##### Table of Contents









UNITED STATES SECURITIES AND EXCHANGE
COMMISSION

Washington, D.C. 20549




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Form 10-K

|   |  |                                                                                             
|-- |  | --------------------------------------------------------------------------------------------
|þ  |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934    
|  
|   |  | For the fiscal year ended September 30,
    2004                                            
|  
|or
|  
|o  |  | TRANSITION REPORT PURSUANT TO SECTION 13
    OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|  
|   |  | For the transition period
    from           to                                             

Commission File Number 0-27234



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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)




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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)




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

Indicate by check
mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein,
and will not be contained, to the best of registrants
knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this
Form 10-K or any amendment to this
Form 10-K.     o

Indicate by check
mark whether the registrant is an accelerated filer (as defined
in Rule 12b-2 of the
Act).     Yes þ          No o

As of
March 31, 2004, the aggregate market value of the voting
stock held by non-affiliates of the registrant, computed by
reference to the last sale price of such stock as of such date
on the NASDAQ National Market, was approximately $475,679,585.
Excludes an aggregate of 2,057,546 shares of common stock
held by officers and directors and by each person known by the
registrant to own 5% or more of the outstanding common stock as
of March 31, 2004. Exclusion of shares held by any of these
persons should not be construed to indicate that such person
possesses the power, direct or indirect, to direct or cause the
direction of the management or policies of the registrant, or
that such person is controlled by or under common control with
the registrant.

As of
November 30, 2004, there were 16,873,772 shares of the
registrants Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions
of the registrants definitive Proxy Statement for the 2005
Annual Meeting of Shareholders to be filed with the Securities
and Exchange Commission pursuant to Regulation 14A not
later than 120 days after the end of the fiscal year
covered by this Form 10-K, are incorporated by reference in
Part III, Items 10-14 of this Form 10-K.



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PHOTON DYNAMICS, INC.

ANNUAL REPORT ON FORM 10-K

FOR THE FISCAL YEAR ENDED SEPTEMBER 30,
2004


TABLE OF CONTENTS

|                |  |                                                                                                                          |    |      |    | 
|--------------- |  | ------------------------------------------------------------------------------------------------------------------------ | -- | ---- | -- | 
|                |  |                                                                                                                          |    | Page
|                |  |                                                                                                                          |    |     
|PART I          |  |                                                                                                                          | 3  |     
|Item 1.         |  | Business                                                                                                                 |    |      | 3  | 
|Item 2.         |  | Properties                                                                                                               |    |      | 12 | 
|Item 3.         |  | Legal Proceedings                                                                                                        |    |      | 12 | 
|Item 4.         |  | Submission of Matters to a
    Vote of Security Holders                                                                  |    |      | 13 | 
|PART II         |  |                                                                                                                          | 13 |     
|Item 5.         |  | Market for the
    Registrants Common Equity, Related Stockholder Matters and
    Issuer Purchases of Equity Securities |    |      | 13 | 
|Item 6.         |  | Selected Financial Data                                                                                                  |    |      | 14 | 
|Item 7.         |  | Managements Discussion
    and Analysis of Financial Condition and Results of Operations                                |    |      | 15 | 
|Item 7A.        |  | Quantitative and Qualitative
    Disclosures About Market Risk                                                           |    |      | 42 | 
|Item 8.         |  | Financial Statements and
    Supplementary Data                                                                          |    |      | 44 | 
|                |  | REPORT OF ERNST &
    YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM                                           |    |      | 45 | 
|                |  | CONSOLIDATED BALANCE
    SHEETS                                                                                          |    |      | 46 | 
|                |  | CONSOLIDATED STATEMENTS OF
    OPERATIONS                                                                                |    |      | 47 | 
|                |  | CONSOLIDATED STATEMENTS OF
    SHAREHOLDERS EQUITY                                                                      |    |      | 48 | 
|                |  | CONSOLIDATED STATEMENTS OF
    CASH FLOWS                                                                                |    |      | 49 | 
|                |  | NOTES TO CONSOLIDATED
    FINANCIAL STATEMENTS                                                                           |    |      | 51 | 
|Item 9.         |  | Changes in and Disagreements
    With Accountants on Accounting and Financial Disclosure                                 |    |      | 86 | 
|Item 9A.        |  | Controls and Procedures                                                                                                  |    |      | 86 | 
|Item 9B.        |  | Other Information                                                                                                        |    |      | 87 | 
|PART III        |  |                                                                                                                          | 87 |     
|Item 10.        |  | Directors and Executive
    Officers of the Registrant                                                                   |    |      | 87 | 
|Item 11.        |  | Executive Compensation                                                                                                   |    |      | 87 | 
|Item 12.        |  | Security Ownership of
    Certain Beneficial Owners and Management and Related Stockholder
    Matters                   |    |      | 87 | 
|Item 13.        |  | Certain Relationships and
    Related Transactions                                                                       |    |      | 88 | 
|Item 14.        |  | Principal Accounting Fees
    and Services                                                                               |    |      | 88 | 
|PART IV         |  |                                                                                                                          | 88 |     
|Item 15.        |  | Exhibits and Financial
    Statement Schedules                                                                           |    |      | 88 | 
|Signatures      |  |                                                                                                                          | 93 |     
|EXHIBIT 10.20.1
|EXHIBIT 10.22.1
|EXHIBIT 10.38  
|EXHIBIT 10.39  
|EXHIBIT 21.1   
|EXHIBIT 23.1   
|EXHIBIT 31.1   
|EXHIBIT 31.2   
|EXHIBIT 32.1   



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SPECIAL NOTE REGARDING FORWARD-LOOKING
STATEMENTS

This Annual Report on Form 10-K 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. All
statements included or incorporated by reference in this Annual
Report on Form 10-K other than statements of historical
fact, are forward-looking statements. You can identify these and
other forward-looking statements by the use of words such as
may, will, could,
anticipate, expect, intend,
believe, continue or the negative of
such terms, or other comparable terminology. Forward-looking
statements also include the assumptions underlying or relating
to such statements.

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 under the
caption Factors Affecting Operating Results in
Part II Item 7 Managements Discussion and
Analysis of Financial Condition and Results of Operations
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.

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PART I






|        |         
|------- | --------
|Item 1. | Business

Introduction

Photon Dynamics, Inc. (Photon
Dynamics) is a California corporation incorporated on
May 12, 1986. We are a leading provider of yield management
solutions to the flat panel display industry. Manufacturers in
this industry use our solutions to collect data, analyze product
quality and identify and repair product defects at critical
steps in their manufacturing processes. Our customers use our
test, repair and inspection systems to increase manufacturing
yields of high performance flat panel displays used in a number
of products, including notebook and desktop computers,
televisions and advanced mobile electronic devices such as
cellular phones, personal digital assistants and portable video
games.

During fiscal 2004, we acquired all of the assets
relating to the design and manufacture of laser assembly
products used in our array repair products from Quantum
Composers, Inc. We also acquired all of the assets relating to
the design and manufacture of pellicle products used in our
array checker modulators from Tucson Optical Research
Corporation. For further details of these and our fiscal 2003
and 2002 acquisitions relating to our current business, see
Business Combinations, below.

Prior to fiscal 2003, we also were engaged in the
printed circuit board assembly inspection business and the
cathode ray tube display and high quality glass inspection
businesses. During fiscal 2003, we implemented a plan to exit
these businesses and consequently, we now operate in one
reportable business segment  the flat panel display
industry. Accordingly, the operating results of both the printed
circuit board assembly inspection business and the cathode ray
tube display and high quality glass inspection business segments
have been presented as discontinued operations in our statements
of operations. As a result, revenue from our flat panel display
products represent 100% of our revenues in all fiscal years
presented. For further details of our discontinued operations,
see Note 3 of our Notes to Consolidated Financial
Statements included under Part II Item 8.
Financial Statements and Supplementary Data.

Additional information about Photon Dynamics,
Inc. is available on our website at
www.photondynamics.com. We make available free of charge,
on or through our website, our Annual Report on Form 10-K,
our Quarterly Reports on Form 10-Q, our Current Reports on
Form 8-K, and any amendments to those reports filed or
furnished pursuant to Section 13(a) or 15(d) of the
Exchange Act, as soon as reasonably practicable after
electronically filing such reports with, or furnishing such
reports to, the Securities and Exchange Commission. Information
contained on our website is not incorporated by reference in, or
made part of this Annual Report on Form 10-K or our other
filings with or reports furnished to the SEC.

Industry



| |                                           
| | ------------------------------------------
| | Flat Panel Display Industry
    Background

Continuous innovations in microelectronics and
materials science have enabled flat panel displays with sharper
resolution, brighter pixels and faster imaging to be produced in
varying sizes for differing applications. Similar innovations
have led to the introduction of a broad array of electronic
devices with increasing performance and decreasing size
characteristics. Manufacturing these highly engineered products
requires complex, multi-stage production processes, increasing
the potential for defects and errors associated with equipment
failures, contamination of materials, drift in process
parameters, human error and other related factors. Manufacturing
complexity also increases investment in work-in-progress
inventories and lengthens production cycles. To better manage
and enhance their yields and reduce product costs, manufacturers
are increasing their emphasis on automated testing, inspection
and repair at various points in the manufacturing process. As
production processes become more complex and reducing material
and labor costs becomes increasingly important, we believe that
ongoing yield management solutions provides manufacturers with
an important competitive advantage.

Growth in the mobile electronic devices market,
the desktop computer market and the television market have
driven the demand for flat panel displays, which offer reduced
footprint, weight, power consumption and

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heat emission and better picture quality as
compared to cathode ray tube displays, the current standard
technology for stationary display devices.


Active matrix liquid crystal display
(AMLCD), the most prevalent and one of the highest
performance flat panel displays available today, produces full
color images and operates at much faster refresh rates than
earlier passive monochrome liquid crystal displays. The color
capability, resolution, speed and picture quality of active
matrix liquid crystal displays currently make these displays the
preferred choice for high-performance mobile applications, such
as portable computers, multimedia, televisions and other
applications requiring the display of video and graphics.

Manufacture of Active Matrix Liquid Crystal
Displays.The manufacture of active
matrix liquid crystal displays is an extremely complex process,
which has been developed and refined for different panel sizes
and resolutions through research and development, pre-production
prototyping and commercial production.

An AMLCD uses liquid crystal to control the
passage of light. The basic structure of an AMLCD panel may be
thought of as two glass substrates sandwiching a layer of liquid
crystal. The front glass substrate is fitted with a color
filter, while the back glass substrate has transistors
fabricated on it. When voltage is applied to a transistor, the
liquid crystal is bent, allowing light to pass through to form a
pixel. A light source is located at the back of the panel and is
called a backlight unit. The front glass substrate is fitted
with a color filter, which gives each pixel its own color. The
combination of these pixels in different colors forms the image
on the panel.

Substrate glass panels are initially manufactured
in large glass panels which are subsequently cut down to the
size of the needed application. Each progressive increase in
panel size is referred to by its generation.
Generation 5 panels are approximately 1,200 × 1,300 mm in
size, Generation 6 panels are approximately 1,500 × 1,800
mm in size and Generation 7 panels are approximately 1,870
× 2,200 mm in size. Manufacturing an active matrix liquid
crystal display involves a series of three principal phases:



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Array Phase.The
    first phase of the process involves the production of both the
    array plate and color filter plate. This phase of the process is
    the fabrication of an array of thin-film transistors
    (TFT), each of which is connected to a transparent
    sub-pixel, the smallest addressable unit in the display. Three
    or more sub-pixels are combined to produce a pixel, millions of
    which are fabricated, using semiconductor processes, on a large
    glass substrate. A similar process is used to fabricate an array
    of color filter sub-pixels on a large glass substrate. The array
    fabrication process is the most capital-intensive process and is
    housed in cleanrooms in order to minimize particles that can
    cause pixel defects.
|
| | Cell Phase.The
    second phase, cell assembly, is the joining of the TFT array
    plate and the color filter plate with liquid crystal material.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|
| | Module Assembly
    Phase.The third phase, module
    assembly, involves packaging the display and attaching the
    electronics and illumination, or backlight, which will allow the
    device to display text, graphics and video images.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

The AMLCD market is both price sensitive and cost
competitive, making it critical for manufacturers to constantly
strive for the highest possible yields to decrease costs. Unlike
semiconductor fabs, where productivity can be increased by
shrinking features and die size, AMLCD fab productivity is
driven by yield and substrate size, the latter being because the
processing equipment cost increases are less than the plate area
increases with each new generation.

At various points in the manufacturing process,
the flat panel display manufacturer uses test and inspection
equipment to identify defects to permit repair and to avoid
wasting costly materials on continued manufacturing of a
defective product. In addition, test and inspection systems can
provide qualitative feedback to the flat panel display
manufacturer and enable the manufacturer to address yield
problems and to optimize the manufacturing process.

Challenges Faced by Flat Panel Display
Manufacturers.The ability of flat
panel display manufacturers to improve yields of active matrix
liquid crystal displays and other flat panel displays depends,
in large part, on their ability to test, repair and inspect
displays during the manufacturing process and to use the
resulting data

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collection to refine the manufacturing process.
The ability to test, repair and inspect helps manufacturers
address a number of challenges, including:




| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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% 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. 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.                                                                                                                                              

Products

Todays market dynamics demand that flat
panel display manufacturers leverage the latest yield management
and process tools. We focus specifically on delivering yield
management solutions that enable manufacturers to collect data
from the production line, analyze it, and quickly diagnose and
repair process-related defects. We focus specifically on
delivering solutions that help manufacturers decrease material
costs and improve throughput to gain that incremental yield edge
so critical to success. Our offerings can be broadly classified
into two categories: Yield Management Products and Customer
Service and Support.



| |                          
| | -------------------------
| | Yield Management Products

Our flat panel display yield management products
include test and repair equipment that are used primarily in the
Array phase of production, and inspection equipment that is used
primarily in Cell and Module Assembly phases of production. Our
test equipment can identify and characterize defects at early
stages of the manufacturing process so that the panels may be
repaired before the next stage or, if necessary, discarded,
minimizing the loss of time and materials. Our test and repair
systems use similar software-based controls, processing and
graphical user interfaces. Products can be networked together
with our products as well as complementary vendor products so
that defect data can be stored, analyzed and used throughout the
manufacturing process. Our systems are also compatible with a
variety of material handling automation systems. Our inspection
equipment can identify visual defects after cell assembly and
also during and after module assembly.

Flat Panel Display Array Test
Systems.Our ArrayCheckerTM
test systems detect, locate, quantify and characterize
electrical, contamination and other defects in active matrix
liquid crystal displays after array fabrication. These systems
use our proprietary non-contact voltage imaging technology to
provide a high-resolution voltage map of the entire display and
our proprietary image analysis software converts this voltage

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map into complete pixel defect data. The
ArrayCheckerTM test systems determine whether
individual pixels or lines of pixels are functional and also
find more subtle defects such as variations in individual pixel
voltage. These defect data files are then used for repair and
statistical process control.


Flat Panel Display Array Repair
Systems.Our ArraySaverTM
repair systems utilize multiple wavelength laser technology to
repair defects in flat panel displays during and after array
fabrication. Our systems can use defect data files downloaded
from our array test systems or other test and inspection systems
to automatically position the panel for repair, thereby
eliminating the time spent by operators locating defects.

The ArraySaverTM system includes a
high-precision materials handling platform and a user-friendly
graphical interface allowing for high throughput. Our
high-precision materials handling platform fully automates the
precise positioning of the plate for each successive repair,
thereby substantially increasing throughput. Our graphical user
interface and software supports semi-automated setup of repair
programs for common types of defects so that repairs can be
executed rapidly and accurately. These programs provide a series
of actions that the system automatically executes to repair the
particular defect type.

Flat Panel Display Inspection
Systems.Our PanelMasterTM
inspection systems use our proprietary image analysis and
moiré interference canceling algorithms and technology to
inspect flat panel displays for visual defects after cell
assembly and also during and after module assembly. Our systems
use multiple high-resolution cameras and computer workstations
to quantitatively measure visual characteristics and to
precisely locate and characterize line, cluster, pixel and
blemish defects. Inspection data generated by the system is
displayed on a video monitor for immediate interpretation and
can be stored or sent to a repair system to effect repairs. Our
inspection systems offer different levels of resolution,
functionality and flexibility to suit customers needs. The
system is available either as a stand-alone unit or as a modular
unit that can be integrated with manufacturers material
handling equipment.



| |                             
| | ----------------------------
| | Customer Service and Support

We enhance the value of our products through our
customer support programs, which provide comprehensive worldwide
service and support across all of our product lines. With years
of experience helping our customers increase yields across a
myriad of production environments, our global yield management
support organization is equipped to provide customers with a
range of preventative and corrective services. These include
design, development, and integration services associated with
yield management, as well as comprehensive education, project
management, process and applications consulting, product
maintenance, and life cycle optimization.

Customers

We sell our products to manufacturers in the flat
panel display industries. All of our flat panel display
customers are located in Korea, Taiwan and Japan, where flat
panel display production is concentrated, and China. We derive
most of our revenue from a small number of customers, and we
expect this to continue for the foreseeable future. Sales to our
top three unaffiliated customers accounted for 63%, 79%, and 70%
of revenue in fiscal 2004, 2003, and 2002, respectively. During
fiscal 2004, sales to AU Optronics Corp., LG Phillips LCD Co.
Ltd., Hannstar Display Corporation and Innolux Display
Corporation each accounted for more than 10% of our total
revenues. See Note 12 of our Notes to Consolidated
Financial Statements in Part II, Item 8.
Financial Statements and Supplementary Data for
further information, which is incorporated here by reference,
regarding sales to our major customers.

Our business depends upon the capital
expenditures of flat panel display manufacturers, which in turn
depend on the current and anticipated market demand for products
utilizing flat panel displays. We do not consider our business
to be seasonal in nature, but it is cyclical with respect to the
capital equipment procurement practices of flat panel display
manufacturers and is impacted by the investment patterns of
these manufacturers in different global markets. Downturns in
the industry or slowdowns in the worldwide economy could have a
material adverse effect on our future business and financial
results.

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Sales and Service

Our sales and marketing strategy is to provide
our customers with increased manufacturing yields and
throughput, improved quality and greater overall efficiency in
their manufacturing process. Our sales, service and marketing
efforts are focused on building long-term relationships with our
customers. We sell our products for the flat panel display
industry directly to our customers in Korea, Taiwan, China and
Japan. We also, on a limited basis, have sold in Japan through
Ishikawajima-Harima Heavy Industries Co., Ltd.
(IHI), our value-added distributor in Japan. In
February 2004, we terminated this agreement. As part of this
termination agreement, IHI assigned to us the right to use all
intellectual property rights associated with our products held
by IHI, including any patents and patent applications associated
with the intellectual property rights. IHI retains the rights to
resell our products to one particular customer in Japan through
March 2005. We service our products worldwide directly,
including primary responsibility for the customer in Japan to
which IHI has retained the rights.

Revenue from our flat panel display products
represented 100% of our revenue in fiscal 2004, 2003 and 2002,
and all of this revenue was derived from sales to companies
located outside of the United States. International sales expose
us to risks that are not experienced with domestic sales, such
as export license restrictions, political instability, trade
restrictions and currency fluctuations. These and other risks
relating to our business are detailed under the caption
Factors Affecting Operating Results in Part II,
Item 7. Managements Discussion and Analysis of
Financial Condition and Results of Operations. See
Note 12 of our Notes to Consolidated Financial
Statements included under Part II, Item 8.
Financial Statements and Supplementary Data for
additional geographic information, which is incorporated herein
by reference, including long-lived assets by geographic area as
well as revenue from external customers attributable to
geographic areas during the last three years.

Our sales terms are typically 80% to 90% of the
sales price due upon shipment with the remaining amount due
after installation and upon final customer acceptance. We
typically provide a limited warranty on our products for a
period of 12 months from final acceptance. Our field
service personnel provide customers with repair and maintenance
services, primarily warranty related. As of September 30,
2004, we had 102 sales and service personnel, 74 of whom were
located in Asia-Pacific region and 28 of whom were located in
North America.

Research and Development

The market for integrated yield management
systems is characterized by rapid and continuous technological
development and product innovation. We believe that it is
necessary to maintain our competitive position through continued
and timely development of new products and enhancements to
existing products. Accordingly, we devote a significant portion
of our human and financial resources to research and development
and seek to maintain close relationships with customers to
remain responsive to their needs. For information regarding our
research and development expenses during the last three years,
see Part II, Item 7. Managements
Discussion and Analysis of Financial Condition and Results of
Operations in this Annual Report on Form 10-K, which
is incorporated here by reference.

We are focusing our current research and
development on increasing the performance of our array test,
array repair and cell and module inspection systems, enabling
manufacturers to minimize the loss of time and materials in
production.

Manufacturing

Our flat panel display products are primarily
manufactured in San Jose, California. Our manufacturing
activities consist primarily of final assembly and test of
components and subassemblies, which are purchased from third
party vendors.

We have utilized suppliers of fully or partially
assembled and tested subsystems for many years. In December
2001, we entered into a three-year manufacturing outsourcing
agreement with Sanmina-SCI Corporation. Under this and related
agreements, Sanmina-SCI was to provide a significant portion of
the

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procurement of raw materials, manufacturing,
assembly and test operations for our yield management products.
We continued to purchase from other vendors and manufacture some
of the proprietary and more complex pieces of our equipment,
such as our modulators. Under the terms of this agreement,
Sanmina-SCI leased 15,000 square feet of our San Jose
facility and leased and operated certain equipment, expanded our
San Jose clean room and purchased a substantial portion of
our existing raw materials inventory. In the fourth quarter of
2003, we terminated our relationship with Sanmina-SCI, shifted
production of components to other vendors, and assumed in-house
purchasing activities formerly provided by Sanmina-SCI. See
Note 11 of our Notes to Consolidated Financial
Statements included under Part II, Item 8.
Financial Statements and Supplementary Data for
additional information on the termination of our relationship
with Sanmina-SCI.


We schedule production based upon customer
purchase orders and anticipated orders during the planning
cycle. We generally expect to be able to accept a customer
order, build the required machinery and ship to the customer
within approximately 26 to 39 weeks. We maintain quality
control through inspection of components, in-process inspection
during equipment assembly and final inspection and operation of
all manufactured equipment prior to shipment. Although we
assemble some components and final test our systems under
limited clean room conditions, most of our manufacturing occurs
in standard manufacturing space.

Because of the long lead time required to
manufacture a customer order and the cyclical nature of the
business, a significant increase in orders could necessitate a
build up in inventory and therefore have a negative impact on
cash. During the last half of fiscal 2004, we experienced a
major production increase associated with our Generation 6
repair products. This resulted in an increase of inventory from
$9.9 million at the end of fiscal 2003 to
$31.7 million at the end of fiscal 2004.

Prior to February 2004, under the terms of our
relationship with IHI, IHI had the right to manufacture,
assemble and sell array test systems. To date, we have
manufactured all array test systems sold by IHI. Furthermore,
IHI has sold products only in its capacity as our distributor in
Japan. In February 2004, these prior existing agreements were
terminated. As part of this termination agreement, IHI assigned
to us the right to use all intellectual property rights
associated with our products held by IHI, including any patents
and patent applications associated with the intellectual
property rights. IHI has retained the rights to resell our
products to one particular customer in Japan through March 2005.

Suppliers

We obtain some equipment for our systems from a
single source or a limited group of suppliers. For example, we
currently obtain material handling platforms from a single
source supplier. Although we seek to reduce dependence on our
single source and limited group suppliers, alternative sources
of supply for certain pieces of equipment may not be available
or may be available on unfavorable terms. The partial or
complete loss of a single source or limited group of suppliers
or any delay in shipment from a single source or limited group
of suppliers could at least temporarily harm our results of
operations and damage customer relationships. Further, a
significant increase in the price of one or more of these pieces
of equipment could harm our results of operations. To date we
have not experienced the loss of any single source or limited
group of suppliers or any related delays in shipment.

