$
726











(229
)

$
497   Exhibits
  Form 10-K,
  Exhibits
    Financial Statement Schedules
   92




---



##### Table of Contents



SIGNATURES      By:
    /s/  JEFFREY
    A. HAWTHORNE   President, Chief Executive Officer,
 Acting Chief Financial Officer and Director
    POWER OF
    ATTORNEY
  attorney-in-fact, Form 10-K, attorney-in-fact attorney-in-fact
  Pursuant to the requirements of the Securities Exchange Act
    of 1934, this report has been signed below by the following
    persons on behalf of the registrant and in the capacities and on
    the dates indicated.
  Signature

Title

Date/s/  JEFFREY
    A.
    HAWTHORNEJeffrey
    A. Hawthorne

President, Chief Executive
    Officer, Acting Chief Financial Officer and Director (Principal
    Executive, Financial and Accounting Officer)

December 14, 2006/s/  MALCOLM
    J. THOMPSONMalcolm
    J. Thompson

Chairman of the Board and 
    Director

December 14, 2006/s/  NICHOLAS
    BRATHWAITENicholas
    Brathwaite

Director

December 14, 2006/s/  TERRY
    CARLITZTerry
    Carlitz

Director

December 14, 2006/s/  MICHAEL
    J. KIMMichael
    J. Kim

Director

December 14, 2006/s/  EDWARD
    ROGAS JR.Edward
    Rogas Jr.

Director

December 14, 2006/s/  CURT
    WOZNIAKCurt
    Wozniak

Director

December 14, 2006  93




---



##### Table of Contents



EXHIBIT INDEX
  Number

Exhibit3
.1(H)

Amended and Restated Articles of
    Incorporation of the Registrant.3
.2(C)

Bylaws of the Registrant and
    amendments thereto.3
.3(H)

Certificate of Amendment to
    Articles of Incorporation of the Registrant.4
.1

Reference is made to
    Exhibits 3.1, 3.2 and 3.3.10
.1(J)*

Form of Indemnification Agreement
    between the Registrant and each of its executive officers and
    directors.10
.3.1(B)

Lease Agreement between
    Berg & Berg Developers and the Registrant, dated
    August 6, 1996.10
.3.2(V)

Third Amendment to Lease Agreement
    between Mission West Properties L.P. II (fka
    Berg & Berg Developers) and the Registrant dated
    August 12, 2003.10
.9(P)*

Agreement Regarding Change of
    Control between the Registrant and Jeffrey Hawthorne dated
    December 13, 2005.10
.20.1(L)*

Amended and Restated 1995 Stock
    Option Plan, as amended.10
.20.2(P)

Form of Stock Option Agreement
    under 1995 Stock Option Plan, as amended.10
.22.1(M)*

2001 Equity Incentive Plan, as
    amended.10
.22.2(W)

Form of Stock Option Agreement
    under 2001 Equity Incentive Plan, as amended.10
.25.1(Q)

Lease Agreement between Bruce N.
    Huntley Contracting Limited and Image Processing Systems Inc.
    dated September 17, 1997.10
.25.2(Q)

Option to Renew Agreement between
    Bruce N. Huntley Contracting Limited and Photon Dynamics Canada
    Inc. dated May 24, 2002.10
.25.3(A)

Offer to Sublease, dated
    April 15, 2005 among Photon Dynamics Canada, Inc., Service
    Results Technology, and Huntley Contracting Limited.10
.29(R)*

Offer Letter between the
    Registrant and Richard Okumoto dated April 21, 2003.10
.30.1(V)*

Consulting Agreement between the
    Registrant and Malcolm Thompson dated July 28, 2003.10
.30.2(V)*

Amendment to Consulting Agreement
    between the Registrant and Malcolm Thompson dated
    September 1, 2003.10
.34(S)

Settlement and License Agreement,
    dated November 10, 2003, between Photon Dynamics, Inc.,
    Shimadzu Corporation, Panelvision Technology, Inc. and Guillermo
    Toro-Lira.10
.35.1(T)*

Consulting Agreement, dated
    March 18, 2004, between the Registrant and Malcolm Thompson.10
.35.2(Y)*

Amendment to Consulting Agreement
    between the Registrant and Malcolm Thompson, dated
    December 22, 2004.10
.36(T)

Termination and Assignment
    Agreement, dated February 27, 2004, between Photon
    Dynamics, Inc. and Ishikawajima-Harima Heavy Industries Co. Ltd.10
.38.1(W)*