Intellectual Property

We protect our proprietary technology through
various methods such as patents and patent applications,
trademarks, non-disclosure agreements and trade secrets. We have
filed and obtained a number of patents in the United States and
abroad and have also jointly filed patent applications in Japan
with IHI. As of November 10, 2004, we have been issued 42
patents in the United States that are in force. The normal
expiration dates of these patents range from 2006 to 2023. As of
November 10, 2004, there are 13 pending patent applications
in the United States. As of November 10, 2004, we have been
issued 28 non-U.S. patents that are in force, the normal
expiration dates beginning in 2011, and there are 34
non-U.S. pending patent applications.

8



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Our patents relate to various aspects of our
yield management and rapid thermal processing solutions as set
forth in the following table (as of November 10, 2004):

|                          |       |                  |    |          |  |  |    |    | 
|------------------------- | ----- | ---------------- | -- | -------- |  |  | -- | -- | 
|                          |       |                 
|                          |       | Patents in Force
|                          |       |                 
|                          |       | U.S.             |    | Non-U.S.
|                          |       |                  |    |         
|Yield Management Products |       |                  | 32 |          |  |  | 23 |   
|Process Products          |       |                  | 8  |          |  |  | 4  |   
|Other                     |       |                  | 2  |          |  |  | 1  |   
|                          |       |                  |    |          |  |  |    |   
|                          | Total |                  |    | 42       |  |  |    | 28 | 
|                          |       |                  |    |          |  |  |    |   

We intend to continue to pursue the legal
protection of our technology through intellectual property laws.
However, we cannot be certain that the steps we have taken to
protect our intellectual property rights will be adequate or
that third parties will not infringe or misappropriate our
proprietary rights.

Backlog

Our backlog consists of orders for which we have
accepted purchase orders and assigned shipment dates within the
next twelve months and which are reasonably expected to be
filled within that time frame. All orders are subject to delay
or cancellation with limited or no penalty to the customer.
Because of possible changes in product delivery schedules and
cancellation of product orders, among other factors, our backlog
may vary significantly and, at any particular date, is not
necessarily indicative of actual sales for any succeeding
period. Our backlog as of September 30, 2004 and 2003 was
approximately $81.1 million and $45.4 million,
respectively.

Competition

The worldwide market for integrated yield
management systems is highly competitive. We face substantial
competition from established companies, many of which have
greater financial, engineering and manufacturing resources,
larger service organizations and long-standing customer
relationships with key existing and potential customers. We may
also face future competition from new market entrants from other
overseas and domestic sources.

Our competitors primarily are Micronics Japan Co.
Ltd., Applied Komatsu Technology, Inc. and Shimadzu Corporation
in array testing, NEC Corporation, NTN Corporation, Contrel
Limited, Charm Engineering Co., Ltd and Hoya Continuum
Corporation in array repair and several competitors in the cell
and module inspection market. We may also face future
competition from new market entrants from other overseas and
domestic sources.

We expect our competitors to continue to improve
the design and performance of their products and to introduce
new products with competitive price and performance
characteristics. In addition, our customers may choose to
develop proprietary technology that may obviate or lessen their
need to purchase our products. Moreover, increased competitive
pressure may necessitate price based competition, which could
harm our business, financial condition and results of operations.

We believe that we can compete effectively with
our competitors by building on our substantial installed
customer base, providing technologically superior, competitively
priced products and emphasizing our easy-to-use user interfaces
and customer support. However, realizing and maintaining such
advantages will require a continued high level of investment by
us in engineering, research and development, marketing and
customer service and support. We may not have sufficient
resources to continue to make such investments. Even if
sufficient funds are available, we may not be able to make the
technological advances in a timely manner necessary to maintain
such competitive advantages.

Significant competitive factors in the market for
our yield management systems include system performance, ease of
use, reliability, installed base and technical service and
support. We believe that, while price and delivery are important
competitive factors, the customers overriding requirement
is for systems that

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easily and effectively incorporate automated and
highly accurate inspection and repair capabilities into their
existing manufacturing processes, thereby enhancing productivity.


Our yield management systems for the flat panel
display industry are intended to compete based upon performance
and technical capabilities. These systems may compete with less
expensive and more labor-intensive manual inspection devices.

Employees

As of September 30, 2004, we employed 414
persons. No employees are represented by a labor union or
covered by a collective bargaining agreement. We consider our
relationships with our employees to be good.

Competition is intense in the recruiting of
personnel in the flat panel display industry. Our future success
may depend in part on our continued ability to hire and retain
qualified management and technical employees.

Business Combinations

In August 2004, we acquired from Tucson Optical
Research Corporation all of the assets related to the design and
manufacture of pellicle products which are used in our
modulators. This acquisition has enabled us to reduce product
costs of modulators used in our array checker products while
improving performance.

In June 2004, we acquired from Quantum Composers,
Inc. all of the assets related to the design and manufacture of
laser assembly products used in our repair product line. This
acquisition has enabled us to reduce product costs while
improving performance.

In May 2003, we acquired substantially all of the
assets of Summit Imaging, Inc., a privately held designer and
manufacturer of cooled cameras for the capital equipment
industry. This acquisition has enabled us to reduce the costs of
cameras used in our flat panel display yield management products
while improving performance.

In October 2002, we purchased certain assets from
Intevac, Inc. related to Intevacs Rapid Thermal Processing
(RTP) Division. The rapid thermal processing systems
use a patented technology designed to activate low temperature
poly-silicon films utilizing a precise heating process critical
to the manufacture of advanced active matrix, thin film
transistor liquid crystal displays and organic light emitting
diodes. This acquisition expanded our flat panel display product
offering. Due to deterioration of business conditions and lower
than expected demand for low temperature poly-silicon film
technology, as of December 31, 2003, we determined that all
the goodwill and intangible assets associated with this RTP
reporting unit had been impaired and, as a result, their
carrying value was reduced to zero. Due to deteriorating
business conditions and the emergence of alternative and
competing technologies, we continue to support RTP systems in
the field but are not pursuing new business for systems upgrades
or enhancements.

In September 2002, we acquired Akcron
Corporation, LTD., a privately held manufacturer of automated
optical inspection equipment, image processing hardware and
software algorithms and high-performance liquid crystal display
backlight inverters for flat panel displays. The acquisition of
Akcron expanded our cell and module inspection capabilities. In
the third quarter of fiscal 2004, we sold all assets related to
this business.

For further details regarding our business
combinations and dispositions, please see Note 4 of
Notes to Consolidated Financial Statements included
under Part II, Item 8. Financial Statements and
Supplementary Data.

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##### Table of Contents



Executive Officers of the Registrant

Our executive officers, their ages and their
positions as of November 30, 2004, are as follows:

|                     |  |     |    |          |  |                                                
|-------------------- |  | --- | -- | -------- |  | -----------------------------------------------
|Name                 |  | Age |    | Position
|                     |  |     |    |         
|Malcolm J. Thompson  |  |     | 59 |          |  | Executive Chairman of the Board of Directors   
|Jeffrey A. Hawthorne |  |     | 47 |          |  | Chief Executive Officer, President and Director
|Richard Okumoto      |  |     | 52 |          |  | Chief Financial Officer and Secretary          
|Steve Song           |  |     | 49 |          |  | Vice President, Worldwide Sales                
|Mark Merrill         |  |     | 41 |          |  | Vice President, Marketing                      

Malcolm J. Thompsonhas been a member of our Board of
Directors since 1992 and has served as the Executive Chairman of
our Board of Directors since October 2003. Since April 2003,
Dr. Thompson has served as the interim Chief Executive
Officer of Vitex Systems, Inc., a provider of components for
flat panel displays. From November 2001 to May 2002, he was a
member of the Technical Advisory Board of Novalux, Inc., a laser
module provider for optical networks, and from 1998 through
November 2001, he was President and Chief Executive Officer of
Novalux, Inc., a provider of laser modules for optical networks.
From 1996 to 1998, he was President and Chief Executive Officer
of dpiX, Inc., a digital image capture and display products
company, and from 1981 to 1996, he was the Chief Technologist
for Xerox PARC. He also has served as Chairman of the Board of
the United States Display Consortium, an industry-government
consortium of over 135 member companies. Dr. Thompson
received a B.S. and a Ph.D. in Applied Physics from the
University of Brighton, Sussex in the United Kingdom.

Jeffrey A. Hawthornehas been our President and Chief
Executive Officer since October 2003, and has been a member of
our Board of Directors since December 2003. From July 2003 to
October 2003, Mr. Hawthorne was our Chief Operating
Officer. From November 2001 to July 2003, Mr. Hawthorne was
our Vice President and President, Image Processing Systems
Division. Mr. Hawthorne joined us in 1991 and has held a
series of other management positions including Vice President,
Development from September 1994 to November 2001.
Mr. Hawthorne received a B.S. degree in Engineering Physics
from the University of Colorado and an M.S. degree in Optical
Engineering from the University of Rochester.

Richard Okumotohas
been our Chief Financial Officer and Secretary since May 2003.
From February 2003 until May 2003, he was Vice President of
Administration and Chief Financial Officer at ESI, a
manufacturer of semiconductor capital equipment. From October
2001 to December 2002, Mr. Okumoto was executive Vice
President of The Garrett Group, a technology financial services
firm. From May 2000 to May of 2001, Mr. Okumoto was Senior
Vice President and General Manager of the I.C.E. division of
Credence Systems Corporation, a manufacturer of semiconductor
capital equipment. From October 1998 to May 2000,
Mr. Okumoto was President and Chief Executive Officer of
TMT, Inc., a manufacturer of semiconductor capital equipment.
From March 1993 until January 1998, Mr. Okumoto was
Executive Vice President and Chief Financial Officer for
Credence Systems Corporation. Mr. Okumoto brings over
20 years of financial experience in the semiconductor test
industry. Mr. Okumoto received a B.S. degree in Business
Administration at San Jose State University.

Steve Songhas been
our Vice President, Worldwide Sales since November 2003. From
August 1998 to November 2003, Mr. Song was our Vice
President of Sales. Mr. Song joined us in April 1994 as our
Korean sales and support manager. He was promoted to director of
Korean operations in August 1995 and established our Korean
subsidiary. Mr. Song received a B.S. degree in Electrical
Engineering from Korea University in Seoul, Korea.

Mark Merrillhas
been our Vice President, Marketing since July 2004.
Mr. Merrill has over 15 years of experience in the
industry and joined Photon Dynamics from KLA-Tencor, Inc., a
semiconductor capital equipment company, where he was employed
from 1990 to 2004 and assumed increasing levels of
responsibility culminating in his appointment as the
companys Chief Marketing Officer. In addition to his
affiliation with KLA-Tencor, from 2001 to 2002 Mr. Merrill
was vice president of Product and Market Development, Inc., a
consulting firm, where he consulted with venture capital firms
and their start-up

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companies in multiple industries. Previously,
Mr. Merrill also was an applications and software engineer
at Ultratech Stepper, Inc., a semiconductor capital equipment
company. He holds a B.S. degree in Electronic Engineering, Summa
cum Laude, from Maharishi International University and attended
the Stanford/ AEA Executive Institute at Stanford University.







|        |           
|------- | ----------
|Item 2. | Properties

Information regarding our principal properties at
September 30, 2004 is as follows:

|                         |  |                  |  |                                                                                          |  |         |         |           |  |  |        | 
|------------------------ |  | ---------------- |  | ---------------------------------------------------------------------------------------- |  | ------- | ------- | --------- |  |  | ------ | 
|Location                 |  | Type             |  | Principal Use                                                                            |  | Footage |         | Ownership
|                         |  |                  |  |                                                                                          |  |         |         |          
|San Jose, California     |  | Office and plant |  | Vacant                                                                                   |  |         | 22,000  |           |  |  | Owned  | 
|San Jose, California     |  | Plant            |  | Headquarters, marketing, sales, administration,
    manufacturing, research, engineering |  |         | 128,520 |           |  |  | Leased | 
|Austin, Texas            |  | Office and plant |  | Vacant
    ( 1/2 sublet)                                                                 |  |         | 35,200  |           |  |  | Leased | 
|Markham, Ontario, Canada |  | Office and plant |  | Research and engineering
    ( 1/2 vacant)                                               |  |         | 50,000  |           |  |  | Leased | 
|Hsin Chu, Taiwan         |  | Office and plant |  | Sales, service, marketing, administration,
    manufacturing, research                   |  |         | 10,255  |           |  |  | Leased | 
|Daejeon, Korea           |  | Office and plant |  | Sales, service, marketing, administration,
    manufacturing, research                   |  |         | 6,049   |           |  |  | Leased | 

We also lease office space for other, smaller
research, sales and service offices in Bozeman, Montana, USA;
Tucson, Arizona, USA; Colorado Springs, Colorado, USA; Tokyo,
Japan; Mie, Japan; Seoul, Korea; Kumi, Korea; Cheonan, Korea;
Tainan City, Taiwan; TaiChung, Taiwan; and Beijing, China.

Our operating leases expire at various times
through December 2010, with renewal options at the fair market
value for additional periods up to five years. Additional
information on these leases is incorporated by reference from
Note 11 of the Notes to Consolidated Financial
Statements in Part II, Item 8. Financial
Statements and Supplementary Data. We believe our
properties are adequately maintained and suitable for their
intended use and that our production facilities have adequate
capacity for our current needs.






|        |                  
|------- | -----------------
|Item 3. | Legal Proceedings

Photon Dynamics and certain of our directors and
officers have been named as defendants in a lawsuit captioned
Amtower v. Photon Dynamics, Inc., No. CV797876, filed on
April 30, 2001 in the Superior Court of the State of
California, County of Santa Clara. The plaintiff, who
previously served as one of our officers, has asserted several
causes of action arising out of alleged misrepresentations made
to plaintiff regarding the existence and enforcement of our
insider trading policy. The plaintiff is seeking damages of
approximately $17.7 million for our alleged refusal to
allow plaintiff to sell shares of our stock in May of 2000, plus
unspecified emotional distress and punitive damages. On
December 6, 2001, the court granted our motion to dismiss
the complaint for failure to allege facts sufficient to state a
cause of action, with leave to file an amended complaint. On
January 17, 2002, plaintiff filed his amended complaint and
we again moved to dismiss the action. On June 27, 2002, the
court issued an order granting in part and denying in part the
motion, and further granted plaintiff an opportunity to restate
certain claims. On October 1, 2002, plaintiff filed his
Second Amended Complaint, which was heard on April 8, 2003,
and we again moved to dismiss the action. On April 21,
2003, the court granted in part and denied in part our motion.
The pleadings have been finalized and certain claims against us
and the individual defendants will proceed. The parties
currently are engaged in discovery, and a court-mandated
mediation session on July 30, 2004 did not resolve the
case. Trial is scheduled to commence on March 7, 2005. We
believe the plaintiffs case is without merit and intend to
defend this action vigorously. Although we cannot predict the
outcome of this litigation, we believe that an

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adverse judgment in this litigation could have a
material adverse effect on our financial condition or results of
operations.


We have been named as a defendant in a lawsuit
captioned Sanmina SCI Corporation v. Photon Dynamics, Inc.,
No. CV 013715, filed on February 3, 2004 in the
Superior Court of the State of California, County of
Santa Clara. The plaintiff in this action, which previously
was a third-party manufacturer of Photon Dynamics, has asserted
several causes of action arising out of our alleged
nonperformance of our manufacturing outsourcing agreement with
the plaintiff and is seeking approximately $3.1 million in
compensatory damages and punitive damages in a unknown amount.
We responded to the complaint on March 19, 2004, by filing
an answer and cross complaint seeking damages of at least
$135,000. We amended our cross complaint on June 26, 2004.
The parties attempted to mediate this dispute, which attempt was
not successful. The parties are currently engaged in discovery.
Although we cannot predict the outcome of this litigation, we
believe that an adverse judgment in this litigation would not
have a material adverse effect on our financial condition or
results of operations.

From time to time we are subject to other legal
proceedings and claims, either asserted or unasserted, which
arise in the ordinary course of business. While the outcome of
these proceedings and claims cannot be predicted with certainty,
management does not believe that the outcome of any of these
legal matters will have a material adverse effect on our results
of operations or financial condition.






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

No matters were submitted to a vote of our
security holders during the quarter ended September 30,
2004.




PART II






|        |                                                                                                                        
|------- | -----------------------------------------------------------------------------------------------------------------------
|Item 5. | Market for the Registrants Common
    Equity, Related Stockholder Matters and Issuer Purchase of
    Equity Securities

Common Stock Market Price

Our common stock commenced trading on the NASDAQ
National Market on November 15, 1995 under the symbol
PHTN. The following table sets forth the high and
low close prices of our common stock as traded on the NASDAQ
National Market for the periods indicated.

|                          |  |              |       |           |  |          |       |               |  |   |       |  |  |   |       | 
|------------------------- |  | ------------ | ----- | --------- |  | -------- | ----- | ------------- |  | - | ----- |  |  | - | ----- | 
|                          |  | December 31, |       | March 31, |  | June 30, |       | September 30,
|Fiscal 2004 Quarter Ended |  | 2003         |       | 2004      |  | 2004     |       | 2004         
|                          |  |              |       |           |  |          |       |              
|High                      |  | $            | 41.80 |           |  | $        | 45.82 |               |  | $ | 38.10 |  |  | $ | 32.47 | 
|Low                       |  | $            | 28.70 |           |  | $        | 29.69 |               |  | $ | 28.20 |  |  | $ | 19.81 | 

|                          |  |              |       |           |  |          |       |               |  |   |       |  |  |   |       | 
|------------------------- |  | ------------ | ----- | --------- |  | -------- | ----- | ------------- |  | - | ----- |  |  | - | ----- | 
|                          |  | December 31, |       | March 31, |  | June 30, |       | September 30,
|Fiscal 2003 Quarter Ended |  | 2002         |       | 2003      |  | 2003     |       | 2003         
|                          |  |              |       |           |  |          |       |              
|High                      |  | $            | 35.39 |           |  | $        | 26.65 |               |  | $ | 29.60 |  |  | $ | 34.00 | 
|Low                       |  | $            | 16.15 |           |  | $        | 13.27 |               |  | $ | 16.88 |  |  | $ | 24.17 | 

The closing price for our common stock as
reported by the NASDAQ National Market on December 1, 2004
was $23.33 per share. As of December 1, 2004, there
were approximately 147 shareholders of record of our common
stock.

We have never declared or paid any cash dividends
to our shareholders and we have agreed not to pay cash dividends
under our current bank line of credit. We do not presently plan
to pay cash dividends in the foreseeable future and intend to
retain any future earnings for reinvestment in our business.

13



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|        |                        
|------- | -----------------------
|Item 6. | Selected Financial Data

The following selected consolidated summary
financial data should be read in conjunction with Part II,
Item 8. Financial Statements and Supplementary
Data, and with Part I, Item 7.
Managements Discussion and Analysis of Financial
Condition and Results of Operations in this Annual Report
on Form 10-K. The consolidated statements of operations
data for the years ended September 30, 2004, 2003 and 2002,
and the consolidated balance sheet data as of September 30,
2004 and 2003 are derived from the audited consolidated
financial statements included elsewhere in this report. The
consolidated statements of operations data for the years ended
September 30, 2001 and 2000, and the consolidated balance
sheet data as of September 30, 2002, 2001 and 2000 are
derived from audited consolidated financial statements not
included in this report.

In fiscal 2003, we discontinued operations in two
business segments  the printed circuit board assembly
inspection business and the cathode ray tube display and high
quality glass inspection business. Accordingly, the operating
results of these businesses have been reclassified as
discontinued operations for all periods presented.

|                                                                                                                                                     |         |                                       |         |       |     |      |         |       |      |      |         |       |      |   |         |       |      |   |        |      | 
|---------------------------------------------------------------------------------------------------------------------------------------------------- | ------- | ------------------------------------- | ------- | ----- | --- | ---- | ------- | ----- | ---- | ---- | ------- | ----- | ---- | - | ------- | ----- | ---- | - | ------ | ---- | 
|                                                                                                                                                     |         |                                      
|                                                                                                                                                     |         | Year Ended September 30,             
|                                                                                                                                                     |         |                                      
|                                                                                                                                                     |         | 2004                                  |         | 2003  |     | 2002 |         | 2001  |      | 2000
|                                                                                                                                                     |         |                                       |         |       |     |      |         |       |      |     
|                                                                                                                                                     |         |                                      
|                                                                                                                                                     |         | (In thousands, except per share data)
|Statements of Operations Data:                                                                                                                       |         |                                       |         |       |     |      |         |       |      |      |         |       |      |   |         |       |      |   |        |     
|Revenue                                                                                                                                              |         | $                                     | 143,269 |       |     | $    | 67,196  |       |      | $    | 49,342  |       |      | $ | 38,319  |       |      | $ | 64,221 |     
|Income (loss) from operations                                                                                                                        |         |                                       | 8,259   |       |     |      | (30,692 | )     |      |      | 3,402   |       |      |   | (7,304  | )     |      |   | 11,994 |     
|Income (loss) from continuing operations before
    discontinued operations and cumulative effect of a change in
    accounting principle            |         |                                       | 12,455  | (1)   |     |      | (27,780 | )(2)  |      |      | 6,230   | (3)   |      |   | (2,349  | )(4)  |      |   | 12,952 |     
|Income (loss) from discontinued operations                                                                                                           |         |                                       | (1,391  | )     |     |      | (44,592 | )     |      |      | (28,032 | )     |      |   | (4,218  | )     |      |   | 583    |     
|Income (loss) before cumulative effect of a
    change in accounting principle                                                                       |         |                                       | 11,064  |       |     |      | (72,372 | )     |      |      | (21,802 | )     |      |   | (6,567  | )     |      |   | 13,535 |     
|Cumulative effect of change in accounting
    principle                                                                                              |         |                                       |        |       |     |      |        |       |      |      |        |       |      |   | (6,560  | )(5)  |      |   |       |     
|Net income (loss)                                                                                                                                    |         | $                                     | 11,064  |       |     | $    | (72,372 | )     |      | $    | (21,802 | )     |      | $ | (13,127 | )     |      | $ | 13,535 |     
|Income (loss) per share from continuing
    operations before discontinued operations and cumulative effect
    of a change in accounting principle: |         |                                       |         |       |     |      |         |       |      |      |         |       |      |   |         |       |      |   |        |     
|                                                                                                                                                     | Basic   |                                       | $       | 0.75  | (1) |      | $       | (1.73 | )(2) |      | $       | 0.39  | (3)  |   | $       | (0.18 | )(4) |   | $      | 1.08 | 
|                                                                                                                                                     | Diluted |                                       | $       | 0.73  | (1) |      | $       | (1.73 | )(2) |      | $       | 0.37  | (3)  |   | $       | (0.18 | )(4) |   | $      | 0.99 | 
|Income (loss) per share from discontinued
    operations:                                                                                            |         |                                       |         |       |     |      |         |       |      |      |         |       |      |   |         |       |      |   |        |     
|                                                                                                                                                     | Basic   |                                       | $       | (0.08 | )   |      | $       | (2.77 | )    |      | $       | (1.76 | )    |   | $       | (0.32 | )    |   | $      | 0.05 | 
|                                                                                                                                                     | Diluted |                                       | $       | (0.08 | )   |      | $       | (2.77 | )    |      | $       | (1.67 | )    |   | $       | (0.32 | )    |   | $      | 0.04 | 
|Income (loss) per share before cumulative effect
    of a change in accounting principle:                                                            |         |                                       |         |       |     |      |         |       |      |      |         |       |      |   |         |       |      |   |        |     
|                                                                                                                                                     | Basic   |                                       | $       | 0.67  |     |      | $       | (4.50 | )    |      | $       | (1.37 | )    |   | $       | (0.50 | )    |   | $      | 1.13 | 
|                                                                                                                                                     | Diluted |                                       | $       | 0.65  |     |      | $       | (4.50 | )    |      | $       | (1.30 | )    |   | $       | (0.50 | )    |   | $      | 1.04 | 
|Cumulative effect per share of a change in
    accounting principle, net of tax benefit:                                                             |         |                                       |         |       |     |      |         |       |      |      |         |       |      |   |         |       |      |   |        |     
|                                                                                                                                                     | Basic   |                                       | $       |      |     |      | $       |      |      |      | $       |      |      |   | $       | (0.50 | )(5) |   | $      |     | 
|                                                                                                                                                     | Diluted |                                       | $       |      |     |      | $       |      |      |      | $       |      |      |   | $       | (0.50 | )(5) |   | $      |     | 
|Net income (loss) per share:                                                                                                                         |         |                                       |         |       |     |      |         |       |      |      |         |       |      |   |         |       |      |   |        |     
|                                                                                                                                                     | Basic   |                                       | $       | 0.67  | (1) |      | $       | (4.50 | )(2) |      | $       | (1.37 | )(3) |   | $       | (1.00 | )(4) |   | $      | 1.13 | 
|                                                                                                                                                     | Diluted |                                       | $       | 0.65  | (2) |      | $       | (4.50 | )(2) |      | $       | (1.30 | )(3) |   | $       | (1.00 | )(4) |   | $      | 1.04 | 

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|                                                  |  |                                       |         |      |  |      |         |      |  |      |         |  |  |   |         |  |  |   |         | 
|------------------------------------------------- |  | ------------------------------------- | ------- | ---- |  | ---- | ------- | ---- |  | ---- | ------- |  |  | - | ------- |  |  | - | ------- | 
|                                                  |  |                                      
|                                                  |  | Year Ended September 30,             
|                                                  |  |                                      
|                                                  |  | 2004                                  |         | 2003 |  | 2002 |         | 2001 |  | 2000
|                                                  |  |                                       |         |      |  |      |         |      |  |     
|                                                  |  |                                      
|                                                  |  | (In thousands, except per share data)
|Balance Sheet Data:                               |  |                                       |         |      |  |      |         |      |  |      |         |  |  |   |         |  |  |   |         | 
|Cash, cash equivalents and short-term investments |  | $                                     | 84,155  |      |  | $    | 116,469 |      |  | $    | 170,143 |  |  | $ | 84,091  |  |  | $ | 102,726 | 
|Working capital                                   |  |                                       | 133,705 |      |  |      | 125,624 |      |  |      | 190,188 |  |  |   | 99,457  |  |  |   | 126,042 | 
|Total assets                                      |  |                                       | 207,900 |      |  |      | 161,919 |      |  |      | 249,159 |  |  |   | 158,635 |  |  |   | 155,054 | 
|Shareholders equity                              |  |                                       | 161,329 |      |  |      | 144,143 |      |  |      | 226,143 |  |  |   | 143,308 |  |  |   | 131,800 | 



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Includes a goodwill impairment charge of
    $665,000, purchased intangible asset write-off of
    $2.1 million, acquired in-process research and development
    charge of $210,000 in connection with the acquisition of certain
    assets from Quantum Composers, Inc., gain on fixed assets of
    $427,000 related to the sale of the TFT-LCD Backlight Inverter
    Business, and amortization of intangibles of $789,000.                                                                                                          
|   
|(2) | Includes a goodwill impairment charge of
    $10.0 million related to the Akcron and RTP Assets,
    purchased intangible asset write-off of $3.5 million
    related to the Akcron and RTP Assets, and an acquired in-process
    research and development charge of $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 amortization of intangibles of $1.2 million.
|   
|(3) | Includes an acquired in-process research and
    development charge of $410,000 in connection with the
    acquisition of Akcron.                                                                                                                                                                                                                                                                                                                                                                                                          
|   
|(4) | Includes acquisition related charges of
    $1.4 million in connection with the acquisition of Image
    Processing Systems Inc., as well as restructuring charges of
    $976,000.                                                                                                                                                                                                                                                                                                                                                        
|   
|(5) | We recorded a non-cash charge of
    $6.6 million, net of tax, or $0.50 per diluted share,
    to reflect the cumulative effect of an accounting change as of
    October 1, 2000 related to the adoption of SEC Staff
    Accounting Bulletin No. 101, Revenue Recognition in
    Financial Statements.                                                                                                                                                                                                                                 




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
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
this discussion, especially under the caption Factors
Affecting Operating Results, and elsewhere in this Annual
Report on Form 10-K. Generally, the use of words such as
may, will, could,
anticipate, expect, intend,
believe, continue or the negative of
such terms, or other comparable terminology and similar
expressions identify forward-looking statements. The information
included in this 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

We are a leading provider of yield management
solutions to the flat panel display industry. Our customers use
our systems to increase manufacturing yields of high performance
flat panel displays used in a number of products, including
notebook and desktop computers, televisions and advanced mobile
electronic devices such as cellular phones, personal digital
assistants and portable video games. Our test and repair systems
are used by manufacturers to collect data, analyze product
quality and identify and repair product defects at critical
steps in the manufacturing process.

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We sell our products to manufacturers in the flat
panel display industries. Our flat panel display customers are
located in Korea, Taiwan and Japan, where flat panel display
production is concentrated, and China. We derive most of our
revenue from a small number of customers, and we expect this to
continue for the foreseeable future.

Our products are primarily manufactured in
San Jose, California. Our manufacturing activities consist
primarily of final assembly and test of components and
subassemblies, which are purchased from third party vendors. We
schedule production based upon customer purchase orders and
anticipated orders during the planning cycle. We generally
expect to be able to accept a customer order, build the required
machinery and ship to the customer within 26 to 39 weeks.

The success of our business depends upon numerous
factors, including, but not limited to:



| |   |                                                                                                                                                                                                      
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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.                                                                                                                                       

We do not consider our business to be seasonal in
nature, but it is cyclical with respect to the capital equipment
procurement practices of flat panel display manufacturers and is
impacted by the investment patterns of these manufacturers in
different global markets. A substantial percentage of our
revenue is derived from the sale of a small number of yield
management systems ranging in price from approximately $400,000
to $2.5 million. Therefore, the timing of the sale of a
single system could have a significant impact on our quarterly
results.



| |                                         
| | ----------------------------------------
| | Focus on Flat Panel Display
    Industry

We have not always focused solely on the flat
panel display industry. Previously we also produced printed
circuit board assembly inspection products and cathode ray tube
display and high quality glass inspection products. However, we
determined to exit these markets as we believed that they did
not have the potential to be profitable for us. Consequently, in
January 2003 we implemented a plan to exit the printed circuit
board assembly inspection business, and in June 2003 we
implemented a plan to exit the cathode ray tube display and high
quality glass inspection business. Accordingly, the operating
results of these former businesses are classified as
discontinued operations for all periods presented.

In view of continued deterioration in market
opportunities that began in the fourth quarter of fiscal 2003,
we have suspended operations in the low temperature poly-silicon
(LTPS) technology and inverter markets. Although we
continue to support LTPS systems in the field with parts and
service, we currently are not actively pursuing new business for
systems, upgrades or enhancements for the foreseeable future. In
our third quarter of fiscal 2004, we sold all assets related to
the inverter business.

Our transition to the singular focus on our core
business of developing yield management solutions for the flat
panel display industry has given us a clear focus and direction
in fiscal 2004 to strengthen our product and market position.
Our fiscal 2004 strategic objectives were to build stronger
customer partnerships and to enhance our operating performance.
Our management team has been focused on several imperatives to
support these objectives:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Gross margin improvement: We have instituted
    supply chain management programs with all key suppliers to focus
    on volume purchase agreements. We have developed cost reduction
    programs focused at vertical integration of some purchased
    assemblies, building some subassemblies both with lower cost
    outside providers and lower cost in-house manufacturing. We have
    also established product quality programs focused at improving
    product reliability and reducing product warranty costs.
|
| |  | Production capacity expansion: We have moved into
    a new facility to increase our manufacturing capacity in
    response to increasing demand for our products. Our new facility
    provides a larger area to manufacture our larger Generation 6
    and 7 products and we have been hiring additional staff to
    support increased production.                                                                                                                                                                    

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| |   |                                                                                                                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Asia localization: We continue to build up our
    Asia local management and customer support resources in order to
    meet our customers expectations of local product support
    and local engineering support.                           
|
| |  | Quality improvement: We are continuing to
    implement processes to drive product quality improvement and
    ease of use for our customers.                                                                                                  
|
| |  | Vertical Integration: We have consolidated some
    of our core technology through vertical acquisition of key
    suppliers to reduce product costs, and continue to explore
    opportunities to further reduce product costs in this manner.

We moved into our new facility in our second
fiscal quarter of 2004. We have increased our manufacturing
operations staff in order to meet increased demand for our
products. Our total headcount increased from 292 at the end of
fiscal 2003 to 414 at the end of fiscal 2004. In the short-term,
the incremental capacity of our new facilities has caused our
manufacturing operations to be less efficient due to staff
training and redundancy. This has caused some delays in
executing our cost reduction programs and has impacted our
ability to increase our gross margins.

During the last half of fiscal 2004, we
experienced a major production ramp up associated with our
Generation 6 repair products. In our fourth quarter, in an
effort to meet our customers delivery requirements, we
incurred higher overtime costs, warranty costs, rework costs and
expedite fees. These higher costs, combined with a higher mix of
revenue from repair systems, negatively impacted gross margins.



| |                              
| | -----------------------------
| | Acquisitions and Dispositions

Acquisition of TORC
Assets.In August 2004, we acquired
all of the assets of Tucson Optical Research Corporation related
to the design and manufacture of pellicle products used for our
modulators. The purchase price was approximately
$1.3 million, which we paid in cash and notes.

Acquisition of Quantum Composers
Assets.In June 2004, we acquired from
Quantum Composers, Inc. all of the assets related to the design
and manufacture of laser assembly products for our repair
product line. The purchase price was approximately
$3.0 million, which we paid in cash and notes, and assumed
approximately $156,000 in liabilities.

Acquisition of Summit Imaging
Assets.In May 2003, we acquired
substantially all of the assets of Summit Imaging, Inc., a
privately held designer and manufacturer of cooled cameras for
the capital equipment industry. The purchase price was
approximately $1.5 million, which we paid in cash, and
assumed approximately $15,000 in liabilities.

Acquisition of RTP
Assets.In November 2002, we from
Intevac, Inc. certain assets relating to rapid thermal
processing technology (the RTP Assets). The purchase
price was $20.0 million of cash.

Acquisition of
Akcron.In September 2002, we acquired
Akcron Corporation LTD (Akcron), a designer and
seller of automated optical inspection equipment, image
processing hardware and software algorithms and high-performance
liquid crystal display backlight inverters for flat panel
displays, which has expanded our cell and module inspection
capability. The purchase price was approximately
$4.2 million.

Acquisition of ISIS
Assets.In July 2002, we purchased
certain assets from Advanced Research Technologies, Inc. related
to their Infrared Screening and Inspection Solutions
(ISIS) Division. The purchase price was
approximately $5.5 million in cash and we assumed
liabilities of approximately $100,000. All of these assets were
written off as part of the discontinuation of the printed
circuit board assembly inspection business.

For further details of these acquisitions, see
Note 4 of the Notes to Consolidated Financial
Statements included under Part II, Item 8.
Financial Statements and Supplementary Data.

We also continue to refine our strategic
direction and, as a result, no longer have a need for some
acquired businesses and technologies. For example, in the first
quarter of fiscal 2004 we suspended operations in the LTPS
technology and inverter markets. In fiscal 2003, we exited the
printed circuit board assembly inspection and cathode ray tube
and high quality glass inspection businesses. As a result, some
or all of the technologies

17



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acquired in connection with some of our prior
acquisitions, including Advanced Research Technologies Inc.,
Intelligent Reasoning Systems, Inc., Image Processing Systems,
Inc. and Infrared Screening and Inspection Solutions have been
sold or abandoned.


In the fourth quarter of fiscal 2003, as a result
of limited opportunities in the inverter market and uncertainty
with regard to flat panel manufacturers commitment to LTPS
technology, we performed an impairment analysis of the goodwill
and the purchased intangible assets and certain other long-lived
assets associated with the Akcron and RTP reporting units. As a
result of this analysis, we recorded impairment charges of
approximately $10.0 million related to goodwill and
$3.5 million related to the unamortized portion of the
acquired developed technology, core technology and patent
intangible assets associated with these reporting units. The
remaining $365,000 of goodwill and $2.1 million of acquired
core technology and acquired developed technology associated
with these reporting units were written off in the three months
ended December 31, 2003 as additional impairment charges.
These additional impairment charges were a result of the
continuing deterioration in business conditions that included
emergence of alternative and competing technologies, shrinkage
of potential total market opportunity due to one of the primary
potential customers decision to pursue an alternative
technology and further softness in this particular sector of the
market since September 30, 2003. While continuing to
support RTP systems in the field with parts and service, we will
not pursue new business for systems, upgrades or enhancements
for the foreseeable future. In the third quarter of fiscal 2004,
we sold all of our assets related to our TFT-LCD Backlight
Inverter business and recorded a gain on the transaction of
$419,000 which is included in Gain on sale of fixed
assets in the Consolidated Statements of Operations. See
Note 4 of our Notes to Consolidated Financial
Statements in Part II, Item 8. Financial
Statements and Supplementary Data for further information,
which is incorporated by reference.



| |         
| | --------
| | Industry

Continuous innovations in microelectronics and
materials science have enabled manufacturers, including our
customers, to produce flat panel displays with sharper
resolution, brighter pixels and faster imaging in varying sizes
for differing applications. Growth in the mobile electronic
devices market, the desktop computer market and the television
market have driven the demand for flat panel displays, which
offer reduced footprint, weight, power consumption and heat
emission and better picture quality as compared to cathode ray
tube displays, the current standard technology for stationary
display devices.

During calendar 2003, demand for computer monitor
displays and notebook demand resulted in Korean and Taiwanese
flat panel display manufacturers investing heavily in Generation
5 factories to keep pace with the demand for products. In
addition, calendar 2003 signaled the start of AMLCD television
mass production.

In the last half of our fiscal year 2004, there
has been uncertainty in the flat panel display market as supply
exceeded demand; however, this over-supply has been
significantly moderated given the panel price decreases and a
slowdown in capacity increases. Despite this uncertainty, flat
panel display manufacturers have continued to press forward with
carefully considered new capacity investments in Generation 6
and Generation 7 factories in order to keep their competitive
edge in the market.

Growth in the AMLCD television market is expected
to continue to fuel the overall growth in the flat panel display
market. Lower panel prices, however, are essential to stimulate
demand. The next generation factories are being built to help
reduce manufacturing cost to allow panel producers to achieve
the proper panel pricing. However, there are many factors that
will dictate how successful AMLCD manufacturers are in
penetrating the television market, including display
performance, price reduction and the ability to maintain
profitability. The adoption rate of television products is
uncertain and will affect demand and overall market growth.

Demand for our Generation 5 and 6 test and repair
equipment remains high, as reflected in our bookings and
backlog. Our Generation 7 test system installation and
acceptance is underway. In addition, we continue to see a
growing interest in our automated cell and module inspection
systems.

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We believe continued growth in demand for AMLCD
products will fuel investments in Generation 6 and 7 factories
to keep pace and that inspection, test and repair systems will
continue to represent a significant percentage of our
customers capital spending, driving increased demand for
our products and services.



| |        
| | -------
| | Backlog

Our backlog for unshipped system orders as of
September 30, 2004, was approximately $81.1 million, a
majority of which we expect to ship within the next six to
twelve months. We received orders valued at $42.0 million
in the three months ended September 30, 2004,
$46.2 million in the three months ended June 30, 2004,
$47.2 million in the three months ended March 31,
2004, and $42.1 million in the three months ended
December 31, 2003.

Critical Accounting Policies and
Estimates

Our discussion and analysis of our financial
condition and results of operations are based upon our
consolidated financial statements, which have been prepared in
accordance with U.S. generally accepted accounting
principles. The preparation of our financial statements and the
related disclosures requires our management to make judgments,
assumptions and estimates that affect the reported amounts of
assets, liabilities, revenue and expenses, and related
disclosure of contingent assets and liabilities. Note 1 of
the Notes to Consolidated Financial Statements
included under Part II, Item 8. Financial
Statements and Supplementary Data, describes significant
accounting policies used in the preparation of our consolidated
financial statements. Some of these significant accounting
policies are considered to be critical accounting policies.

A critical accounting policy is defined as one
that is both material to the presentation of our financial
statements and requires management to make difficult, subjective
or complex judgments that could have a material effect on our
financial condition and results of operations.

Estimates and assumptions about future events and
their effects cannot be determined with certainty. We base our
estimates on historical experience and on various other
assumptions that are believed to be applicable and reasonable
under the circumstances. These estimates may change as new
events occur, as additional information is obtained and as our
operating environment changes. In addition, management is
periodically faced with uncertainties, the outcomes of which are
not within its control and will not be known for prolonged
periods of time. These uncertainties are discussed in the
section below entitled Factors Affecting Operating
Results.

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



| |                    
| | -------------------
| | Revenue Recognition

We recognize revenue when persuasive evidence of
an arrangement exists, delivery has occurred, the services have
been rendered, the selling price is fixed or determinable and
collection of the receivable is reasonably assured. For each
arrangement, we make judgments as to whether each of these
criteria is met. If we determine that any of these criteria are
not met, we defer revenue recognition until such time as we
determine that all of the criteria are met.

In addition, for arrangements with multiple
deliverables, we make additional judgments as to whether each
item has value to the customer on a stand-alone basis, the
amounts of revenue for each element that are not subject to
refund, all defined customer acceptance experience levels have
been met, and the fair values of any undelivered items have been
reliably determined.

We record a provision for estimated sales returns
in the same period as the related revenue is recorded, which is
netted against revenue. These estimates are based on historical
sales returns and other known factors which have not varied
widely in the past and we do not reasonably expect these factors
to significantly change in the foreseeable future. If the
historical data we use to calculate these estimates does not
properly reflect future returns, additional provisions may be
required. Historically, we have not experienced the return of any

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of our flat panel display systems and do not
expect this to change in the foreseeable future. However, due to
the relatively high prices of our systems, the actual return of
one of these systems would have a material adverse effect on our
results of operations.


Note 1 of our Notes to Consolidated
Financial Statements included under Part II,
Item 8. Financial Statements and Supplementary
Data, provides additional information of our revenue
recognition policy.



| |                                    
| | -----------------------------------
| | Allowance for Doubtful
    Accounts

Our trade receivables are derived from sales to
flat panel display manufacturers located in Korea, Taiwan, Japan
and China. In order to monitor potential credit losses, we
perform periodic evaluations of our customers financial
condition. We maintain an allowance for doubtful accounts for
the potential inability of our customers to make required
payments based upon our assessment of the expected
collectibility of all accounts receivable. In estimating the
provision, management considers (i) historical experience,
(ii) the length of time the receivables are past due,
(iii) any circumstances of which we are aware of a
customers inability to meet its financial obligations, and
(iv) other known factors. We review this provision
periodically to assess the adequacy of the provision.

Our allowance for doubtful accounts was
approximately $497,000 and $726,000 at September 30, 2004
and 2003, respectively. These balances each represent less than
2% of each years total revenues. Historically, losses due
to customer bad debts in our flat panel display business have
been immaterial and we expect that this will not change in the
foreseeable future. However, if a single customer returned a
product or was unable or unwilling to make payments, additional
allowances may be required. Accordingly, the inability of a
single customer to make required payments could have a material
adverse effect on our results of operations.



| |            
| | -----------
| | Inventories

The valuation of inventory requires us to
estimate obsolete or excess inventory and inventory that is not
of saleable quality. The determination of obsolete or excess
inventory requires us to estimate the future demand for our
products within specific time horizons, generally twelve months
or less. If our demand forecast for specific products is greater
than actual demand and we fail to reduce manufacturing output
accordingly, we could be required to record additional inventory
write-offs, which would have a negative impact on our gross
margin.

We review the adequacy of our inventory valuation
on a quarterly basis. For production inventory, our methodology
involves matching our on-hand inventory with our build forecast
over the next twelve months on a part-by-part basis. We then
evaluate the parts found to be in excess of the twelve-month
demand and take appropriate write-downs to reflect the risk of
obsolescence. This methodology is significantly affected by the
usage assumption. Using a longer time period of estimated usage
could result in reduced inventory adjustment requirements. Based
on our past experience, we believe the twelve-month time period
to best reflect the reasonable and relative obsolescence risks.
If actual demand or usage were to be substantially lower than
estimated, additional inventory adjustments for excess or
obsolete inventory may be required.



| |         
| | --------
| | Warranty

Our warranty policy generally states that we will
provide warranty coverage for a period of one year from final
acceptance. We record the estimated cost of warranty coverage,
primarily material and labor to repair and service the
equipment, upon product shipment, when the related revenue is
recognized. Our warranty obligation is affected by product
failure rates, consumption of field service parts and the
efficiency by which the product failure is corrected. We
estimate our warranty cost based on historical data related to
these factors.

Our liability for warranty coverage was
approximately $6.2 million and $2.4 million at
September 30, 2004 and 2003, respectively, with the
increase being attributable to a greater number of systems being
under warranty due to our increased sales in the past year and
incremental warranty reserves to cover quality

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problems identified in the fourth quarter of
fiscal 2004. Should actual product failure rates, material usage
and labor efficiencies differ from our estimates, revisions to
the estimated warranty liability would be required.




| |                                   
| | ----------------------------------
| | Goodwill and Intangible
    Assets

We have accounted for goodwill and other
intangible assets resulting from our acquisitions in accordance
with Statement of Financial Accounting Standards No. 142
Goodwill and Other Intangible Assets
(FAS 142). FAS 142 prohibits the
amortization of goodwill and intangible assets with indefinite
useful lives and requires that these assets be reviewed for
impairment at least annually, and more frequently if there are
indicators of impairment. The process for evaluating the
potential impairment of goodwill is highly subjective and
requires significant judgment at many points during the
analysis. Should actual results differ from our estimates,
revisions to the recorded amount of goodwill could be reported.

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

As described in Acquisitions and
Dispositions above, we have recently recorded both
goodwill and intangible asset impairment charges as part of our
transition to a singular focus on our core business of
developing yield management solutions for the flat panel display
industry. In the fourth quarter of fiscal 2003, we recorded a
goodwill impairment charge of $10.0 million and an
intangible asset impairment charge of $3.5 million
associated with our Akcron and RTP reporting units. During
fiscal quarter ended December 31, 2003, we recorded a
goodwill impairment charge of approximately $365,000 and an
intangible asset impairment charge of $2.1 million
associated with our Akcron reporting unit and the remaining
intangible assets associated with our RTP and Akcron reporting
units. These charges were reflected in our results of operations
for the three months ended December 31, 2003. In October
2003, $1.7 million of the $2.0 million escrow related
to the purchase of certain assets relating to the RTP Assets was
settled in our favor, and $300,000 was settled in favor of
Intevac, resulting in an additional goodwill impairment charge
of $300,000 in the three months ended December 31, 2003.

Goodwill as of September 30, 2004, was
approximately $153,000, related entirely to our purchase of
assets from Summit Imaging. Intangible assets as of
September 30, 2004 were approximately $4.8 million,
related to patents and acquired core technology resulting from
our purchase of assets from Summit Imaging, the assignment and
license agreement signed with IHI in March 2004, the purchase of
Quantum Composers in June 2004 and the purchase of Tucson
Optical Research Corporation in August 2004.



| |                             
| | ----------------------------
| | Contingencies and Litigation

We make an assessment of the probability of an
adverse judgment resulting from current and threatened
litigation. We accrue the cost of an adverse judgment if, in our
estimation and based on the advice of legal counsel, the adverse
settlement is probable and we can reasonably estimate the
ultimate cost of such a judgment. We are engaged in two
significant litigation matters as of September 30, 2004,
Amtower v. Photon Dynamics, Inc. in which the plaintiffs
are seeking damages of approximately $17.7 million and
Sanmina SCI Corporation v. Photon Dynamics, Inc. in which the
plaintiffs are seeking damages of approximately
$3.1 million. These matters are as described in Item
3  Legal Proceedings. We have made our
requisite assessments and accruals, as warranted, as of
September 30, 2004. We believe that an adverse judgment in
the Amtower litigation could have a material adverse effect on
our financial condition or results of operations. We

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believe that an adverse judgment in the Sanmina
litigation would not have a material adverse effect on our
financial condition or results of operations.