Offer Letter between the
    Registrant and Mark Merrill dated April 27, 2004.10
.38.2(X)*

Amendment to Employment Agreement,
    dated April 5, 2005, between Photon Dynamics, Inc. and Mark
    Merrill.10
.39(W)*

2005 Executive Officer Bonus
    Compensation Plan.10
.42(Z)

Letter Agreement between the
    Registrant and Malcolm Thompson, dated April 8, 2005.10
.43(C)

Form of Stock Option Agreement for
    use in the 2005 Equity Incentive Plan.10
.44(N)

Photon Dynamics, Inc. 2005 Equity
    Incentive Plan.10
.45(N)

Photon Dynamics, Inc. 2005
    Employee Stock Purchase Plan.10
.46(N)

Photon Dynamics, Inc. 2005
    Non-Employee Directors Stock Option Plan.10
.48(X)*

Offer letter, dated April 29,
    2005, between Photon Dynamics, Inc. and Maureen Lamb.10
.49(A)*

Separation Agreement, dated
    May 5, 2005, between Photon Dynamics, Inc., and Richard
    Okumoto.10
.50(X)*

Amendment to Employment Agreement,
    dated April 5, 2005, between Photon Dynamics, Inc. and
    Steve Song. 94




---



##### Table of Contents



Number

Exhibit10
.52(P)

Form of Stock Option Agreement for
    use in the 2005 Non-Employee Directors Stock Option Plan.10
.53(D)*

Photon Dynamics, Inc. Fiscal 2006
    Management Incentive Plan.10
.54(F)*

Compensation for Outside
    Directors, Effective May 24, 2006.21
.1

Subsidiaries of the Registrant.23
.1

Consent of Ernst & Young
    LLP, Independent Registered Public Accounting Firm.24
.1

Power of Attorney (included on the
    signature pages hereto).31
.1

Certification required by
    Rule 13a-14(a)
    or
    Rule 15d-14(a).31
.2

Certification required by
    Rule 13a-14(a)
    or
    Rule 15d-14(a).32
.1**

Certifications required by
    Rule 13a-14(b)
    or
    Rule 15d-14(b)
    and Section 1350 of Chapter 63 of Title 18 of the
    United States Code (18 U.S.C. §1350).     Key to
    Exhibits:
  (A)
    
    Previously filed as an exhibit to the Registrants
    Quarterly Report Form on
    Form 10-Q
    for the quarter ended June 30, 2005 (Commission File
    No. 000-27234)
    as filed with SEC on August 9, 2005, and incorporated
    herein by reference.(B)
    
    Previously filed as an exhibit to the Registrants Annual
    Report on
    Form 10-KSB
    for the fiscal year ended September 30, 1996 (Commission
    File
    No. 000-27234)
    as filed with the SEC on December 30, 1996, and
    incorporated herein by reference.(C)
    
    Previously filed as an exhibit to the Registrants
    Quarterly Report Form on
    Form 10-Q
    for the quarter ended December 31, 2005 (Commission File
    No. 000-27234)
    as filed with SEC on February 9, 2006, and incorporated
    herein by reference.(D)
    
    Previously filed as an exhibit to the Registrants Current
    Report on
    Form 8-K
    (Commission File
    No. 000-27234)
    as filed with SEC on January 24, 2006, and incorporated
    herein by reference.(E)
    
    Previously filed as an exhibit to the Registrants Current
    Report on
    Form 8-K
    (Commission File
    No. 000-27234)
    as filed with the SEC on July 25, 2001, and incorporated
    herein by reference.(F)
    
    Previously filed as an exhibit to the Registrants
    Quarterly Report Form on
    Form 10-Q
    for the quarter ended June 30, 2006 (Commission File
    No. 000-27234)
    as filed with SEC on August 9, 2006, and incorporated
    herein by reference.(H)
    
    Previously filed as an exhibit to the Registrants
    Registration Statement on
    Form S-1
    (Reg.
    No. 333-76650)
    as filed with the SEC on January 14, 2002, as amended, and
    incorporated by reference herein.(I)
    
    Previously filed as an exhibit to the Registrants Current
    Report on
    Form 8-K
    (Commission File
    No. 000-27234)
    as filed with the SEC on January 7, 2002, and incorporated
    herein by reference. Confidential treatment has been granted for
    portions of this exhibit.(J)
    