Results of Operations



| |                                                         
| | --------------------------------------------------------
| | Fiscal Years Ended September 30, 2004,
    2003 and 2002

The following table sets forth, for the periods
indicated, the percentage of revenue of certain items in our
Consolidated Statements of Operations.

|                                                                                             |                                              |                          |       |      |      |      |        |      |      |  |       |      |      | 
|-------------------------------------------------------------------------------------------- | -------------------------------------------- | ------------------------ | ----- | ---- | ---- | ---- | ------ | ---- | ---- |  | ----- | ---- | ---- | 
|                                                                                             |                                              |                         
|                                                                                             |                                              | Year Ended September 30,
|                                                                                             |                                              |                         
|                                                                                             |                                              | 2004                     |       | 2003 |      | 2002
|                                                                                             |                                              |                          |       |      |      |     
|Revenue                                                                                      |                                              |                          | 100.0 | %    |      |      | 100.0  | %    |      |  | 100.0 | %   
|Cost of revenue                                                                              |                                              |                          | 58.6  |      |      |      | 65.6   |      |      |  | 52.3  |     
|                                                                                             |                                              |                          |       |      |      |      |        |      |      |  |       |     
|Gross margin                                                                                 |                                              |                          | 41.4  |      |      |      | 34.4   |      |      |  | 47.7  |     
|Operating expenses:                                                                          |                                              |                          |       |      |      |      |        |      |      |  |       |     
|                                                                                             | Research and development                     |                          |       | 20.7 |      |      |        | 33.9 |      |  |       | 22.0 |     
|                                                                                             | Selling, general and administrative          |                          |       | 12.4 |      |      |        | 20.5 |      |  |       | 17.9 |     
|                                                                                             | Goodwill impairment charge                   |                          |       | 0.5  |      |      |        | 14.9 |      |  |       |     |     
|                                                                                             | Impairment of purchased intangibles          |                          |       | 1.5  |      |      |        | 5.3  |      |  |       |     |     
|                                                                                             | Impairment of fixed assets                   |                          |       | 0.2  |      |      |        |     |      |  |       |     |     
|                                                                                             | Gain on sale of fixed assets                 |                          |       | (0.3 | )    |      |        |     |      |  |       |     |     
|                                                                                             | Acquired in-process research and development |                          |       | 0.1  |      |      |        | 3.7  |      |  |       | 0.8  |     
|                                                                                             | Amortization of intangible assets            |                          |       | 0.6  |      |      |        | 1.8  |      |  |       |     |     
|                                                                                             |                                              |                          |       |      |      |      |        |      |      |  |       |     
|                                                                                             |                                              | Total operating expenses |       |      | 35.7 |      |        |      | 80.1 |  |       |      | 40.8 | 
|                                                                                             |                                              |                          |       |      |      |      |        |      |      |  |       |     
|Income (loss) from operations                                                                |                                              |                          | 5.7   |      |      |      | (45.7  | )    |      |  | 6.9   |     
|Interest income and other, net                                                               |                                              |                          | 3.4   |      |      |      | 4.4    |      |      |  | 5.9   |     
|                                                                                             |                                              |                          |       |      |      |      |        |      |      |  |       |     
|Income (loss) from continuing operations before
    income taxes and discontinued operations |                                              |                          | 9.1   |      |      |      | (41.3  | )    |      |  | 12.8  |     
|Provision for income taxes                                                                   |                                              |                          | 0.4   |      |      |      | 0.1    |      |      |  | 0.2   |     
|                                                                                             |                                              |                          |       |      |      |      |        |      |      |  |       |     
|Income (loss) from continuing operations before
    discontinued operations                  |                                              |                          | 8.7   |      |      |      | (41.4  | )    |      |  | 12.6  |     
|Loss from discontinued operations                                                            |                                              |                          | (1.0  | )    |      |      | (66.4  | )    |      |  | (56.8 | )   
|                                                                                             |                                              |                          |       |      |      |      |        |      |      |  |       |     
|Net income (loss)                                                                            |                                              |                          | 7.7   | %    |      |      | (107.7 | )%   |      |  | (44.2 | )%  
|                                                                                             |                                              |                          |       |      |      |      |        |      |      |  |       |     



| |        
| | -------
| | Revenue

|        |  |                        |         |                   |  |      |     |      |  |        |        |      |  |   |        |  |  |  |    |   |  |   |        | 
|------- |  | ---------------------- | ------- | ----------------- |  | ---- | --- | ---- |  | ------ | ------ | ---- |  | - | ------ |  |  |  | -- | - |  | - | ------ | 
|        |  |                        |         |                  
|        |  | Fiscal Year Ended      |         | Fiscal Year Ended
|        |  | September 30,          |         | September 30,    
|        |  |                        |         |                  
|        |  | 2004                   |         | Change            |  | 2003 |     | 2003 |  | Change |        | 2002
|        |  |                        |         |                   |  |      |     |      |  |        |        |     
|        |  |                       
|        |  | (Dollars in thousands)
|Revenue |  | $                      | 143,269 |                   |  |      | 113 | %    |  | $      | 67,196 |      |  | $ | 67,196 |  |  |  | 36 | % |  | $ | 49,342 | 

The increase in revenue in fiscal 2004 from
fiscal 2003 was primarily due to the continued customer
expansion of manufacturing capacity. Flat panel display
manufacturers continue to increase capacity to meet computer
notebook and monitor demand. In addition, price elasticity is
creating strong demand for 22  26
television displays. Generation 5 capacity additions continued
in Korea and Taiwan as flat panel display manufacturers
continued to invest to keep pace with the AMLCD demand. In
addition, Generation 6 factories are now coming on line and
several manufacturers have either broken ground or announced
their Generation 7 factories.

22



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##### Table of Contents



Total revenue from our Generation 5 and earlier
generation products represented approximately 53% and 85% of
revenue in fiscal 2004 and 2003, respectively. The decrease in
fiscal 2004 was due primarily to revenue from our new Generation
6 products. Revenue from our Generation 6 products represented
approximately 42% of revenue in fiscal 2004, with no
corresponding revenue in fiscal 2003. Our products in each new
generation contain new performance and control features designed
specifically to enhance yield improvement and process control.
As a result, we have historically experienced increases in our
average selling prices (ASPs) of between 20% and 50%
in each new generation product. As with prior generation
products, our Generation 6 ArrayCheckerTM products
have greater ASPs than previous generations. However, the ASPs
of our Generation 6 ArraySaverTM products were
relatively flat as compared to the prior generations. There is
no assurance that we will be successful at achieving or
sustaining ASP increases on our Generation 6 and future
generation products.

The increase in fiscal 2004 revenue as compared
to fiscal 2003 was due to increased shipments of both our
ArrayCheckerTM and ArraySaverTM products
shipped. Revenue from our ArrayCheckerTM products
represented approximately 75% and 81% of our total revenue for
fiscal 2004 and 2003, respectively. Revenue from our test
products increased in absolute dollars primarily due to the
continued customer expansion of manufacturing capacity. Revenue
from our test products decreased as a percentage of revenue due
primarily to the increase in revenue from our repair products.
Revenue from our ArraySaverTM products represented
approximately 19% and 4% of our total revenue for fiscal 2004
and 2003, respectively. Revenue from our repair products have
increased in both absolute dollars and as a percentage of total
revenue partly in response to the larger glass size of
Generation 6 and to expansion of customer manufacturing
facilities. The cost of yield loss associated with large monitor
or television panels is driving flat panel display manufacturers
to increase the number of repair systems used in the
manufacturing process in an effort to maximize yields. Our sales
terms are typically 80% to 90% of the sales price due upon
shipment with the remaining amount due after installation and
upon final customer acceptance. During fiscal 2004, we placed
greater emphasis on obtaining final customer acceptances. As a
result, fiscal 2004 revenue includes a higher percentage of
revenue related to the receipt of final customer acceptances
following completed installation of our products compared with
our prior fiscal year. Spare part sales represented
approximately 5% and 9% of our total revenue for fiscal 2004 and
2003, respectively. This change from prior year represents an
increase in absolute dollars due primarily to the increase in
total machines in the field in 2004; however, it represents a
decrease as a percentage of revenue due to the increase in test
and repair machines sold.

Revenue from our rapid thermal processing
products, which are based on the technology we acquired in
November 2002, represented approximately 0.5% and 6% of our
revenue for fiscal 2004 and 2003, respectively. The revenue
reported in 2004 reflected sales of upgrades to an existing
product and we do not expect sales, if any, of this product line
to be a significant portion of revenue in the foreseeable
future. While we continue to support systems in the field, we
are not pursuing new business for this product offering.

Our international revenue is derived from
customers in Korea, Taiwan, Japan and China. International
revenue represented 100% of our revenue in both fiscal 2004 and
2003. In fiscal 2004, revenue from customers in Korea increased
approximately $21.5 million, or 46%, revenue from customers
in Taiwan increased approximately $43.0 million, or 225%,
revenue from customers in Japan increased approximately
$10.0 million, or 952%, compared to fiscal 2003. The
remainder of the revenue in fiscal 2004 of approximately $1.6,
or 1%, was derived from customers based in China. In fiscal
2004, approximately $4.4 million of our sales were made in
currencies other than U.S. dollars.

We experienced a greater growth in revenue from
our ArraySaverTM products throughout fiscal 2004,
particularly in the fourth quarter, compared to the growth in
revenue from our ArrayCheckerTM products. This shift
in product mix had a negative impact on our gross profit as a
percentage of our revenue. We expect our ArraySaverTM
revenue to approach 33% of our revenue in our first quarter of
fiscal 2005.

The increase in revenue in fiscal 2003 from
fiscal 2002 was primarily due to sustained growth in the flat
panel display market and in our share of the market as a result
of our focused product strategy. The flat panel display market
grew due to a strong demand for both monitors and notebooks.
Korean and Taiwanese flat panel display manufacturers invested
heavily in Generation 5 factories to keep pace with demand.

23



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##### Table of Contents



Total revenue from our Generation 5 and earlier
generation products represented approximately 85% and 88% of
revenue in fiscal 2003 and 2002, respectively.

The increase in fiscal 2003 revenue as compared
to fiscal 2002 was due to increased shipments of both our
ArrayCheckerTM and rapid thermal processing products
shipped. Revenue from our ArrayCheckerTM products
represented approximately 81% and 72% of our total revenue for
fiscal 2003 and 2002, respectively. Revenue from our rapid
thermal processing products, which are based on the technology
we acquired in November 2002, represented approximately 6% and
0% of our revenue in 2003 and 2002, respectively. Revenue from
our ArraySaverTM products represented approximately
4% and 15% of our total revenue for fiscal 2003 and 2002,
respectively, due primarily to delayed shipments and acceptance
of our generation 5 products. Spare part sales represented
approximately 8% and 13% of our total revenue for fiscal 2003
and 2002, respectively.

Our international revenue was derived from
customers in Korea, Taiwan, Japan and China. International
revenue represented 100% of our revenue in both fiscal 2003 and
2002. In fiscal 2003, revenue from customers in Korea increased
approximately $18.9 million, or 67%, revenue from customers
in Taiwan increased approximately $2.6 million, or 16%, and
revenue from customers in Japan decreased approximately
$3.6 million, or 77%, compared to fiscal 2002. In fiscal
2003, none of our sales were made in currencies other than
U.S. dollars.



| |             
| | ------------
| | Gross Margin

|             |  |                     |    |                     |  |      |    |      |  |        |    |      |  |  |    |   |  |  |     |    |  |  |    |  
|------------ |  | ------------------- | -- | ------------------- |  | ---- | -- | ---- |  | ------ | -- | ---- |  |  | -- | - |  |  | --- | -- |  |  | -- | -
|             |  |                     |    |                    
|             |  | Fiscal Year         |    | Fiscal Year        
|             |  | Ended September 30, |    | Ended September 30,
|             |  |                     |    |                    
|             |  | 2004                |    | Change              |  | 2003 |    | 2003 |  | Change |    | 2002
|             |  |                     |    |                     |  |      |    |      |  |        |    |     
|Gross Margin |  |                     | 41 | %                   |  |      | 20 | %    |  |        | 34 | %    |  |  | 34 | % |  |  | (28 | )% |  |  | 48 | %

The improvement of gross margin in fiscal 2004 as
compared to fiscal 2003 is a reflection of the benefits of:



| |   |                                                                                                                                                                                                                        
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The full manufacturing integration of the
    ArrayCheckerTM high-speed cameras, acquired as part
    of our acquisition of assets from Summit Imaging in May 2003;                                                    
|
| |  | A higher percentage of revenue recognized after
    installation and final customer acceptance, which typically has
    a higher margin than revenue billed on the associated items that
    were previously delivered;
|
| |  | Improved manufacturing efficiencies resulting
    from a more stable design of our Generation 5 products, which
    were introduced in fiscal 2003;                                                                    
|
| |  | Elimination of our use of a third-party contract
    manufacturer; and                                                                                                                                                 
|
| |  | Manufacturing cost reduction due to sourcing of
    some raw materials and subassemblies in Asia.                                                                                                                      

These benefits were partially offset by:



| |   |                                                                                                                                                                            
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Longer cycle times and inefficiencies brought
    about by the addition and training of a second manufacturing
    shift during our second quarter;                        
|
| |  | Higher initial costs related to the first
    production build of our dual-camera ArrayCheckerTM
    and our Generation 6 ArraySaverTM systems                             
|
| |  | The temporary loss of capacity early in our
    second quarter caused by the move to our new facility; and                                                                 
|
| |  | Higher warranty costs, rework costs and expedite
    fees incurred as a result of the execution issues surrounding
    the production ramp up in our Generation 6 products.

We anticipate that our gross margins for our
first quarter of fiscal 2005 will increase slightly to 37-39%
from our gross margins in our fourth quarter of fiscal 2004 of
34%. We anticipate that approximately 33% of our first quarter
revenues will be generated from our repair systems, representing
only a slight increase over the 31% in our fourth quarter of
fiscal 2004.

24



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##### Table of Contents



Key factors that may impact our future gross
margins include:



| |   |                                                                                                                                                                                                                                                                                      
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Our revenue mix between higher margin
    ArrayCheckerTM systems and lower margin
    ArraySaverTM systems;                                                                                                                                                                          
|
| |  | The costs of increasing customer service staff to
    support the increased demands of our customers;                                                                                                                                                                                
|
| |  | The challenges associated with our steep
    manufacturing ramp up, including gaining efficiencies or
    reducing manufacturing cycle times from a new manufacturing
    staff and costs associated with accelerating material
    procurement to support the ramp up in production;
|
| |  | The inefficiencies of building new products;                                                                                                                                                                                                                                         
|
| |  | Costs associated with the integration of Quantum
    Composers and Tucson Optical Research Corporation; and                                                                                                                                                                          
|
| |  | Competitive pricing pressures, particularly in
    the array repair market.                                                                                                                                                                                                          

The overall decrease in gross margin in fiscal
2003 as compared to fiscal 2002 was primarily due to
manufacturing inefficiencies and additional costs incurred to
meet product delivery dates and resolve quality problems as a
result of technical design issues related to the release of our
ArrayCheckerTM 3500 product. Additionally,
end-of-life pricing on the ArrayCheckerTM 2000
systems, competitive pricing pressures, particularly on the
ArraySaverTM product, and lower modulator yields
contributed to lower gross margins.



| |                         
| | ------------------------
| | Research and Development

|                   |  |                        |        |                  |  |      |    |      |  |        |        |      |  |   |        |   |  |  |     |   |  |   |        |  
|------------------ |  | ---------------------- | ------ | ---------------- |  | ---- | -- | ---- |  | ------ | ------ | ---- |  | - | ------ | - |  |  | --- | - |  | - | ------ | -
|                   |  |                        |        |                 
|                   |  | Fiscal Year Ended      |        | Fiscal YearEnded
|                   |  | September 30,          |        | September 30,   
|                   |  |                        |        |                 
|                   |  | 2004                   |        | Change           |  | 2003 |    | 2003 |  | Change |        | 2002
|                   |  |                        |        |                  |  |      |    |      |  |        |        |     
|                   |  |                       
|                   |  | (Dollars in thousands)
|Expense            |  | $                      | 29,701 |                  |  |      | 30 | %    |  | $      | 22,786 |      |  | $ | 22,786 |   |  |  | 109 | % |  | $ | 10,878 |  
|Percent of Revenue |  |                        | 21     | %                |  |      |    |      |  |        | 34     | %    |  |   | 34     | % |  |  |     |   |  |   | 22     | %

Our research and development expenses consisted
primarily of salaries, related personnel costs, depreciation,
prototype materials and fees paid to consultants and outside
service providers, all of which relate to the design,
development, testing, pre-manufacturing and improvement of our
products. We increased our overall research and development
spending in fiscal 2003 over fiscal 2002 to support simultaneous
development of Generation 5, 6 and 7 test and repair
products, primarily related to higher spending on prototype
materials and engineering headcount. This spending increased
again in absolute dollars in fiscal 2004 due to additional
timing demands placed on both the ArrayCheckerTM and
ArraySaverTM Generation 6 and 7 product development
groups, as well as our cell/module inspection systems group. In
our fourth quarter of fiscal 2004, we incurred significant costs
for redesign work performed during the quarter on our Generation
6 repair products.

We expect our research and development expenses
to be flat to slightly higher in absolute dollars during our
first quarter of fiscal 2005 as compared to research and
development expenses of approximately $9.7 million in
fourth quarter of fiscal 2004 due to the continuation of our
fourth quarter redesign work expected to be completed in early
fiscal 2005. For fiscal 2005, we expect our research and
development expenses to be flat to slightly greater in absolute
dollars as compared to fiscal 2004 as we continue to expand our
research and development efforts to address three areas:



| |   |                                                                                                                   
| | - | ------------------------------------------------------------------------------------------------------------------
| |  | Ramp up our cell/module program to address mass
    production requirements;                                      
|
| |  | Increase our efforts on Generation 7 products and
    launch development programs for Generation 7.5 products; and
|
| |  | Expand our repair product offering.                                                                               

We will continue to invest in R&D to maintain
technology leadership in our products. Our customers must
continually improve their display quality performance and
production costs in order to be successful in

25



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##### Table of Contents



the display market. To meet our customers
needs, we must improve our product performance in defect
detection, repair success, cost of ownership, ease of use and
throughput for each of our product generations.




| |                                        
| | ---------------------------------------
| | Selling, General and
    Administrative

|                   |  |                        |        |                   |  |      |    |      |  |        |        |      |  |   |        |   |  |  |    |   |  |   |       |  
|------------------ |  | ---------------------- | ------ | ----------------- |  | ---- | -- | ---- |  | ------ | ------ | ---- |  | - | ------ | - |  |  | -- | - |  | - | ----- | -
|                   |  |                        |        |                  
|                   |  | Fiscal Year Ended      |        | Fiscal Year Ended
|                   |  | September 30,          |        | September 30,    
|                   |  |                        |        |                  
|                   |  | 2004                   |        | Change            |  | 2003 |    | 2003 |  | Change |        | 2002
|                   |  |                        |        |                   |  |      |    |      |  |        |        |     
|                   |  |                       
|                   |  | (Dollars in thousands)
|Expense            |  | $                      | 17,780 |                   |  |      | 29 | %    |  | $      | 13,763 |      |  | $ | 13,763 |   |  |  | 55 | % |  | $ | 8,853 |  
|Percent of Revenue |  |                        | 12     | %                 |  |      |    |      |  |        | 21     | %    |  |   | 21     | % |  |  |    |   |  |   | 18    | %

Our selling, general and administrative expenses
consisted primarily of salaries and related expenses for
marketing, sales, finance, administration and human resources
personnel, accounting, commissions, insurance, legal and other
corporate expenses. The increase in selling, general and
administrative expenses in absolute dollars in both fiscal 2004
and 2003 was primarily attributed to increases in expenses
related to corporate governance requirements, severance
expenses, legal costs and increased headcount. We expect these
expenses to increase slightly in our first quarter of fiscal
2005 as compared to selling, general and administrative expenses
of approximately $4.6 million in our fourth quarter of
fiscal 2004. For fiscal 2005, we expect our selling, general and
administrative expenses to be flat to slightly higher in
absolute dollars as compared to fiscal 2004 due to investments
we intend to make in the marketing area.



| |                                                                   
| | ------------------------------------------------------------------
| | Impairment of Goodwill, Purchased
    Intangibles and Fixed Assets

As previously discussed in Overview and Critical
Accounting Policies and Estimates, we have exited all business
lines other than the flat panel display products market and
within the flat panel display market we have suspended
operations of the LTPS and inverter products. As a result, we
determined that all of our goodwill and long-lived assets
related to LTPS and inverter products we had manufactured had
been impaired, resulting in goodwill, intangible and fixed asset
impairment charges of approximately $665,000, $2.1 million
and $234,000, respectively, in our first fiscal quarter of 2004.

In the fourth quarter of fiscal 2003, as a result
of limited opportunities in the inverter market and uncertainty
with regard to flat panel manufacturers commitment to LTPS
technology, we performed an impairment analysis of the
$3.5 million and $7.4 million of goodwill associated
with the acquisitions of Akcron and the RTP Assets,
respectively. The valuations were done as of July 1, 2003,
using established valuation techniques, specifically, the income
and market approaches. As a result of these analyses, we
recorded goodwill impairment charges of $2.7 million and
$7.3 million associated with the Akcron and RTP asset
goodwill, respectively.

In the fourth quarter of fiscal 2003, we also
performed an impairment analysis of purchased intangible assets
associated with the acquisitions of Akcron and the RTP Assets.
As a result, we recorded a write-off of $2.0 million and
$1.5 million related to the acquired core and developed
technologies of the Akcron and RTP Assets, respectively.



| |                             
| | ----------------------------
| | Gain on Sale of Fixed Assets

In fiscal 2004, we recorded a net gain on sale of
fixed assets of approximately $427,000. In May 2004, we sold all
of our assets in Korea related to our TFT-LCD Backlight Inverter
business for approximately $481,000. The assets include
inventory and production equipment, intellectual property and
some of the employees related to the inverter business. In the
three months ended June 30, 2004, we recorded a gain on the
transaction of approximately $419,000.

26



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##### Table of Contents





| |                                                 
| | ------------------------------------------------
| | Acquired In-Process Research and
    Development

|                   |  |                        |     |                   |  |      |     |      |  |        |       |      |  |   |       |   |  |  |     |   |  |   |     |  
|------------------ |  | ---------------------- | --- | ----------------- |  | ---- | --- | ---- |  | ------ | ----- | ---- |  | - | ----- | - |  |  | --- | - |  | - | --- | -
|                   |  |                        |     |                  
|                   |  | Fiscal Year Ended      |     | Fiscal Year Ended
|                   |  | September 30,          |     | September 30,    
|                   |  |                        |     |                  
|                   |  | 2004                   |     | Change            |  | 2003 |     | 2003 |  | Change |       | 2002
|                   |  |                        |     |                   |  |      |     |      |  |        |       |     
|                   |  |                       
|                   |  | (Dollars in thousands)
|Expense            |  | $                      | 210 |                   |  |      | (92 | )%   |  | $      | 2,474 |      |  | $ | 2,474 |   |  |  | 503 | % |  | $ | 410 |  
|Percent of Revenue |  |                        | 0   | %                 |  |      |     |      |  |        | 4     | %    |  |   | 4     | % |  |  |     |   |  |   | 1   | %

In June 2004, we acquired from Quantum Composers
all of the assets of Quantum Composers related to the design and
manufacture of laser assembly products for flat panel display
LCD manufacturing and repair. In May 2003, we acquired all of
the assets of Summit Imaging related to the design and
manufacture of cooled cameras specifically tailored
to our product offerings. In November 2002, we completed our
acquisition of certain assets from Intevac, Inc. related to
Intevacs rapid thermal processing technology. In September
2002, we acquired Akcron Corporation, LTD., a privately held
manufacturer of automated optical inspection equipment, image
processing hardware and software algorithms and high-performance
liquid crystal display backlight inverters for flat panel
displays. The purchase prices of these acquisitions were
allocated in accordance with FAS 141, Business
Combinations, including in-process research and
development charges that were expensed on the acquisition date
as they represented ongoing research and development projects
that had not yet reached technological feasibility and had no
alternative future uses.

Acquired in-process research and development was
identified and valued through interviews with executives of the
companies from which the assets were acquired, analysis of data
concerning developmental products and their stage of
development, the time and resources needed to complete the
projects, their expected income generating ability, target
markets and associated risks. The income approach, which
includes an analysis of the markets, cash flows and risks
associated with achieving such cash flows, was the primary
technique we utilized in valuing in-process research and
development. We discounted projected incremental cash flows back
to their present value using discount rates of 30%, 25% and 50%
for the Quantum Composers, Intevac technology and Summit Imaging
asset purchases, respectively, which was determined after
consideration of our weighted average cost of capital and the
weighted average return on assets.

In-process research and development related to
Quantum Composers involves the design of the next generation
laser cutting/ablation systems for our LCD panel repair
products. At the time of acquisition, the project was
approximately 75% complete, and was substantially completed by
the end of fiscal 2004, with additional incurred costs of
approximately $25,000 to complete this development.

In-process research and development projects
related to Intevac included a new transport system for more
efficient handling of larger glass, redesign of the lamphouse
for selective heating of the film and enhancement of low oxygen
technology. These projects were substantially complete as of
June 30, 2003.

In-process research and development related to
Summit Imaging involved the design of the next generation cooled
cameras for our ArrayCheckerTM tools. This project
was substantially complete as of September 30, 2003.

Risks associated with our acquired in-process
research and development include the inherent difficulties and
uncertainties in completing each project and thereby achieving
technological feasibility, anticipated levels of market
acceptance and penetration, market growth rates and risks
related to the impact of potential changes in future target
markets. The nature of the efforts required to develop the
acquired in-process research and development into commercially
viable products principally relate to the completion of all
planning, designing, prototyping, verification and testing
activities that are necessary to establish that the products can
be produced to meet their design specifications, including
functions, features and technical performance requirements. As
such, the timing of completion and ultimate commercial
application are affected by the successful completion of these
activities and ultimately, market acceptance.

27



---



##### Table of Contents





| |                                      
| | -------------------------------------
| | Amortization of Intangible
    Assets

|                   |  |                        |     |                   |  |      |     |      |  |        |       |      |  |   |       |   |  |  |   |  |  |   |   | 
|------------------ |  | ---------------------- | --- | ----------------- |  | ---- | --- | ---- |  | ------ | ----- | ---- |  | - | ----- | - |  |  | - |  |  | - | - | 
|                   |  |                        |     |                  
|                   |  | Fiscal Year Ended      |     | Fiscal Year Ended
|                   |  | September 30,          |     | September 30,    
|                   |  |                        |     |                  
|                   |  | 2004                   |     | Change            |  | 2003 |     | 2003 |  | Change |       | 2002
|                   |  |                        |     |                   |  |      |     |      |  |        |       |     
|                   |  |                       
|                   |  | (Dollars in thousands)
|Expense            |  | $                      | 789 |                   |  |      | (36 | )%   |  | $      | 1,236 |      |  | $ | 1,236 |   |  |  |  |  |  | $ |  | 
|Percent of Revenue |  |                        | 0.6 | %                 |  |      |     |      |  |        | 1.8   | %    |  |   | 1.8   | % |  |  |   |  |  |   |  | 

Through December 31, 2003, our identified
intangible assets associated with the RTP Assets, Akcron and
Summit Imaging acquisitions were being amortized over a two to
five year period, commencing on the date of the acquisitions. As
of December 31, 2003, all intangible assets associated with
the RTP Assets and Akcron acquisitions had been written off. In
March of 2004, we acquired additional intangible assets related
to our termination and assignment agreement with
Ishikawajima-Harima Heavy Industries. In June of 2004, we
acquired certain intangible assets related to Quantum Composers.
In August of 2004, we acquired certain intangible assets from
Tucson Optical Research Corporation. As a result, we expect
amortization of existing intangibles to be approximately
$397,000 per quarter through the second quarter of fiscal
2005. We then expect amortization of our existing intangibles to
be approximately $381,000 and $372,000 in our third and fourth
quarters of fiscal 2005, respectively, as the intangible asset
associated with the Quantum non-compete agreement will be fully
amortized. These estimates do not include any amounts that may
be associated with any acquisitions that may occur in fiscal
2005.



| |                                   
| | ----------------------------------
| | Interest Income and Other,
    Net

|                   |  |                        |       |                   |  |      |    |      |  |        |       |      |  |   |       |   |  |  |   |   |  |   |       |  
|------------------ |  | ---------------------- | ----- | ----------------- |  | ---- | -- | ---- |  | ------ | ----- | ---- |  | - | ----- | - |  |  | - | - |  | - | ----- | -
|                   |  |                        |       |                  
|                   |  | Fiscal Year Ended      |       | Fiscal Year Ended
|                   |  | September 30,          |       | September 30,    
|                   |  |                        |       |                  
|                   |  | 2004                   |       | Change            |  | 2003 |    | 2003 |  | Change |       | 2002
|                   |  |                        |       |                   |  |      |    |      |  |        |       |     
|                   |  |                       
|                   |  | (Dollars in thousands)
|Income             |  | $                      | 4,802 |                   |  |      | 62 | %    |  | $      | 2,968 |      |  | $ | 2,968 |   |  |  | 2 | % |  | $ | 2,913 |  
|Percent of Revenue |  |                        | 3.4   | %                 |  |      |    |      |  |        | 4.4   | %    |  |   | 4.4   | % |  |  |   |   |  |   | 5.9   | %

Interest income and other, net consisted
primarily of interest income, foreign currency exchange gains
and losses, changes in the fair value of derivative financial
instruments and other miscellaneous income and expense. The
increase in Interest income and other, net, in
fiscal 2004, as compared to fiscal 2003, was primarily
attributable to the receipt of a technology license fee
resulting from a litigation settlement in the first quarter of
fiscal 2004, the terms of which were confidential. This gain was
offset by lower interest income earned in fiscal 2004 due to
lower overall cash and investment balances as we used our cash
to initially fund the ramp up in business in the last half of
our fiscal year.



| |                           
| | --------------------------
| | Provision for Income Taxes

The fiscal 2004, 2003 and 2002 effective tax
rates were 4.6%, 0% and 0.1%, respectively. The effective tax
rates for fiscal 2004 included a foreign withholding tax related
to a technology license fee resulting from a litigation
settlement in the first quarter of fiscal 2004. The effective
tax rate in fiscal 2004 is lower than the statutory rate due
primarily to tax benefits arising from net operating losses and
primarily relate to alternative minimum taxes. The effective tax
rate in fiscal 2003 is lower than the statutory rate due to tax
net operating losses not being recognized. The effective tax
rate in fiscal 2002 is less than the statutory federal income
tax rate primarily as a result of an election reducing our tax
benefits arising from acquired net operating losses and
increasing tax bases in various purchased intangible assets.

As of September 30, 2004, we have federal
and state net operating loss carryforwards of approximately
$68.3 million and $12.0 million, respectively. We
expect that our effective tax rate will be less than our
statutory tax rate in fiscal 2005.

We record a valuation allowance against our net
deferred tax assets. Realization of our deferred tax assets
depends on our generating sufficient taxable income in future
years in appropriate tax jurisdictions to obtain benefit from
the reversal of temporary differences and from net operating
loss and credit carryforwards. Due to

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the uncertainty of the timing and the amount of
such realization, management concluded that a full valuation
allowance was required at September 30, 2004.


Our future effective income tax rate depends on
various factors, such as tax legislation, the geographic
composition of our pre-tax income, amount of and access to tax
loss carryforwards, expenses incurred in connection with
acquisitions that are not deductible for tax purposes, amounts
of tax-exempt interest income and research and development
credits as a percentage of aggregate pre-tax income, and the
effectiveness of our tax planning strategies.

Discontinued Operations

Through January 14, 2003, we conducted
business in three operating segments: flat panel display
products, cathode ray tube display and high quality glass
inspection products and printed circuit board assembly
inspection products. In January 2003, we implemented a plan to
exit the printed circuit board assembly inspection business. In
June 2003, we implemented a plan to exit the cathode ray tube
display and high quality glass inspection businesses.
Accordingly, the operating results of these former business
segments have been presented as discontinued operations for all
periods presented.



| |                                                       
| | ------------------------------------------------------
| | Printed Circuit Board Assembly Inspection
    Business

|         |  |                   |        |      |  |      |         |   |  |   |         |  
|-------- |  | ----------------- | ------ | ---- |  | ---- | ------- | - |  | - | ------- | -
|         |  |                  
|         |  | Fiscal Year Ended
|         |  | September 30,    
|         |  |                  
|         |  | 2004              |        | 2003 |  | 2002
|         |  |                   |        |      |  |     
|         |  |                  
|         |  | (In thousands)   
|Net Loss |  | $                 | (1,562 | )    |  | $    | (38,586 | ) |  | $ | (24,585 | )

The loss from discontinued operations for the
year ended September 30, 2004, included approximately
$1.5 million in litigation costs for settlement of prior
inventory purchase commitments and for settlement of a lawsuit
brought by a former employee.

The loss from discontinued operations for the
year ended September 30, 2003, includes a write-off of
inventory of approximately $7.6 million, a write-off of
accounts receivable of approximately $2.0 million, and a
write-off of licensed technology of approximately
$1.9 million. The fiscal 2003 loss also includes impairment
charges of approximately $15.1 million of goodwill,
$2.9 million of purchase intangibles and $2.5 million
of long-lived assets recorded during the three months ended
December 31, 2002, as a result of our assessment of
indicators of impairment that existed prior to our formal
decision to discontinue the operations of this segment.

The loss from discontinued operations for the
year ended September 30, 2002, includes a restructuring
charge of approximately $2.6 million recorded in the fourth
quarter of fiscal 2002 associated with a reduction in workforce,
consolidation and closing of facilities and a write-off of
related fixed assets. The fiscal 2002 loss also includes
impairment charges of approximately $11.2 million of
goodwill and $1.0 million of purchased intangibles recorded
during the fourth quarter of 2002, as a result of our assessment
of indicators of impairment related to the acquisition of
Intelligent Reasoning Systems, Inc. In addition, we recorded
approximately $244,000 of acquired in-process research and
development charges related to the acquisition of certain assets
from Advanced Research Technologies, Inc. related to its
Infrared Screening and Inspection Solutions Infrared Screening
and Inspection Solutions (ISIS) Division.



| |                                                                        
| | -----------------------------------------------------------------------
| | Cathode Ray Tube Display and High Quality
    Glass Inspection Business

|                  |  |                   |     |      |  |      |        |   |  |   |        |  
|----------------- |  | ----------------- | --- | ---- |  | ---- | ------ | - |  | - | ------ | -
|                  |  |                  
|                  |  | Fiscal Year Ended
|                  |  | September 30,    
|                  |  |                  
|                  |  | 2004              |     | 2003 |  | 2002
|                  |  |                   |     |      |  |     
|                  |  |                  
|                  |  | (In thousands)   
|Net Income (Loss) |  | $                 | 171 |      |  | $    | (6,006 | ) |  | $ | (3,447 | )

The income from discontinued operations for the
year ended September 30, 2004, includes a gain on the sale
of certain assets related to the former glass inspection
business.

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The loss from discontinued operations for the
year ended September 30, 2003, includes a write-off of
inventory of approximately $1.8 million, a write-off of
accounts receivable of approximately $152,000, and a write-off
of fixed assets of approximately $490,000. The fiscal 2003 loss
also includes approximately $460,000 in lease-related charges
associated with excess facilities, and approximately $979,000 in
employee severance and related benefit charges.

In the future, we expect the effects of
discontinued operations to be minimal, if any, and to relate
primarily to settlements that may arise that are in addition to
those amounts accounted for at the time the operations were
discontinued. These expectations exclude amounts, if any,
resulting from the outcome of our Amtower litigation. These
matters are as described in Item 3  Legal
Proceedings. Although we cannot predict the outcome of
this litigation, we believe that an adverse judgment in this
litigation could have a material adverse effect on our financial
condition or results of operations.

Liquidity and Capital Resources

We have financed our growth primarily by a
combination of cash flows from operations and public stock
offerings. Working capital was $133.7 million as of
September 30, 2004, compared to $125.6 million as of
September 30, 2003. A major component of working capital is
$84.1 million of cash, cash equivalents and short-term
investments as of September 30, 2004, compared to
$116.5 million as of September 30, 2003. Cash, cash
equivalents and short-term investments were $116.5 million
as of September 30, 2003, compared to $170.1 million
as of September 30, 2002.

Operating Activities of Continuing
Operations.Cash used in operating
activities from continuing operations was $24.4 million and
$6.7 million in fiscal 2004 and 2003, respectively, while
cash provided by operating activities was $2.3 million in
fiscal 2002. In fiscal 2004, cash was provided by net income
adjusted for non-cash related items. However, changes in assets
and liabilities consumed approximately $43.5 million of
cash, resulting in a net use of cash in operations. Working
capital sources of cash, primarily a $14.4 million increase
in accounts payable related primarily to inventory purchases,
were more than offset by working capital uses of cash. The
primary reductions in cash from changes in our working capital
levels were: (a) an increase of approximately
$48.1 million in our net accounts receivable, resulting
primarily from sales increasing from approximately
$21.0 million in the fourth quarter of fiscal 2003 to
approximately $24.5 million, $26.5 million,
$38.5 million and $53.8 million in our first, second,
third and fourth quarters of fiscal 2004, respectively, and the
timing of shipments in our fourth quarter; and (b) an
increase of approximately $22.7 million in our net
inventory, which increased as a result of our ramping up
inventory in preparation for our first quarter build schedules.

In January 2004, we moved into our new
San Jose, California manufacturing and headquarters
facility. In our second quarter of fiscal 2004, we began
increasing our operations staff in order to meet market demand
and to gain market share. We also saw in our second and third
fiscal quarters an increase in operating expenses and certain
working capital items, such as inventory and accounts receivable
during this ramp up period, which has caused our use of cash in
operating activities to increase. We continued to use cash in
operating activities in our fourth quarter, but we were able to
fund these increasing operating expenses and changes in working
capital components with our cash, cash equivalents and
short-term investments. We expect that inventory levels will
stabilize in our fiscal 2005 and that our use of cash in
operations will decline.

The increase in cash used in operating activities
in fiscal 2003 compared to fiscal 2002 was primarily due to the
$27.8 million net loss generated in fiscal 2003, as
compared to the $6.2 million net income generated in fiscal
2002, and decrease in accounts payable partially offset by
increases in deferred revenue. The increase in deferred revenue
related to shipments occurring in the fourth quarter, while the
decrease in accounts payable corresponded to a decrease in
inventory levels.

Investing Activities of Continuing
Operations.Cash provided by investing
activities from continuing operations was $26.7 million and
$21.9 million in fiscal 2004 and 2003, respectively, while
cash used in investing activities was $83.0 million in
fiscal 2002. Cash provided by investing activities in fiscal
2004 was primarily the result of approximately
$39.1 million of net redemptions of short-term investments.
This was partially offset by the acquisition of the Quantum and
TORC Assets for approximately $1.0 million and

30



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##### Table of Contents



$625,000, respectively, and by approximately
$9.8 million in capital expenditures, of which
approximately $6.1 million was related to expenditures on
leasehold improvements associated with our new facility in
San Jose, California. Capital expenditures related to the
facility move-in for leasehold improvements were substantially
complete at March 31, 2004. The increase in cash provided
by investing activities in fiscal 2003 compared to fiscal 2002
was primarily due to increases in the redemption of our
short-term investments to fund our operations, offset by the
purchase of the Intevac assets. Capital expenditures were
$2.6 million and $2.1 million in fiscal 2003 and 2002,
respectively.


Financing Activities of Continuing
Operations.Cash provided by financing
activities was $6.2 million in fiscal 2004, resulting
solely from sales of our common stock under our employee equity
compensation plans. Cash used in financing activities was
$9.8 million in fiscal 2003, as sales of our common stock
under our employee equity compensation plans was more than
offset by the $17.7 million of repurchases of our common
stock during fiscal 2003. Cash provided by financing activities
was $105.5 million in fiscal 2002, primarily due to our
public offering of our common stock during that year, resulting
in net proceeds to us of approximately $107.0 million,
together with sales of our common stock under our employee
equity compensation plans, which were partially offset by
repurchases of our common stock in the amount of
$6.9 million.

The timing of and amounts received from employee
stock option exercises are dependent upon the decisions of the
respective option holders, and are not controlled by us.
Therefore, funds raised from the issuance of common stock upon
the exercise of employee stock options should not be considered
an indication of additional funds to be received in future
periods.

In March 2000, we entered into a bank line of
credit (line of credit) which had an initial term of
one year. We have renegotiated the line of credit on an annual
basis and currently have a $4.0 million borrowing capacity
on the line of credit with an interest rate of floating prime,
expiring in October 2005. The line of credit is secured by
substantially all of our assets and contains certain financial
and other covenants. At September 30, 2004, no amounts were
outstanding under the line of credit.

In August 2002, our Board of Directors approved a
stock repurchase program authorizing us to repurchase up to an
aggregate of $25.0 million of our common stock. The
repurchase program was terminated on January 15, 2003. The
repurchases were made from time to time on the open market at
prevailing prices, in negotiated transactions off the market or
pursuant to a 10b5-1 plan adopted by us. The 10b5-1 plan allowed
us to repurchase our shares during a period in which we were in
possession of material non-public information, provided that we
communicated share repurchase instructions to the broker at a
time when we were not in possession of such material non-public
information. During the period October 1, 2002 through
January 15, 2003, we repurchased 903,032 shares for an
aggregate repurchase price of approximately $17.7 million.
As of January 15, 2003, at the termination of the program,
we had purchased a total of 1,253,932 shares for an
aggregate repurchase price of approximately $24.6 million.



| |                        
| | -----------------------
| | Contractual Obligations

The following table summarizes the approximate
contractual obligations that we have at September 30, 2004.
Such obligations include both non-cancelable obligations and
other obligations that are generally non-cancelable except under
certain limited conditions.

Contractual Obligations

|                            |       |                             |        |        |  |      |        |        |  |      |       |       |  |            |       |       |  |   |       |       |  |   |       |       |  |   |       |       | 
|--------------------------- | ----- | --------------------------- | ------ | ------ |  | ---- | ------ | ------ |  | ---- | ----- | ----- |  | ---------- | ----- | ----- |  | - | ----- | ----- |  | - | ----- | ----- |  | - | ----- | ----- | 
|                            |       |                            
|                            |       | Payments Due by Fiscal Year
|                            |       |                            
|                            |       | Total                       |        | 2005   |  | 2006 |        | 2007   |  | 2008 |       | 2009  |  | Thereafter
|                            |       |                             |        |        |  |      |        |        |  |      |       |       |  |           
|                            |       |                            
|                            |       | (In thousands)             
|Notes payable               |       | $                           | 2,829  |        |  | $    | 1,446  |        |  | $    | 1,383 |       |  | $          |      |       |  | $ |      |       |  | $ |      |       |  | $ |      |      
|Operating lease obligations |       |                             | 18,930 |        |  |      | 3,713  |        |  |      | 3,533 |       |  |            | 3,007 |       |  |   | 2,652 |       |  |   | 2,627 |       |  |   | 3,398 |      
|Purchase obligations        |       |                             | 27,326 |        |  |      | 24,582 |        |  |      | 1,294 |       |  |            | 726   |       |  |   | 715   |       |  |   | 9     |       |  |   |      |      
|                            |       |                             |        |        |  |      |        |        |  |      |       |       |  |            |       |       |  |   |       |       |  |   |       |       |  |   |       |      
|                            | Total |                             | $      | 49,085 |  |      | $      | 29,741 |  |      | $     | 6,210 |  |            | $     | 3,733 |  |   | $     | 3,367 |  |   | $     | 2,636 |  |   | $     | 3,398 | 
|                            |       |                             |        |        |  |      |        |        |  |      |       |       |  |            |       |       |  |   |       |       |  |   |       |       |  |   |       |      

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In August 2003, we signed a lease agreement for a
128,520 square-foot building in San Jose, California
into which we consolidated our former San Jose facilities,
effective January 5, 2004. The lease on our prior
San Jose location terminated concurrently with the
inception date of the new lease. The new facility is leased
under a non-cancelable operating lease that expires in 2010,
with two renewal options at fair market value for additional
five year periods and is reflected in the operating lease
obligations in the table above.

We maintain certain open inventory purchase
commitments with our suppliers to ensure a smooth and continuous
supply chain for key components. Our liability under these
purchase arrangements is generally restricted to purchase
commitments over a forecasted time horizon as mutually agreed
upon between the parties and is reflected in purchase
obligations in the table above. The majority of these
purchase commitments are covered by confirmed customer orders.



| |                
| | ---------------
| | Working Capital

We believe that cash generated from operations,
together with the liquidity provided by existing cash balances
and borrowing capability, will be sufficient to meet our
operating and capital requirements and obligations for at least
the next twelve months. However, this forward-looking statement
is based upon our current plans and assumptions, which may
change, and our capital requirements may increase in future
periods. In addition, we believe that success in our industry
requires substantial capital in order to maintain the
flexibility to take advantage of opportunities as they may
arise. We may, from time to time, invest in or acquire
complementary businesses, products or technologies and may seek
additional equity or debt financing to fund such activities.
There can be no assurance that such funding will be available to
us on commercially reasonable terms, if at all, and if we were
to proceed with acquisitions without this funding or with
limited funding it would decrease our capital resources. The
sale of additional equity or convertible debt securities could
result in dilution to our existing shareholders.



| |                                   
| | ----------------------------------
| | Off-Balance Sheet
    Arrangements

As of September 30, 2004, we did not have
any significant off-balance sheet arrangements, as defined in
Item 303(a)(4)(ii) of SEC Regulation S-K.