    Previously filed as an exhibit to the Registrants Current
    Report on
    Form 8-K
    (Commission File
    No. 000-27234)
    as filed with the SEC on December 20, 2004, and
    incorporated herein by reference.(K)
    
    Previously filed as an exhibit to the Registrants Current
    Report on
    Form 8-K/A
    (Commission File
    No. 000-27234)
    as filed with the SEC on July 29, 2002, and incorporated
    herein by reference.(L)
    
    Previously filed as an exhibit to the Registrants
    Registration Statement on
    Form S-8
    (Reg.
    No. 333-117021)
    as filed with the SEC on June 30, 2004, and incorporated
    herein by reference.(M)
    
    Previously filed as an exhibit to the Registrants
    Quarterly Report Form on
    Form 10-Q
    (Commission File
    No. 000-27234)
    for the quarter ended March 31, 2003 as filed with the SEC
    on May 9, 2003, and incorporated herein by reference.(N)
    
    Previously filed as an exhibit to the Registrants Current
    Report on
    Form 8-K
    (Commission File
    No. 000-27234)
    as filed with the SEC on March 9, 2005 and incorporated
    herein by reference.(O)
    
    Previously filed as an exhibit to the Registrants
    Registration Statement on
    Form S-3
    (Reg.
    No. 333-49444)
    as filed with the SEC on November 7, 2000 and incorporated
    herein by reference. 95




---



##### Table of Contents



(P)
    
    Previously filed as an exhibit to the Registrants
    Registration Annual Report on
    Form 10-K
    for the fiscal year ended September 30, 2005 (Commission
    File
    No. 000-27234)
    as filed with the SEC on December 14, 2006, and
    incorporated herein by reference.(Q)
    
    Previously filed as an exhibit to the Registrants Annual
    Report on
    Form 10-K
    for the fiscal year ended September 30, 2002 (Commission
    File
    No. 000-27234)
    as filed with the SEC on December 11, 2002, and
    incorporated here by reference.  (R)
    
    Previously filed as an exhibit to the Registrants
    Quarterly Report Form on
    Form 10-Q
    for the quarter ended June 30, 2003 (Commission File
    No. 000-27234)
    as filed with SEC on August 14, 2003, and incorporated
    herein by reference.  (S)
    
    Previously filed as an exhibit to the Registrants
    Quarterly Report Form on
    Form 10-Q
    for the quarter ended December 31, 2003 (Commission File
    No. 000-27234)
    as filed with SEC on February 17, 2004, and incorporated
    herein by reference. Confidential treatment has been granted for
    portions of Exhibit 10.34.(T)
    
    Previously filed as an exhibit to the Registrants
    Quarterly Report Form on
    Form 10-Q
    for the quarter ended March 31, 2004 (Commission File
    No. 000-27234)
    as filed with SEC on May 14, 2004, and incorporated herein
    by reference. Confidential treatment has been granted for
    portions of Exhibit 10.36.(V)
    
    Previously filed as an exhibit to the Registrants Annual
    Report on
    Form 10-K
    for the fiscal year ended September 30, 2003 (Commission
    File
    No. 000-27234)
    as filed with the SEC on December 24, 2003, and
    incorporated here by reference.(W)
    
    Previously filed as an exhibit to the Registrants Annual
    Report on
    Form 10-K
    for the fiscal year ended September 30, 2004 (Commission
    File
    No. 000-27234)
    as filed with the SEC on December 14, 2004, and
    incorporated here by reference.(X)
    
    Previously filed as an exhibit to the Registrants Current
    Report on
    Form 8-K
    (Commission File
    No. 000-27234),
    filed with the SEC on November 9, 2005, and incorporated
    herein by reference.(Y)
    
    Previously filed as an exhibit to the Registrants
    Quarterly Report Form on
    Form 10-Q
    for the quarter ended December 31, 2004 (Commission File
    No. 000-27234)
    as filed with SEC on February 9, 2005, and incorporated
    herein by reference.(Z)
    
    Previously filed as an exhibit to the Registrants Current
    Report on
    form 8-K
    (Commission File
    No. 000-27234)
    as filed with the Securities and Exchange Commission on
    April 11, 2005, and incorporated herein by reference*
    
    Indicates a management contract or compensatory plan or
    arrangement.**
    
    The certification attached as Exhibit 32.1 accompanies the
    Annual Report on
    Form 10-K
    pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
    and shall not be deemed filed by the Company for
    purposes of Section 18 of the Securities Exchange Act of
    1934, as amended. 96