32



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##### Table of Contents



Operating, Investing and Financing Activities
of Discontinued Operations.In January
2003, we implemented a plan to exit the printed circuit board
assembly inspection business and in June 2003 we implemented a
plan to exit the cathode ray tube display and high quality glass
inspection business. Accordingly, the operating results of these
business segments have been reclassified as discontinued
operations. Net cash used by discontinued operations during
fiscal 2004, 2003 and 2002 is as follows:

|                                                                            |                                                                            |                                                                         |   |        |        |      |   |         |         |   |   |         |        |  
|--------------------------------------------------------------------------- | -------------------------------------------------------------------------- | ----------------------------------------------------------------------- | - | ------ | ------ | ---- | - | ------- | ------- | - | - | ------- | ------ | -
|                                                                            |                                                                            |                                                                        
|                                                                            |                                                                            | Fiscal Year Ended                                                      
|                                                                            |                                                                            |                                                                        
|                                                                            |                                                                            | 2004                                                                    |   | 2003   |        | 2002
|                                                                            |                                                                            |                                                                         |   |        |        |     
|                                                                            |                                                                            |                                                                        
|                                                                            |                                                                            | (In thousands)                                                         
|Cash flows from operating activities:                                       |                                                                            |                                                                         |   |        |        |      |   |         |         |   |   |        
|                                                                            |                                                                            | Printed circuit board business                                          |   | $      | (1,387 | )    |   | $       | (10,777 | ) |   | $       | (2,709 | )
|                                                                            |                                                                            | Cathode ray tube display and high quality glass
    inspection business |   |        | (47    | )    |   |         | (1,858  | ) |   |         | (8,994 | )
|                                                                            |                                                                            |                                                                         |   |        |        |      |   |         |         |   |   |        
|                                                                            | Net cash used in operating activities from
    discontinued operations     |                                                                         |   | (1,434 | )      |      |   | (12,635 | )       |   |   | (11,703 | )     
|                                                                            |                                                                            |                                                                         |   |        |        |      |   |         |         |   |   |        
|Cash flows from investing activities:                                       |                                                                            |                                                                         |   |        |        |      |   |         |         |   |   |        
|                                                                            |                                                                            | Printed circuit board business                                          |   |        |       |      |   |         | (92     | ) |   |         | (4,133 | )
|                                                                            |                                                                            | Cathode ray tube display and high quality glass
    inspection business |   |        |       |      |   |         |        |   |   |         | 131    |  
|                                                                            |                                                                            |                                                                         |   |        |        |      |   |         |         |   |   |        
|                                                                            | Net cash used in investing activities from
    discontinued operations     |                                                                         |   |       |        |      |   | (92     | )       |   |   | (4,002  | )     
|                                                                            |                                                                            |                                                                         |   |        |        |      |   |         |         |   |   |        
|Cash flows from financing activities:                                       |                                                                            |                                                                         |   |        |        |      |   |         |         |   |   |        
|                                                                            |                                                                            | Printed circuit board business                                          |   |        |       |      |   |         |        |   |   |         |       |  
|                                                                            |                                                                            | Cathode ray tube display and high quality glass
    inspection business |   |        |       |      |   |         |        |   |   |         |       |  
|                                                                            |                                                                            |                                                                         |   |        |        |      |   |         |         |   |   |        
|                                                                            | Net cash provided by financing activities from
    discontinued operations |                                                                         |   |       |        |      |   |        |         |   |   |        |       
|                                                                            |                                                                            |                                                                         |   |        |        |      |   |         |         |   |   |        
|Net decrease in cash and cash equivalents from
    discontinued operations: |                                                                            |                                                                         |   |        |        |      |   |         |         |   |   |        
|                                                                            |                                                                            | Printed circuit board business                                          |   |        | (1,387 | )    |   |         | (10,869 | ) |   |         | (6,842 | )
|                                                                            |                                                                            | Cathode ray tube display and high quality glass
    inspection business |   |        | (47    | )    |   |         | (1,858  | ) |   |         | (8,863 | )
|                                                                            |                                                                            |                                                                         |   |        |        |      |   |         |         |   |   |        
|                                                                            | Net decrease in cash and cash equivalents from
    discontinued operations |                                                                         | $ | (1,434 | )      |      | $ | (12,727 | )       |   | $ | (15,705 | )     
|                                                                            |                                                                            |                                                                         |   |        |        |      |   |         |         |   |   |        

Cash used in discontinued operations in fiscal
2004 consisted primarily of changes in working capital balances,
payments for settlement of prior inventory purchase commitments,
and the settlement of a lawsuit.

Impact of Accounting Pronouncements

In March 2004, the FASB issued a proposed
Statement, Share-Based Payment, an amendment of FASB
Statements Nos. 123 and 95, that addresses the accounting
for share-based payment transactions in which a company receives
employee services in exchange for either equity instruments of
the company or liabilities that are based on the fair value of
the companys equity instruments or that may be settled by
the issuance of such equity instruments. The proposed statement
would eliminate the ability to account for share-based
compensation transactions using the intrinsic method that we
currently use and generally would require that such transactions
be accounted for using a fair-value-based method and recognized
as expense in our consolidated statements of operations. The
recommended effective date of the proposed standard is currently
for fiscal years beginning after June 15, 2005. Should this
proposed statement be finalized in its current form,

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it will have a significant impact on our
consolidated statements of operations as we will be required to
expense the fair value of our stock option grants and stock
purchases under our employee stock purchase plan.


In March 2004, the Emerging Issues Task Force
(EITF) reached a consensus on recognition and
measurement guidance previously discussed under EITF Issue
No. 03-01, The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments.
(EITF 03-01). The consensus clarifies the
meaning of other-than-temporary impairment and its application
to investments in debt and equity securities, in particular
investments within the scope of FASB Statement No. 115,
Accounting for Certain Investments in Debt and Equity
Securities, and investments accounted for under the cost
method. In September 2004, the Financial Accounting Standards
Board approved the issuance of a FASB staff position to delay
the requirement to record impairment losses under
EITF 03-1. The approved delay applies to all securities
within the scope of EITF 03-1 and is expected to end when
new guidance is issued and comes into effect. Adoption of this
consensus is not expected to have a material impact on our
consolidated results of operations.

Factors Affecting Operating Results



| |                                                                      
| | ---------------------------------------------------------------------
| | We have sustained losses and we may sustain
    losses in the future.

We reported net losses for each of the fiscal
years ended September 30, 2003 and 2002. Although we
reported profits in each of the four quarters of fiscal 2004,
and expect to report a profit in the first quarter of fiscal
2005, in the future our revenue may decline, remain flat or grow
at a rate slower than expected. Our ability to maintain
profitability is dependent in part on the success of our efforts
to increase revenues and to reduce operating expenses as a
percentage of revenue through our ongoing cost-cutting measures
and our gross margin improvement programs. However, we recently
increased our manufacturing capacity to meet greater demand for
our products, and this has caused us to experience increased
operating expenses. If the increase in demand for our products
is not sustained, or if we are not able to increase our
manufacturing capacity in a cost-efficient manner, this would
impair our ability to maintain our recently achieved
profitability. For all of these reasons, there is no assurance
that we will be successful in achieving or maintaining increased
revenue, reduced operating expenses, positive cash flows or
profitability.



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

We have experienced, and expect to continue to
experience, significant fluctuations in our quarterly results.
Consequently, past financial results may not be indicative of
future financial results. A substantial percentage of our
revenue is derived from the sale of a small number of yield
management systems ranging in price from $400,000 to
$2.5 million. Therefore, the timing of the sale of a single
system could have a significant impact on our quarterly results.
Moreover, customers may cancel or reschedule shipments, and
production difficulties could delay shipments. For example, in
the fourth quarter of 2004, we incurred additional costs such as
expedite fees, premiums and delivery penalties in an effort to
meet customer delivery schedules and quality related costs such
as rework and higher warranty. In December 2002, we experienced
technical delays with respect to the introduction of our next
generation ArrayCheckerTM 3500 system. This delay had
a significant impact on the timing of both our revenue and net
income for the second quarter of fiscal 2003.

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



| |   |                                                                                                     
| | - | ----------------------------------------------------------------------------------------------------
| |  | the timing of the receipt of orders from major
    customers;                                       
|
| |  | our product mix;                                                                                    
|
| |  | competitive pricing pressures;                                                                      
|
| |  | our ability to obtain components from our single
    or limited source suppliers in a timely manner;
|
| |  | global economic uncertainty;                                                                        

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| |   |                                                                                                                                                               
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | changing international economic conditions;                                                                                                                   
|
| |  | 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.                                                                                                      

Our operating results also could be affected by
sudden changes in customer requirements, currency exchange rate
fluctuations and other economic conditions affecting customer
demand and the cost of operations in the global markets in which
we do business. As a result of these or other factors, our
operating results could be significantly and adversely affected
and our stock price could decline. In addition, it is possible
that in some future quarter our operating results may be below
the expectations of public market analysts and investors, which
could cause our stock price to fall.



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

We believe that future orders of our products
will depend in part on our ability to satisfy the performance,
reliability and quality standards required by our customers.
Particularly as customers seek increased yields, greater
throughput and higher quality end products we must continually
redesign our products to meet the needs of our customers. As
with the introduction of any new product, our customers may
experience yield loss. For example, with our
ArraySaverTM 650, ArrayCheckerTM 3628 and
ArrayCheckerTM 3500, certain customers experienced
yield loss higher than expected when the products were first
introduced. If our products have performance, reliability or
quality problems, then we may experience:



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

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

In addition, we typically provide a limited
warranty on our products for a period of one year from final
acceptance by customers. Warranty claim expense may, at times,
exceed the estimated cost of warranty coverage we record in our
warranty provision. For example, in our fourth quarter of fiscal
2004, we incurred higher warranty costs and recorded incremental
warranty provisions to cover certain identified quality
problems. In the future, we may incur substantial warranty claim
expenses on our products and actual warranty claims may exceed
recorded allowances, resulting in harm to our business.



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

Our business depends in large part on capital
expenditures by manufacturers of flat panel display products,
which in turn depends on the current and anticipated market
demand for the end products in that industry. The market for
flat panel display products is highly cyclical and has
experienced periods of oversupply resulting in significantly
reduced demand for capital equipment. For example, the flat
panel display industry experienced a downturn in 1998, which led
many flat panel display manufacturers to delay or cancel capital
expenditures. Additionally, in 2001, due to the general
deteriorating economic environment, flat panel display
manufacturers reduced capital expenditures resulting in a
decrease in our revenue. In fiscal 2004, we saw AMLCD product
supply exceed demand. Though this oversupply has been moderated
given the panel

35



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price decreases, it has resulted in a slowdown in
capacity increases, with flat panel display manufacturers
pressing forward with carefully considered new capacity
investments.


If the flat panel display markets in which we
sell our products experience further slowdowns in the future, it
could cause our revenue to decrease significantly. We do not
control the timing or volume of orders placed by our customers.
Whether and to what extent our customers place orders for any
specific products, as well as the mix and quantities of products
included in those orders, are factors beyond our control.
Insufficient orders, especially in a down cycle, will result in
under-utilization of our manufacturing facilities and
infrastructure and will negatively affect our operating results
and financial condition. In addition, the need to invest in the
engineering, research and development, and marketing required to
penetrate targeted foreign markets and maintain extensive
service and support capabilities limits our ability to reduce
expenses during these downturns.



| |                                                                                                                                                                                
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We depend on sales to a few large customers
    in the flat panel display industry, and if we lose any of our
    large customers our revenue could decrease
    significantly.

The flat panel display industry is extremely
concentrated with a small number of manufacturers producing the
majority of the worlds flat panel displays. If one or more
of our major customers ceased or significantly curtailed their
purchases, our revenue could drop significantly. We may be
unable to replace sales to these customers. Sales to our greater
than 10% customers in the last three fiscal years is as follows:
top four customers accounted for 73% of our revenues in fiscal
2004; top three customers accounted for 79% of our revenues in
fiscal 2003; and top two customers accounted for 61% of our
revenues in fiscal 2002.



| |                                                                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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.

All of our revenue is expected to come from a
limited range of products for the flat panel display industry.
As a result, we are solely reliant on the flat panel display
industry. Any decline in demand for, or failure to achieve
continued market acceptance of, our primary products or any new
version of these products could harm our business. Continued
market acceptance of our array test, array repair and cell and
module inspection products is critical to our success.



| |                                                                                                                                                                                               
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We may not be able to develop and introduce
    new products that respond to evolving industry requirements in a
    timely manner, which could reduce our ability to compete
    effectively.

The markets for our products are characterized by
rapidly changing technologies and frequent new product
introductions. The failure to develop new products and introduce
them successfully and in a timely manner could harm our
competitive position and results of operations. We believe that
our future success will depend in part upon our ability to
continue to enhance our existing products and to develop and
manufacture new products. For example, the size of glass plates
for flat panel displays and the resolution of flat panel
displays have changed frequently and may continue to change,
requiring us to redesign or reconfigure our flat panel display
products.

We expect to continue to incur significant
research and development costs. There can be no assurance that
we will be successful in the introduction, marketing and cost
effective manufacture of any of our new products, that we will
be able to timely develop and introduce new products and enhance
our existing products and processes to satisfy customer needs or
achieve market acceptance, or that the new markets for which we
are developing new products or expect to sell current products
will develop sufficiently. For example, we experienced technical
delays relating to the introduction of our
ArrayCheckerTM 3500 system causing us to reschedule
several shipments from the first quarter to the second quarter
of fiscal 2003. The initial shipments of the Generation 7
ArrayCheckerTM and ArraySaverTM systems
were shipped later than the customers requested delivery dates.

In addition, we depend on close relationships
with our customers and the willingness of those customers to
share information with us, and the failure to maintain these
relationships could harm our product development efforts.

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| |                                                                                                                                                                                                                                               
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If we are not able to obtain critical
    components from our single or limited source suppliers, we may
    experience significant delays in producing our products, which
    could decrease our revenue for an extended period of
    time.

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



| |                                                                                                                                                                                 
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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.

We expect sales to customers in foreign countries
to continue to represent 100% of our revenue in the foreseeable
future. A number of factors may adversely affect our
international sales and operations, including:



| |   |                                                                                         
| | - | ----------------------------------------------------------------------------------------
| |  | political instability and the possibility of
    hostilities, terrorist attacks, or war;
|
| |  | imposition of governmental controls;                                                    
|
| |  | 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;                                              
|
| |  | changes in tariffs; and                                                                 
|
| |  | difficulties in staffing and managing
    international operations.                     

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



| |                                                                               
| | ------------------------------------------------------------------------------
| | Compliance with Internal Controls
    Evaluations and Attestation Requirements

Pursuant to Section 404 of the
Sarbanes-Oxley Act of 2002, we will be required, beginning with
our Annual Report on Form 10-K for our fiscal year 2005, to
perform an evaluation of our internal control over financial
reporting and have our auditor publicly attest to such
evaluation. We have prepared an internal plan of action for
compliance, which includes a timeline and scheduled activities,
although as of the date of this filing we have not yet prepared
the evaluation. Compliance with these requirements is expected
to be expensive and time-consuming. If we fail to timely
complete this evaluation, or if our registered independent
accounting firm cannot timely attest to our evaluation, we could
be subject to regulatory scrutiny and a loss of public
confidence in our internal control over financial reporting. In
addition, any failure to implement required new or improved
controls, or difficulties encountered in their implementation,
could harm our operating results or cause us to fail to meet our
reporting obligation.



| |                                                                                                                                                                                                    
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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.

In addition to our efforts to develop new
technologies from internal sources, we also may seek to acquire
new technologies from external sources. For example, in August
2004 we acquired all of the assets relating to the design and
manufacture of pellicle products used in our modulators from
Tucson Optical Research Corporation. In June 2004, we acquired
from Quantum Composers, Inc. all of the assets related to the
design

37



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and manufacture of laser assembly products for
our repair systems. In May, 2003, we acquired all of the assets
of Summit Imaging related to the design and manufacture of
cooled cameras. All three of these acquisitions were
to purchase technology that we use in our products, so that we
are not dependent on independent suppliers to provide the
technology and related components. In the future, we may make
additional acquisitions of, or significant investments in,
businesses with complementary products, services and/or
technologies. Integrating businesses can be a complex,
time-consuming and expensive process. If we are not able to do
so effectively, we will not be able to realize the benefits that
we expect to receive from either our past or future
acquisitions. For each acquisition, we must integrate separate
technologies, product lines, business cultures and practices,
employees and systems. Acquisitions are subject to numerous
risks, including:




| |   |                                                                                                  
| | - | -------------------------------------------------------------------------------------------------
| |  | 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.                                                

Any of these difficulties could increase our
operating costs or result in impairment of purchased assets,
which could harm our financial performance.

In addition, we may also elect to change our
strategic direction and may no longer have need for the acquired
businesses or technologies. For example, in 2004, we determined
to not pursue new business for RTP Systems acquired from Intevac
Corporation in November 2002. In 2003, we exited the printed
circuit board assembly inspection and high quality glass
inspection businesses. As a result, some or all of the
technologies acquired in connection with certain of our prior
acquisitions, including Advanced Research Technologies Inc.,
Intelligent Reasoning Systems, Inc. and Image Processing
Systems, Inc. have been abandoned. In the third quarter of
fiscal 2004, we sold all of our assets related to our TFT-LCD
Backlight Inverter business. Future acquisitions may also result
in potentially dilutive issuances of equity securities,
incurrence of debt and contingent liabilities and amortization
expenses related to acquired intangible assets, which could harm
our profitability.



| |                                                                                                                                                                                                                                            
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Any failure of, or other problems at or
    with 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.

We use a wide range of materials in the
production of our products, including custom electronic and
mechanical components, and we use numerous suppliers to supply
these materials. If any third party that we use to manufacture
our products is unable to satisfy our quality requirements or
provide us with the products and services in a timely manner,
our shipments of these products may be delayed, our customer
relationships may be harmed and our results of operations may be
adversely impacted. There can be no assurance that our
relationship with any third party that we use to manufacture our
products will result in a reduction of our expenses or enable us
to satisfy our customers quality requirements or to
deliver our products to our customers in a timely manner.



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

The markets for yield management systems in the
flat panel display industry are highly competitive. We face
substantial competition from established competitors that have
greater financial, engineering and

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




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

While our technology is applicable to other flat
panel display technologies, our experience has been focused on
applications for active matrix liquid crystal displays, the most
prevalent and one of the highest performance flat panel displays
available today. We derive 100% of our revenue from flat panel
display products, substantially all of which were based on the
active matrix liquid crystal display technology. An industry
shift away from active matrix liquid crystal display technology
to existing or new competing technologies could reduce the
demand for our existing products and require significant
expenditures to develop new products, each of which could harm
our business.



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

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

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



| |                                                                                                                                                                                                         
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Litigation may be necessary to enforce or
    defend against claims of intellectual property infringement,
    which could be expensive and, if we lose, could prevent us from
    selling our products.

Litigation may be necessary in the future to
enforce our patents and other intellectual property rights, to
protect our trade secrets or to determine the validity and scope
of the proprietary rights of others. Any litigation, regardless
of the outcome, could be costly and require significant time and
attention of key members of our management and technical
personnel.

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

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to be licensed from third parties or require us
to cease selling our products. Even successful defenses of
patent suits can be costly and time-consuming.




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

Our future success depends in part on our ability
to retain key personnel, particularly senior management and
engineers. We also need to attract additional skilled personnel
in significant areas of our business to grow. There can be no
assurance that we will be able to retain our existing personnel
or attract additional qualified employees in the future. We
generally do not have employment contracts with our employees
and do not maintain key person life insurance on any of our
employees.



| |                                                                                            
| | -------------------------------------------------------------------------------------------
| | Terrorism and international political
    instability may negatively affect our operations.

The threat of terrorism targeted at the regions
of the world in which we do business increases the uncertainty
in our markets and may delay any recovery in the general
economy, which could threaten our business.

Increased international political instability,
particularly resulting from the threat of terrorist attacks, and
further enhanced security measures as a result of the threat of
terrorist attacks may hinder our ability to do business and may
increase our costs of operations. Such continuing instability
could cause us to incur increased costs in transportation, make
such transportation unreliable, increase our insurance costs and
cause international markets to fluctuate. This instability could
have the same effects on our suppliers and their ability to
timely deliver their products to us. If this international
political instability continues or increases, our business and
results of operations could be harmed.



| |                                                                                                                                                                                          
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The outbreak of severe acute respiratory
    syndrome, or other infectious diseases, may impact our
    operations or adversely affect our customers and therefore harm
    our business.

Our ability to address normal business
transaction issues in Asia may still be at risk due to the
potential reoccurrence of a Severe Acute Respiratory Syndrome
(SARS) outbreak or outbreaks of other infectious diseases.
Risks related to an outbreak include but are not limited to
temporary closure of operating facilities in affected locations,
travel restrictions and delays, difficulties generating new
business opportunities and increased political and social
tension. Especially if any of our employees, or any of the
employees of our customers, become infected with SARS or another
outbreak of infectious disease, we may experience reduced sales
and increased costs and our operating results may be harmed.



| |                                                                                      
| | -------------------------------------------------------------------------------------
| | Our manufacturing facilities may be subject
    to disruption from natural disasters.

Operations at our manufacturing facilities are
subject to disruption for a variety of reasons, including work
stoppages, acts of war, terrorism, fire, earthquake, energy
shortages, flooding or other natural disasters. Our corporate
and manufacturing facilities in California are located near
major earthquake faults which have experienced earthquakes in
the past. Such disruption could cause delays in shipments of
products to our customers. We cannot ensure that alternate
production capacity would be available if a major disruption
were to occur or that, if it were available, it could be
obtained on favorable terms. Such disruption could result in
cancellation of orders or loss of customers and could seriously
harm our business. It could also significantly delay our
research and engineering efforts for the development of new
products, most of which is conducted at our California
facilities.

In addition, some of our customers in Asia are
located near fault lines. A major earthquake in Asia could
disrupt our operations or the operations of our customers, which
could reduce demand for our products.

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| |                                                 
| | ------------------------------------------------
| | Our stock price may fluctuate
    significantly.

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



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

In addition, the stock market has in recent years
experienced significant price fluctuations. These fluctuations
often have been unrelated to the operating performance of the
specific companies whose stock is traded. Broad market
fluctuations, general economic condition and specific conditions
in the flat panel display industry may adversely affect the
market price of our common stock.



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

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



| |                                                
| | -----------------------------------------------
| | We do not anticipate paying cash
    dividends.

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



| |                                                                      
| | ---------------------------------------------------------------------
| | Future changes in accounting and taxation
    standards or practices.

A change in accounting standards or practices or
a change in existing taxation rules or practices can have a
significant effect on our reported results and may even affect
our reporting of transactions completed before the change is
effective. New accounting pronouncements and taxation rules and
varying interpretations of accounting pronouncements and
taxation practice have occurred and may occur in the future.
Changes to existing rules or the questioning of current
practices may adversely affect our reported financial results or
the way we conduct our business.

For example, any changes requiring that we record
compensation expense in the statements of operations for
employee stock options using the fair value method or changes in
existing taxation rules related to stock options could have a
significant negative effect on our reported results. Several
agencies and entities are considering, and the FASB has
announced, proposals to change generally accepted accounting
principles in the United States that, if implemented, would
require us to record charges to earnings for employee stock
option grants. This pending requirement would negatively impact
our earnings.



| |                                                                                                                                               
| | ----------------------------------------------------------------------------------------------------------------------------------------------
| | Recent and proposed regulations related to
    equity compensation could adversely affect our ability to
    attract and retain key personnel.

Since our inception, we have used stock options
and other long-term equity incentives as a fundamental component
of our employee compensation packages. We believe that stock
options and other long-term equity incentives directly motivate
our employees to maximize long-term stockholder value and,
through the use of

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vesting, encourage employees to remain with
Photon Dynamics. The Financial Accounting Standards Board
(FASB) has proposed changes to U.S. GAAP that, if
implemented, would require us to record a charge to earnings for
employee stock option grants. This pending accounting standard
would negatively impact our earnings. For example, recording a
charge for employee stock options under SFAS 123,
Accounting for Stock-Based Compensation would have
increased net loss by $6.9 million, $3.6 million and
$7.9 million for fiscal 2004, 2003 and 2002, respectively.
See Note 1 to the Notes to Consolidated Financial
Statements  Summary of Significant Accounting
Policies  Stock-Based Compensation Plans. In
addition, new regulations implemented by The Nasdaq National
Market requiring shareholder approval for all stock option
plans, as well as new regulations implemented by the New York
Stock Exchange prohibiting NYSE member organizations from giving
a proxy to vote on equity-compensation plans unless the
beneficial owner of the shares has given voting instructions,
could make it more difficult for us to grant options to
employees in the future. To the extent that new regulations make
it more difficult or expensive to grant stock options to
employees, we may incur increased compensation costs, change our
equity compensation strategy or find it difficult to attract,
retain and motivate employees, each of which could materially
and adversely affect our business.


Effective Transactions with Related and
Certain Other Parties

A full recourse loan of $250,000 plus accrued
interest of approximately $45,000 was outstanding at
September 30, 2003, from one of our former officers. The
loan, secured by shares of our stock held by the individual, was
repaid in full in fiscal 2004. There were no loans due from any
other of our employees as of September 30, 2004.

During fiscal 2004 and 2003, we paid $138,000 and
$18,000, respectively, to one board member for consulting
services rendered to us. During fiscal 2004 and 2003, we
recorded approximately $206,000 and $190,000, respectively, in
stock ownership expense related to options granted to this
consultant.






|         |                                                               
|-------- | --------------------------------------------------------------
|Item 7A. | Quantitative and Qualitative Disclosures
    about Market Risk

Foreign Currency Exchange Rate Risk

We are exposed to changes in foreign currency
exchange rates primarily related to the operating results of our
foreign affiliates. Actual changes in foreign exchange rates
could adversely affect our operating results or financial
condition. The potential impact depends upon the magnitude of
the rate change. We believe our exposure to changes in foreign
currency exchange rates for our cash, accounts receivable and
accounts payable is limited as substantially all of our cash,
accounts receivable and accounts payable are denominated in
U.S. dollars. In fiscal 2004, approximately
$4.4 million of our sales were made in currencies other
than U.S. dollars.

We did not have any outstanding forward sales
contracts at September 30, 2004. As of September 30,
2003, we had forward exchange contracts outstanding to sell
approximately $2.8 million in foreign currency in order to
hedge certain anticipated foreign currency denominated
transactions that occurred in fiscal 2004. None of these
contracts were held for trading purposes. Detail of these
securities is included in Note 7 of our Notes to
Consolidated Financial Statements included under
Part II, Item 8. Financial Statements and
Supplemental Data. Gains and losses on these contracts had
been recognized in income at September 30, 2003. Net gains
from changes in fair values in fiscal 2004 were approximately
$208,000. Net losses from changes in fair values in fiscal 2003
were approximately $208,000.

Our forward exchange contracts were subject to
exchange rate risk and would fluctuate with the changes in
exchange rates. A hypothetical 10% immediate and uniform adverse
move in all currency exchange rates affecting the contracts from
the rates at September 30, 2003 would have decreased the
fair value of the contracts by approximately $341,000.

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Market Risk

The primary objective of our investment
activities is to preserve principal while maximizing the income
we receive from our investments without significantly increasing
risk. Some of the securities that we may invest in may be
subject to market risk. To minimize this risk, we maintain our
portfolio of cash equivalents and short-term investments in a
variety of securities, including commercial paper, money market
funds, government and non-government debt securities and
certificates of deposit.

Our exposure to market risk relates primarily to
interest rate fluctuations in connection with our cash and cash
equivalents and short-term investment portfolios. We enter into
financial instruments for non-trading purposes and do not have
derivative financial instruments in our portfolio. The following
table presents principal amounts and related weighted average
interest rates by year of maturity for our short-term investment
portfolio, substantially all of which is held in
U.S. dollars:

|                                       |  |                        |        |      |  |      |        |      |  |      |   |       |  |            |   |  |  |  |   |  |  |   |        |  |  |   |        | 
|-------------------------------------- |  | ---------------------- | ------ | ---- |  | ---- | ------ | ---- |  | ---- | - | ----- |  | ---------- | - |  |  |  | - |  |  | - | ------ |  |  | - | ------ | 
|September 30, 2004                     |  | 2005                   |        | 2006 |  | 2007 |        | 2008 |  | 2009 |   | Total |  | Fair Value
|                                       |  |                        |        |      |  |      |        |      |  |      |   |       |  |           
|                                       |  |                       
|                                       |  | (Dollars in thousands)
|Cash equivalents (variable rate)       |  | $                      | 25,483 |      |  |      |       |      |  |      |  |       |  |            |  |  |  |  |  |  |  | $ | 25,483 |  |  | $ | 25,483 | 
|Average interest rate                  |  |                        | 0.65   | %    |  |      |        |      |  |      |   |       |  |            |   |  |  |  |   |  |  |   |        |  |  |   |        | 
|Short-term investments (variable rate) |  | $                      | 24,370 |      |  |      |       |      |  |      |  |       |  |            |  |  |  |  |  |  |  | $ | 24,370 |  |  | $ | 24,370 | 
|Average interest rate                  |  |                        | 1.86   | %    |  |      |        |      |  |      |   |       |  |            |   |  |  |  |   |  |  |   |        |  |  |   |        | 
|Short-term investments (fixed rate)    |  | $                      |       |      |  | $    | 34,488 |      |  |      |  |       |  |            |  |  |  |  |  |  |  | $ | 34,488 |  |  | $ | 34,302 | 
|Average interest rate                  |  |                        |        |      |  |      | 3.42   | %    |  |      |   |       |  |            |   |  |  |  |   |  |  |   |        |  |  |   |        | 

|                                       |  |                        |        |      |  |      |        |      |  |      |   |       |  |            |   |  |  |  |   |  |  |   |        |  |  |   |        | 
|-------------------------------------- |  | ---------------------- | ------ | ---- |  | ---- | ------ | ---- |  | ---- | - | ----- |  | ---------- | - |  |  |  | - |  |  | - | ------ |  |  | - | ------ | 
|September 30, 2003                     |  | 2004                   |        | 2005 |  | 2006 |        | 2007 |  | 2008 |   | Total |  | Fair Value
|                                       |  |                        |        |      |  |      |        |      |  |      |   |       |  |           
|                                       |  |                       
|                                       |  | (Dollars in thousands)
|Cash equivalents (variable rate)       |  | $                      | 18,305 |      |  |      |       |      |  |      |  |       |  |            |  |  |  |  |  |  |  | $ | 18,305 |  |  | $ | 18,305 | 
|Average interest rate                  |  |                        | 0.63   | %    |  |      |        |      |  |      |   |       |  |            |   |  |  |  |   |  |  |   |        |  |  |   |        | 
|Short-term investments (variable rate) |  | $                      | 53,750 |      |  |      |       |      |  |      |  |       |  |            |  |  |  |  |  |  |  | $ | 53,750 |  |  | $ | 53,750 | 
|Average interest rate                  |  |                        | 1.17   | %    |  |      |        |      |  |      |   |       |  |            |   |  |  |  |   |  |  |   |        |  |  |   |        | 
|Short-term investments (fixed rate)    |  | $                      |       |      |  | $    | 44,224 |      |  |      |  |       |  |            |  |  |  |  |  |  |  | $ | 44,224 |  |  | $ | 44,414 | 
|Average interest rate                  |  |                        |        |      |  |      | 2.63   | %    |  |      |   |       |  |            |   |  |  |  |   |  |  |   |        |  |  |   |        | 

These securities, as with all fixed income
instruments, are subject to interest rate risk and will fall in
value if market interest rates increase.

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|        |                                                
|------- | -----------------------------------------------
|Item 8. | Financial Statements and Supplementary
    Data

Index to Consolidated Financial
Statements

|                                                                               |  |      |    | 
|------------------------------------------------------------------------------ |  | ---- | -- | 
|Description                                                                    |  | Page
|                                                                               |  |     
|Report of Ernst & Young LLP, Independent
    Registered Public Accounting Firm |  |      | 45 | 
|Consolidated Balance Sheets                                                    |  |      | 46 | 
|Consolidated Statements of Operations                                          |  |      | 47 | 
|Consolidated Statements of Shareholders
    Equity                            |  |      | 48 | 
|Consolidated Statements of Cash Flows                                          |  |      | 49 | 
|Notes to Consolidated Financial Statements                                     |  |      | 51 | 

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REPORT OF ERNST & YOUNG
LLP,

INDEPENDENT REGISTERED PUBLIC ACCOUNTING
FIRM


The Board of Directors and Shareholders

Photon Dynamics, Inc.


We have audited the accompanying consolidated
balance sheets of Photon Dynamics, Inc. as of September 30,
2004 and 2003, and the related consolidated statements of
operations, shareholders equity, and cash flows for each
of the three years in the period ended September 30, 2004.
Our audits also included the financial statement schedule listed
in the index at Item 15(a)(2). These financial statements
and schedule are the responsibility of the management of Photon
Dynamics, Inc. Our responsibility is to express an opinion on
these financial statements and schedule based on our audits.

We conducted our audits in accordance with the
standards of the Public Company Accounting Oversight Board
(United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating
the overall financial statement presentation. We believe that
our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred
to above present fairly, in all material respects, the
consolidated financial position of Photon Dynamics, Inc. as of
September 30, 2004 and 2003, and the consolidated results
of its operations and its cash flows for each of the three years
in the period ended September 30, 2004, in conformity with
U.S. generally accepted accounting principles. Also, in our
opinion, the related financial statement schedule, when
considered in relation to the basic financial statements taken
as a whole, presents fairly in all material respects the
information set forth therein.



| |                      
| | ---------------------
| | /s/ ERNST & YOUNG LLP

Palo Alto, California

October 24, 2004


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PHOTON DYNAMICS, INC.

CONSOLIDATED BALANCE SHEETS

|                                         |                                                                                                                                                                                |                                            |        |          |         |  |        |          |         | 
|---------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ------------------------------------------ | ------ | -------- | ------- |  | ------ | -------- | ------- | 
|                                         |                                                                                                                                                                                |                                           
|                                         |                                                                                                                                                                                | September 30,                             
|                                         |                                                                                                                                                                                |                                           
|                                         |                                                                                                                                                                                | 2004                                       |        | 2003    
|                                         |                                                                                                                                                                                |                                            |        |         
|                                         |                                                                                                                                                                                |                                           
|                                         |                                                                                                                                                                                | (In thousands except                      
|                                         |                                                                                                                                                                                | share data)                               
|ASSETS                                  
|Current assets:                          |                                                                                                                                                                                |                                            |        |          |         |  |        |         
|                                         | Cash and cash equivalents                                                                                                                                                      |                                            | $      | 25,483   |         |  | $      | 18,305   |        
|                                         | Short-term investments                                                                                                                                                         |                                            |        | 58,672   |         |  |        | 98,164   |        
|                                         | Accounts receivable, net                                                                                                                                                       |                                            |        | 58,341   |         |  |        | 10,402   |        
|                                         | Inventories                                                                                                                                                                    |                                            |        | 31,716   |         |  |        | 9,887    |        
|                                         | Other current assets                                                                                                                                                           |                                            |        | 4,536    |         |  |        | 6,449    |        
|                                         |                                                                                                                                                                                |                                            |        |          |         |  |        |         
|                                         |                                                                                                                                                                                | Total current assets                       |        |          | 178,748 |  |        |          | 143,207 | 
|Land, property and equipment, net        |                                                                                                                                                                                |                                            | 20,337 |          |         |  | 12,298 |         
|Other assets                             |                                                                                                                                                                                |                                            | 3,909  |          |         |  | 3,002  |         
|Intangible assets, net                   |                                                                                                                                                                                |                                            | 4,753  |          |         |  | 2,894  |         
|Goodwill                                 |                                                                                                                                                                                |                                            | 153    |          |         |  | 518    |         
|                                         |                                                                                                                                                                                |                                            |        |          |         |  |        |         
|                                         |                                                                                                                                                                                | Total assets                               |        | $        | 207,900 |  |        | $        | 161,919 | 
|                                         |                                                                                                                                                                                |                                            |        |          |         |  |        |         
|                                        
|LIABILITIES AND SHAREHOLDERS
    EQUITY
|Current liabilities:                     |                                                                                                                                                                                |                                            |        |          |         |  |        |         
|                                         | Accounts payable                                                                                                                                                               |                                            | $      | 18,485   |         |  | $      | 4,239    |        
|                                         | Warranty                                                                                                                                                                       |                                            |        | 6,194    |         |  |        | 2,363    |        
|                                         | Employee notes payable                                                                                                                                                         |                                            |        | 667      |         |  |        |         |        
|                                         | Other current liabilities                                                                                                                                                      |                                            |        | 9,593    |         |  |        | 8,242    |        
|                                         | Deferred gross margin                                                                                                                                                          |                                            |        | 10,104   |         |  |        | 2,739    |        
|                                         |                                                                                                                                                                                |                                            |        |          |         |  |        |         
|                                         |                                                                                                                                                                                | Total current liabilities                  |        |          | 45,043  |  |        |          | 17,583  | 
|Other liabilities                        |                                                                                                                                                                                |                                            | 1,528  |          |         |  | 193    |         
|Commitments and contingencies            |                                                                                                                                                                                |                                            |        |          |         |  |        |         
|Shareholders equity:                    |                                                                                                                                                                                |                                            |        |          |         |  |        |         
|                                         | Preferred stock, no par value,
    5,000,000 shares authorized, none outstanding, as of
    September 30, 2004 and 2003, respectively                                          |                                            |        |         |         |  |        |         |        
|                                         | Common stock, no par value,
    30,000,000 shares authorized, 16,859,084 and
    16,389,727 shares issued and outstanding, as of
    September 30, 2004 and 2003, respectively |                                            |        | 285,790  |         |  |        | 279,417  |        
|                                         | Accumulated deficit                                                                                                                                                            |                                            |        | (124,808 | )       |  |        | (135,872 | )      
|                                         | Accumulated other comprehensive income                                                                                                                                         |                                            |        | 347      |         |  |        | 598      |        
|                                         |                                                                                                                                                                                |                                            |        |          |         |  |        |         
|                                         |                                                                                                                                                                                | Total shareholders equity                 |        |          | 161,329 |  |        |          | 144,143 | 
|                                         |                                                                                                                                                                                |                                            |        |          |         |  |        |         
|                                         |                                                                                                                                                                                | Total liabilities and shareholders equity |        | $        | 207,900 |  |        | $        | 161,919 | 
|                                         |                                                                                                                                                                                |                                            |        |          |         |  |        |         

See accompanying notes to consolidated financial
statements.

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PHOTON DYNAMICS, INC.

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                                                                             |                                              |                                       |         |        |        |      |         |        |         |   |         |        |         |  
|-------------------------------------------------------------------------------------------- | -------------------------------------------- | ------------------------------------- | ------- | ------ | ------ | ---- | ------- | ------ | ------- | - | ------- | ------ | ------- | -
|                                                                                             |                                              |                                      
|                                                                                             |                                              | Year Ended September 30,             
|                                                                                             |                                              |                                      
|                                                                                             |                                              | 2004                                  |         | 2003   |        | 2002
|                                                                                             |                                              |                                       |         |        |        |     
|                                                                                             |                                              |                                      
|                                                                                             |                                              | (In thousands, except per share data)
|Revenue                                                                                      |                                              | $                                     | 143,269 |        |        | $    | 67,196  |        |         | $ | 49,342  |       
|Cost of revenue                                                                              |                                              |                                       | 83,969  |        |        |      | 44,071  |        |         |   | 25,799  |       
|                                                                                             |                                              |                                       |         |        |        |      |         |        |         |   |         |       
|Gross margin                                                                                 |                                              |                                       | 59,300  |        |        |      | 23,125  |        |         |   | 23,543  |       
|Operating expenses:                                                                          |                                              |                                       |         |        |        |      |         |        |         |   |         |       
|                                                                                             | Research and development                     |                                       |         | 29,701 |        |      |         | 22,786 |         |   |         | 10,878 |        
|                                                                                             | Selling, general and administrative          |                                       |         | 17,780 |        |      |         | 13,763 |         |   |         | 8,853  |        
|                                                                                             | Goodwill impairment charge                   |                                       |         | 665    |        |      |         | 10,010 |         |   |         |       |        
|                                                                                             | Impairment of purchased intangibles          |                                       |         | 2,089  |        |      |         | 3,548  |         |   |         |       |        
|                                                                                             | Impairment of fixed assets                   |                                       |         | 234    |        |      |         |       |         |   |         |       |        
|                                                                                             | Gain on sale of fixed assets                 |                                       |         | (427   | )      |      |         |       |         |   |         |       |        
|                                                                                             | Acquired in-process research and development |                                       |         | 210    |        |      |         | 2,474  |         |   |         | 410    |        
|                                                                                             | Amortization of intangible assets            |                                       |         | 789    |        |      |         | 1,236  |         |   |         |       |        
|                                                                                             |                                              |                                       |         |        |        |      |         |        |         |   |         |       
|                                                                                             |                                              | Total operating expenses              |         |        | 51,041 |      |         |        | 53,817  |   |         |        | 20,141  |  
|Income (loss) from operations                                                                |                                              |                                       | 8,259   |        |        |      | (30,692 | )      |         |   | 3,402   |       
|Interest income and other, net                                                               |                                              |                                       | 4,802   |        |        |      | 2,968   |        |         |   | 2,913   |       
|                                                                                             |                                              |                                       |         |        |        |      |         |        |         |   |         |       
|Income (loss) from continuing operations before
    income taxes and discontinued operations |                                              |                                       | 13,061  |        |        |      | (27,724 | )      |         |   | 6,315   |       
|Provision for income taxes                                                                   |                                              |                                       | 606     |        |        |      | 56      |        |         |   | 85      |       
|                                                                                             |                                              |                                       |         |        |        |      |         |        |         |   |         |       
|Income (loss) from continuing operations before
    discontinued operations                  |                                              |                                       | 12,455  |        |        |      | (27,780 | )      |         |   | 6,230   |       
|Loss from discontinued operations                                                            |                                              |                                       | (1,391  | )      |        |      | (44,592 | )      |         |   | (28,032 | )     
|                                                                                             |                                              |                                       |         |        |        |      |         |        |         |   |         |       
|                                                                                             |                                              | Net income (loss)                     |         | $      | 11,064 |      |         | $      | (72,372 | ) |         | $      | (21,802 | )
|                                                                                             |                                              |                                       |         |        |        |      |         |        |         |   |         |       
|Income (loss) per share from continuing
    operations:                                      |                                              |                                       |         |        |        |      |         |        |         |   |         |       
|                                                                                             | Basic                                        |                                       | $       | 0.75   |        |      | $       | (1.73  | )       |   | $       | 0.39   |        
|                                                                                             |                                              |                                       |         |        |        |      |         |        |         |   |         |       
|                                                                                             | Diluted                                      |                                       | $       | 0.73   |        |      | $       | (1.73  | )       |   | $       | 0.37   |        
|                                                                                             |                                              |                                       |         |        |        |      |         |        |         |   |         |       
|Loss per share from discontinued operations:                                                 |                                              |                                       |         |        |        |      |         |        |         |   |         |       
|                                                                                             | Basic                                        |                                       | $       | (0.08  | )      |      | $       | (2.77  | )       |   | $       | (1.76  | )      
|                                                                                             |                                              |                                       |         |        |        |      |         |        |         |   |         |       
|                                                                                             | Diluted                                      |                                       | $       | (0.08  | )      |      | $       | (2.77  | )       |   | $       | (1.67  | )      
|                                                                                             |                                              |                                       |         |        |        |      |         |        |         |   |         |       
|Net income (loss) per share:                                                                 |                                              |                                       |         |        |        |      |         |        |         |   |         |       
|                                                                                             | Basic                                        |                                       | $       | 0.67   |        |      | $       | (4.50  | )       |   | $       | (1.37  | )      
|                                                                                             |                                              |                                       |         |        |        |      |         |        |         |   |         |       
|                                                                                             | Diluted                                      |                                       | $       | 0.65   |        |      | $       | (4.50  | )       |   | $       | (1.30  | )      
|                                                                                             |                                              |                                       |         |        |        |      |         |        |         |   |         |       
|Weighted average number of shares:                                                           |                                              |                                       |         |        |        |      |         |        |         |   |         |       
|                                                                                             | Basic                                        |                                       |         | 16,631 |        |      |         | 16,089 |         |   |         | 15,923 |        
|                                                                                             | Diluted                                      |                                       |         | 17,087 |        |      |         | 16,089 |         |   |         | 16,791 |        

See accompanying notes to consolidated financial
statements.

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PHOTON DYNAMICS, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS
EQUITY

|                                  |                                             |                            |        |             |   |               |         |         |   |       |          |         |   |   |     |      |   |   |         |         |         |  
|--------------------------------- | ------------------------------------------- | -------------------------- | ------ | ----------- | - | ------------- | ------- | ------- | - | ----- | -------- | ------- | - | - | --- | ---- | - | - | ------- | ------- | ------- | -
|                                  |                                             |                            |        |             |   |               |         |        
|                                  |                                             | Common Stock and           |        |             |   |               |         |        
|                                  |                                             | Capital in Excess of       |        |             |   | Accumulated   |         |        
|                                  |                                             | Par Value                  |        |             |   | Other         |         |        
|                                  |                                             |                            |        | Accumulated |   | Comprehensive |         |        
|                                  |                                             | Share                      |        | Amount      |   | Deficit       |         | Income  |   | Total
|                                  |                                             |                            |        |             |   |               |         |         |   |      
|                                  |                                             |                           
|                                  |                                             | (In thousands)            
|Balances at September 30, 2001    |                                             |                            | 13,885 |             |   | $             | 184,500 |         |   | $     | (41,698  | )       |   | $ | 506 |      |   | $ | 143,308 |        
|Components of comprehensive loss: |                                             |                            |        |             |   |               |         |         |   |       |          |         |   |   |     |      |   |   |         |        
|                                  | Net loss                                    |                            |        |            |   |               |         |        |   |       |          | (21,802 | ) |   |     |     |   |   |         | (21,802 | )      
|                                  | Change in unrealized gain on investments    |                            |        |            |   |               |         |        |   |       |          |        |   |   |     | 289  |   |   |         | 289     |        
|                                  | Currency translation adjustments            |                            |        |            |   |               |         |        |   |       |          |        |   |   |     | 15   |   |   |         | 15      |        
|                                  |                                             |                            |        |             |   |               |         |         |   |       |          |         |   |   |     |      |   |   |         |        
|                                  |                                             | Total comprehensive loss   |        |             |   |               |         |         |   |       |          |         |   |   |     |      |   |   |         |         | (21,498 | )
|                                  |                                             |                            |        |             |   |               |         |         |   |       |          |         |   |   |     |      |   |   |         |        
|                                  | Net issuance of common stock                |                            |        | 3,236       |   |               |         | 112,384 |   |       |          |        |   |   |     |     |   |   |         | 112,384 |        
|                                  | Repurchase of common stock, net             |                            |        | (351        | ) |               |         | (6,901  | ) |       |          |        |   |   |     |     |   |   |         | (6,901  | )      
|                                  | Cancellation of returned IRSI escrow shares |                            |        | (53         | ) |               |         | (1,425  | ) |       |          |        |   |   |     |     |   |   |         | (1,425  | )      
|                                  | Stock ownership expense                     |                            |        |            |   |               |         | 275     |   |       |          |        |   |   |     |     |   |   |         | 275     |        
|                                  |                                             |                            |        |             |   |               |         |         |   |       |          |         |   |   |     |      |   |   |         |        
|Balances at September 30, 2002    |                                             |                            | 16,717 |             |   |               | 288,833 |         |   |       | (63,500  | )       |   |   | 810 |      |   |   | 226,143 |        
|Components of comprehensive loss: |                                             |                            |        |             |   |               |         |         |   |       |          |         |   |   |     |      |   |   |         |        
|                                  | Net loss                                    |                            |        |            |   |               |         |        |   |       |          | (72,372 | ) |   |     |     |   |   |         | (72,372 | )      
|                                  | Change in unrealized gain on investments    |                            |        |            |   |               |         |        |   |       |          |        |   |   |     | (206 | ) |   |         | (206    | )      
|                                  | Currency translation adjustments            |                            |        |            |   |               |         |        |   |       |          |        |   |   |     | (6   | ) |   |         | (6      | )      
|                                  |                                             |                            |        |             |   |               |         |         |   |       |          |         |   |   |     |      |   |   |         |        
|                                  |                                             | Total comprehensive loss   |        |             |   |               |         |         |   |       |          |         |   |   |     |      |   |   |         |         | (72,584 | )
|                                  |                                             |                            |        |             |   |               |         |         |   |       |          |         |   |   |     |      |   |   |         |        
|                                  | Net issuance of common stock                |                            |        | 576         |   |               |         | 7,898   |   |       |          |        |   |   |     |     |   |   |         | 7,898   |        
|                                  | Repurchase of common stock, net             |                            |        | (903        | ) |               |         | (17,678 | ) |       |          |        |   |   |     |     |   |   |         | (17,678 | )      
|                                  | Stock ownership expense                     |                            |        |            |   |               |         | 364     |   |       |          |        |   |   |     |     |   |   |         | 364     |        
|                                  |                                             |                            |        |             |   |               |         |         |   |       |          |         |   |   |     |      |   |   |         |        
|Balances at September 30, 2003    |                                             |                            | 16,390 |             |   |               | 279,417 |         |   |       | (135,872 | )       |   |   | 598 |      |   |   | 144,143 |        
|Components of comprehensive loss: |                                             |                            |        |             |   |               |         |         |   |       |          |         |   |   |     |      |   |   |         |        
|                                  | Net income                                  |                            |        |            |   |               |         |        |   |       |          | 11,064  |   |   |     |     |   |   |         | 11,064  |        
|                                  | Change in unrealized gain on investments    |                            |        |            |   |               |         |        |   |       |          |        |   |   |     | (377 | ) |   |         | (377    | )      
|                                  | Currency translation adjustments            |                            |        |            |   |               |         |        |   |       |          |        |   |   |     | 126  |   |   |         | 126     |        
|                                  |                                             |                            |        |             |   |               |         |         |   |       |          |         |   |   |     |      |   |   |         |        
|                                  |                                             | Total comprehensive income |        |             |   |               |         |         |   |       |          |         |   |   |     |      |   |   |         |         | 10,813  |  
|                                  |                                             |                            |        |             |   |               |         |         |   |       |          |         |   |   |     |      |   |   |         |        
|                                  | Net issuance of common stock                |                            |        | 469         |   |               |         | 6,167   |   |       |          |        |   |   |     |     |   |   |         | 6,167   |        
|                                  | Stock ownership expense                     |                            |        |            |   |               |         | 206     |   |       |          |        |   |   |     |     |   |   |         | 206     |        
|                                  |                                             |                            |        |             |   |               |         |         |   |       |          |         |   |   |     |      |   |   |         |        
|Balances at September 30, 2004    |                                             |                            | 16,859 |             |   | $             | 285,790 |         |   | $     | (124,808 | )       |   | $ | 347 |      |   | $ | 161,329 |        
|                                  |                                             |                            |        |             |   |               |         |         |   |       |          |         |   |   |     |      |   |   |         |        

See accompanying notes to consolidated financial
statements.

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##### Table of Contents






PHOTON DYNAMICS, INC.

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                      |                                                                                                                                                    |                                                          |                           |                                                                                    |       |         |         |          |        |        |         |          |       |        |         |  
|------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------- | ------------------------- | ---------------------------------------------------------------------------------- | ----- | ------- | ------- | -------- | ------ | ------ | ------- | -------- | ----- | ------ | ------- | -
|                                      |                                                                                                                                                    |                                                         
|                                      |                                                                                                                                                    | Year Ended September 30,                                
|                                      |                                                                                                                                                    |                                                         
|                                      |                                                                                                                                                    | 2004                                                     |                           | 2003                                                                               |       | 2002   
|                                      |                                                                                                                                                    |                                                          |                           |                                                                                    |       |        
|                                      |                                                                                                                                                    |                                                         
|                                      |                                                                                                                                                    | (In thousands)                                          
|Cash flows from operating activities: |                                                                                                                                                    |                                                          |                           |                                                                                    |       |         |         |          |        |        |         |         
|                                      | Net income (loss) from continuing operations                                                                                                       |                                                          | $                         | 12,455                                                                             |       |         | $       | (27,780  | )      |        | $       | 6,230    |      
|                                      | Adjustments to reconcile net income (loss) from
    continuing operations to net cash used in operating activities
    from continuing operations: |                                                          |                           |                                                                                    |       |         |         |          |        |        |         |          |      
|                                      |                                                                                                                                                    | Depreciation                                             |                           |                                                                                    | 2,898 |         |         |          | 3,119  |        |         |          | 2,058 |       
|                                      |                                                                                                                                                    | Amortization of intangible assets                        |                           |                                                                                    | 789   |         |         |          | 1,793  |        |         |          |      |       
|                                      |                                                                                                                                                    | Acquired in process research and development             |                           |                                                                                    | 210   |         |         |          | 2,474  |        |         |          | 410   |       
|                                      |                                                                                                                                                    | Impairment of goodwill                                   |                           |                                                                                    | 665   |         |         |          | 10,010 |        |         |          |      |       
|                                      |                                                                                                                                                    | Impairment of purchased intangibles and fixed
    assets |                           |                                                                                    | 2,323 |         |         |          | 3,548  |        |         |          |      |       
|                                      |                                                                                                                                                    | Loss on disposal of equipment                            |                           |                                                                                    |      |         |         |          | 211    |        |         |          | 709   |       
|                                      |                                                                                                                                                    | Stock ownership expense                                  |                           |                                                                                    | 206   |         |         |          | 364    |        |         |          | 275   |       
|                                      |                                                                                                                                                    | Gain on sale of fixed assets                             |                           |                                                                                    | (427  | )       |         |          |       |        |         |          |      |       
|                                      |                                                                                                                                                    | Accretion of non-interest bearing notes payable          |                           |                                                                                    | 17    |         |         |          |       |        |         |          |      |       
|                                      |                                                                                                                                                    | Changes in assets and liabilities:                       |                           |                                                                                    |       |         |         |          |        |        |         |          |       |       
|                                      |                                                                                                                                                    |                                                          | Accounts receivable       |                                                                                    |       | (48,074 | )       |          |        | (4     | )       |          |       | (3,603 | )      
|                                      |                                                                                                                                                    |                                                          | Inventories               |                                                                                    |       | (22,720 | )       |          |        | 993    |         |          |       | (1,762 | )      
|                                      |                                                                                                                                                    |                                                          | Other current assets      |                                                                                    |       | 1,553   |         |          |        | 1,498  |         |          |       | (4,598 | )      
|                                      |                                                                                                                                                    |                                                          | Related party receivable  |                                                                                    |       | 250     |         |          |        |       |         |          |       |       |        
|                                      |                                                                                                                                                    |                                                          | Other assets              |                                                                                    |       | (1,157  | )       |          |        | (166   | )       |          |       | (4,271 | )      
|                                      |                                                                                                                                                    |                                                          | Accounts payable          |                                                                                    |       | 14,448  |         |          |        | (4,167 | )       |          |       | 6,421  |        
|                                      |                                                                                                                                                    |                                                          | Other current liabilities |                                                                                    |       | 4,837   |         |          |        | (647   | )       |          |       | 1,883  |        
|                                      |                                                                                                                                                    |                                                          | Deferred gross margin     |                                                                                    |       | 7,365   |         |          |        | 2,717  |         |          |       | (1,477 | )      
|                                      |                                                                                                                                                    |                                                          | Other liabilities         |                                                                                    |       | (49     | )       |          |        | (684   | )       |          |       |       |        
|                                      |                                                                                                                                                    |                                                          |                           |                                                                                    |       |         |         |          |        |        |         |         
|                                      |                                                                                                                                                    |                                                          |                           | Net cash provided by (used in) operating
    activities from continuing operations |       |         | (24,411 | )        |        |        | (6,721  | )        |       |        | 2,275   |  
|                                      |                                                                                                                                                    |                                                          |                           | Net cash used in operating activities from
    discontinued operations             |       |         | (1,434  | )        |        |        | (12,635 | )        |       |        | (11,703 | )
|                                      |                                                                                                                                                    |                                                          |                           |                                                                                    |       |         |         |          |        |        |         |         
|                                      |                                                                                                                                                    |                                                          |                           | Net cash used in operating activities                                              |       |         | (25,845 | )        |        |        | (19,356 | )        |       |        | (9,428  | )
|                                      |                                                                                                                                                    |                                                          |                           |                                                                                    |       |         |         |          |        |        |         |         
|Cash flows from investing activities: |                                                                                                                                                    |                                                          |                           |                                                                                    |       |         |         |          |        |        |         |         
|                                      | Purchase of property and equipment                                                                                                                 |                                                          |                           | (9,803                                                                             | )     |         |         | (2,547   | )      |        |         | (2,099   | )    
|                                      | Proceeds from sale of fixed assets                                                                                                                 |                                                          |                           | 481                                                                                |       |         |         |         |        |        |         |         |      
|                                      | Acquisition of Akcron Corporation
    Ltd.                                                                                                         |                                                          |                           |                                                                                   |       |         |         |         |        |        |         | (2,559   | )    
|                                      | Acquisition of Rapid Thermal Processing Division
    from Intevac, Inc.                                                                            |                                                          |                           | (300                                                                               | )     |         |         | (20,000  | )      |        |         |         |      
|                                      | Acquisition of Quantum Composers,
    Inc.                                                                                                         |                                                          |                           | (1,000                                                                             | )     |         |         |         |        |        |         |         |      
|                                      | Acquisition of Tucson Optical Research Corporation                                                                                                 |                                                          |                           | (625                                                                               | )     |         |         |         |        |        |         |         |      
|                                      | Acquisition of Summit Imaging, Inc.                                                                                                                |                                                          |                           |                                                                                   |       |         |         | (1,676   | )      |        |         |         |      
|                                      | Acquisition of certain intangible assets upon
    termination of a distributor agreement                                                           |                                                          |                           | (1,138                                                                             | )     |         |         |         |        |        |         |         |      
|                                      | Purchase of short-term investments                                                                                                                 |                                                          |                           | (420,296                                                                           | )     |         |         | (569,566 | )      |        |         | (662,097 | )    
|                                      | Redemption of short-term investments                                                                                                               |                                                          |                           | 459,411                                                                            |       |         |         | 615,759  |        |        |         | 583,739  |      
|                                      |                                                                                                                                                    |                                                          |                           |                                                                                    |       |         |         |          |        |        |         |         
|                                      |                                                                                                                                                    |                                                          |                           | Net cash provided by (used in) investing
    activities from continuing operations |       |         | 26,730  |          |        |        | 21,970  |          |       |        | (83,016 | )
|                                      |                                                                                                                                                    |                                                          |                           | Net cash used in investing activities from
    discontinued operations             |       |         |        |          |        |        | (92     | )        |       |        | (4,002  | )
|                                      |                                                                                                                                                    |                                                          |                           |                                                                                    |       |         |         |          |        |        |         |         
|                                      |                                                                                                                                                    |                                                          |                           | Net cash provided by (used in) investing
    activities                            |       |         | 26,730  |          |        |        | 21,878  |          |       |        | (87,018 | )
|                                      |                                                                                                                                                    |                                                          |                           |                                                                                    |       |         |         |          |        |        |         |         

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##### Table of Contents



PHOTON DYNAMICS, INC.


CONSOLIDATED STATEMENTS OF CASH
FLOWS  (Continued)

|                                                                           |                                                                                                                                                |                                                                                    |        |       |       |      |         |         |        |   |         |         |         | 
|-------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------- | ------ | ----- | ----- | ---- | ------- | ------- | ------ | - | ------- | ------- | ------- | 
|                                                                           |                                                                                                                                                |                                                                                   
|                                                                           |                                                                                                                                                | Year Ended September 30,                                                          
|                                                                           |                                                                                                                                                |                                                                                   
|                                                                           |                                                                                                                                                | 2004                                                                               |        | 2003  |       | 2002
|                                                                           |                                                                                                                                                |                                                                                    |        |       |       |     
|                                                                           |                                                                                                                                                |                                                                                   
|                                                                           |                                                                                                                                                | (In thousands)                                                                    
|Cash flows from financing activities:                                      |                                                                                                                                                |                                                                                    |        |       |       |      |         |         |        |   |         |        
|                                                                           | Issuance of common stock, net                                                                                                                  |                                                                                    |        | 6,167 |       |      |         | 7,898   |        |   |         | 112,384 |        
|                                                                           | Repurchase of common stock                                                                                                                     |                                                                                    |        |      |       |      |         | (17,678 | )      |   |         | (6,901  | )      
|                                                                           | Capital lease repayments                                                                                                                       |                                                                                    |        |      |       |      |         | (11     | )      |   |         |        |        
|                                                                           |                                                                                                                                                |                                                                                    |        |       |       |      |         |         |        |   |         |        
|                                                                           |                                                                                                                                                | Net cash provided by (used in) financing
    activities from continuing operations |        |       | 6,167 |      |         |         | (9,791 | ) |         |         | 105,483 | 
|                                                                           |                                                                                                                                                |                                                                                    |        |       |       |      |         |         |        |   |         |        
|Effect of exchange rate changes on cash and cash
    equivalents           |                                                                                                                                                |                                                                                    | 126    |       |       |      | (6      | )       |        |   | 15      |        
|                                                                           |                                                                                                                                                |                                                                                    |        |       |       |      |         |         |        |   |         |        
|Net increase in cash and cash equivalents from
    continuing operations   |                                                                                                                                                |                                                                                    | 8,612  |       |       |      | 5,452   |         |        |   | 24,757  |        
|Net decrease in cash and cash equivalents from
    discontinued operations |                                                                                                                                                |                                                                                    | (1,434 | )     |       |      | (12,727 | )       |        |   | (15,705 | )      
|                                                                           |                                                                                                                                                |                                                                                    |        |       |       |      |         |         |        |   |         |        
|Net increase (decrease) in cash and cash
    equivalents                   |                                                                                                                                                |                                                                                    | 7,178  |       |       |      | (7,275  | )       |        |   | 9,052   |        
|Cash and cash equivalents at beginning of year                             |                                                                                                                                                |                                                                                    | 18,305 |       |       |      | 25,580  |         |        |   | 16,528  |        
|                                                                           |                                                                                                                                                |                                                                                    |        |       |       |      |         |         |        |   |         |        
|Cash and cash equivalents at end of year                                   |                                                                                                                                                | $                                                                                  | 25,483 |       |       | $    | 18,305  |         |        | $ | 25,580  |        
|                                                                           |                                                                                                                                                |                                                                                    |        |       |       |      |         |         |        |   |         |        
|Supplemental cash flow disclosures:                                        |                                                                                                                                                |                                                                                    |        |       |       |      |         |         |        |   |         |        
|                                                                           | Income taxes paid                                                                                                                              |                                                                                    | $      | 59    |       |      | $       | 69      |        |   | $       | 101     |        
|                                                                           | Interest paid                                                                                                                                  |                                                                                    |        | 6     |       |      |         | 21      |        |   |         | 10      |        
|Supplemental non-cash financing and investing
    activities disclosure:   |                                                                                                                                                |                                                                                    |        |       |       |      |         |         |        |   |         |        
|                                                                           | Assumed liabilities from acquisition of Infrared
    Screening and Inspection Solutions Division from Advanced
    Research Technologies, Inc. |                                                                                    |        |      |       |      |         |        |        |   |         | 260     |        
|                                                                           | Assumed liabilities from acquisition of Akcron
    Corporation Ltd.                                                                            |                                                                                    |        |      |       |      |         |        |        |   |         | 970     |        
|                                                                           | Cancellation of returned Intelligent Reasoning
    Systems, Inc. escrow shares                                                                 |                                                                                    |        |      |       |      |         |        |        |   |         | 1,425   |        
|                                                                           | Assumed liabilities from acquisition of Rapid
    Thermal Processing Division from Intevac, Inc. assets                                        |                                                                                    |        |      |       |      |         | 350     |        |   |         |        |        
|                                                                           | Assumed liabilities from acquisition of Summit
    Imaging, Inc. assets                                                                        |                                                                                    |        |      |       |      |         | 15      |        |   |         |        |        
|                                                                           | Assumed liabilities from acquisition of Quantum
    Composers, Inc. assets                                                                     |                                                                                    |        | 155   |       |      |         |        |        |   |         |        |        
|                                                                           | Note payable from acquisition of Quantum
    Composers, Inc. assets                                                                            |                                                                                    |        | 2,000 |       |      |         |        |        |   |         |        |        
|                                                                           | Note payable from acquisition of Tucson Optical
    Research Corporation assets                                                                |                                                                                    |        | 625   |       |      |         |        |        |   |         |        |        

See accompanying notes to consolidated financial
statements.

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##### 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.Photon Dynamics, Inc.
(Photon Dynamics or the Company) is a
supplier of integrated yield management solutions for the flat
panel display industry. The consolidated financial statements
include the accounts of the Company and its wholly owned
subsidiaries. Intercompany accounts and transactions have been
eliminated.

Subsidiaries of the Company are as follows:



| |                                                                                         
| | ----------------------------------------------------------------------------------------
| | Akcron Corporation, Ltd.                                                                
| | CR Technology, Inc.                                                                     
| | Intelligent Reasoning Systems, Inc.                                                     
| | Intelligent Reasoning Systems Intl KK                                                   
| | Kabushiki Kaisha Photon Dynamics                                                        
| | Photon Dynamics Canada Inc., formerly known as
    Image Processing Systems Inc. (IPS)
| | Photon Dynamics International Trading (Shanghai)
    Co., Ltd.                          
| | Photon Dynamics Korea Inc.                                                              
| | Photon Dynamics Nova Scotia Company                                                     
| | Photon Dynamics Technology (Beijing) Co., Ltd.                                          

Through January 14, 2003, the Company
conducted business in three operating segments: flat panel
display products, cathode ray tube display and high quality
glass inspection products and printed circuit board assembly
inspection products. In January 2003, the Company implemented a
plan to exit the printed circuit board assembly inspection
business. In June 2003, the Company implemented a plan to exit
the cathode ray tube display and high quality glass inspection
businesses. Accordingly, the operating results of these former
business segments have been presented as discontinued operations
in accordance with the provisions of Statement of Financial
Accounting Standards No. 144, Accounting for the
Impairment or Disposal of Long-lived Assets,
(FAS 144). Accordingly, in the consolidated
statements of operations, the operating results of these former
businesses have been classified as Loss from discontinued
operations for all periods presented. The cash flows from
these businesses have been presented as Net cash flows
from discontinued operations in the operating, investing
and financing sections of the consolidated statements of cash
flows.

Management
Estimates.The preparation of
financial statements in conformity with U.S. generally
accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of
assets and liabilities at the date of the financial statements
and the reported amounts of revenues and expenses during the
reporting periods. Actual results could differ from those
estimates. Significant estimates made by management include
revenue recognition, the calculation of allowance for doubtful
accounts, inventory write-downs, warranty provisions, impairment
of goodwill and other acquired intangible assets, acquired
in-process research and development, restructuring expenses and
litigation and contingency assessments.

Fair Value of Financial
Instruments.The Company evaluates the
estimated fair value of financial instruments using available
market information and valuation methodologies. The use of
different market assumptions and/or estimation methodologies
could have a negative effect on the estimated fair value
amounts. The fair value of the Companys cash, cash
equivalents, accounts receivable, accounts payable and other
current liabilities approximates the carrying amount due to the
relatively short maturity of these items (see Note 7).

Cash Equivalents and Short-Term
Investments.Cash equivalents consist
of highly liquid investments with insignificant interest rate
risk and have original maturity dates of three months or less
from the date of acquisition. Short-term investments consist of
highly liquid investments with remaining maturities greater than
three months from the balance sheet date. The Company classifies
all securities as available-for-sale in accordance with the
provisions of the Statement of Financial Accounting Standards
No. 115, Accounting for

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PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Certain Investments in Debt and Equity
Securities (FAS 115). The cost and fair
market value of short-term investments are based on the specific
identification method. Securities classified as
available-for-sale are reported at fair market value with the
related unrealized gains or losses, net of tax, presented as a
separate component of shareholders equity under the
caption Accumulated other comprehensive income. All
realized gains and losses and unrealized losses and declines in
fair value that are other than temporary are recorded in
earnings in the period of occurrence.

Inventories.Inventories, consisting of raw materials, work in process and
finished goods, are stated at the lower of cost (first-in,
first-out) or market. Inventory which is obsolete (defined as
inventory that will no longer be used in the manufacturing
process) or in excess of the forecasted usage is written down to
its estimated market value based on projected demand, historical
usage and other known factors. Photon Dynamics reviews the
appropriate valuation of its inventories on a quarterly basis.
If actual demand were to decline below the Companys
forecasts, the Company may need to take additional inventory
write-downs.

Land, Property and
Equipment.Property and equipment are
recorded at cost. Depreciation of property and equipment is
based on the straight-line method over the estimated useful
lives of the assets which are thirty years for buildings, and
three to five years for equipment and office furniture and
fixtures. Leasehold improvements are amortized over the shorter
of the life of the lease or the useful life of the related
asset. Land is recorded at cost, with no depreciation recorded.

Goodwill and Intangible
Assets.The Company accounts for
goodwill and other intangible assets resulting from its
acquisitions in accordance with Statement of Financial
Accounting Standards No. 142 Goodwill and Other
Intangible Assets (FAS142). FAS 142
prohibits the amortization of goodwill and intangible assets
with indefinite useful lives and requires that these assets be
reviewed for impairment at least annually. The process for
evaluating the potential impairment of goodwill is highly
subjective and requires significant judgment at many points
during the analysis. In estimating the fair value of the
reporting unit with recognized goodwill for the purposes of our
fiscal 2004 financial statements, the Company made estimates and
judgments about the future cash flows of that reporting unit.
The Companys cash flow forecasts were based on assumptions
that were consistent with the plans and estimates it was using
to manage the underlying business. The Company also considers
its market capitalization (adjusted for unallocated monetary
assets such as cash, marketable debt securities and debt) in
determining the fair value of the respective businesses.

Intangible assets with finite lives and other
long-lived assets are amortized over their estimated useful
lives and subject to evaluation for impairment.

Impairment of Long-Lived
Assets.The Company reviews long-lived
assets including intangible assets with finite lives for
impairment whenever events or changes in business circumstances
indicate that the carrying amount of the assets may not be fully
recoverable, such as a significant industry downturn,
significant decline in the market value of the company, or
significant reductions in projected future cash flows. An
impairment loss would be recognized when estimated undiscounted
future cash flows expected to result from the use of the asset
and its eventual disposition is less than its carrying amount.
Impairment, if any, is assessed using discounted cash flows. In
assessing the recoverability of long-lived assets, including
intangible assets, the Company must make assumptions regarding
estimated future cash flows and other factors to determine the
fair value of the respective assets.

Accumulated other comprehensive
Income.Statement of Accounting
Standards No. 130 Reporting Comprehensive
Income (FAS 130) requires that all items
required to be recognized under accounting standards as
components of comprehensive income, including unrealized gains
and losses on available-for-sale securities and foreign currency
translation adjustments, be reported in the consolidated
financial statements. As a result, the Company has reported
comprehensive income (loss) within the accompanying Consolidated
Statements of Shareholders Equity.

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PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Concentration of Credit and Other
Risk.Financial instruments which
potentially subject the Company to concentrations of credit risk
consist principally of available for sale securities, trade
accounts receivable and derivative financial instruments used to
mitigate the effect of exchange rate changes.

The Company invests excess cash in securities
that the Company believes bear minimal risk. These investments
are of a short-term nature and include investments in auction
rate preferred securities, commercial paper and government and
corporate debt securities. The Company has not experienced any
losses due to institutional failure or bankruptcy.

The Companys customers are located in
Korea, Taiwan, Japan and China. Therefore, the Companys
sales to these customers may be adversely affected by the
overall health of these economies, including the effects of
currency exchange rate fluctuations. The Company generally does
not require collateral for its trade accounts receivable. The
Company maintains a provision for potential credit losses based
upon expected collectibility of all accounts receivable. For
sales to some of its customers in certain geographic regions,
the Company requires letters of credit. The majority of the
Companys revenue is invoiced in U.S. dollars. The
Company believes its credit evaluation and monitoring mitigates
its credit risk.

The Company is exposed to credit loss in the
event of non-performance by counterparties on the foreign
exchange contracts used to mitigate the effect of exchange rate
changes. These counterparties are large international financial
institutions and to date, no such counterparty has failed to
meet its financial obligations to the Company. Photon Dynamics
does not anticipate nonperformance by these counterparties. The
Company had no outstanding foreign exchange forward contracts at
September 30, 2004.

The Companys products include certain
components that are currently single-sourced. The Company
believes that other vendors would be able to provide similar
components; however, the qualification of such vendors may
require start-up time. In order to mitigate any adverse impacts
from a disruption of supply, the Company attempts to maintain an
adequate supply of critical single-sourced components.

Foreign Currency.The functional currencies of the Companys foreign
subsidiaries are their respective local currencies. Accordingly,
all assets and liabilities of the foreign operations are
translated to U.S. dollars at current period end exchange
rates, and revenues and expenses are translated to
U.S. dollars using weighted average exchange rates in
effect during the period. The gains and losses from the
translation of these subsidiaries financial statements
into the U.S. dollar are recorded directly into a separate
component of shareholders equity under the caption
Accumulated other comprehensive income in
shareholders equity. Currency transaction gains and losses
are included in the Companys results of operations.

Derivative Financial
Instruments.The Company may use
forward exchange contracts to mitigate the effect of exchange
rate changes on a portion of, but not all, existing and
anticipated foreign currency denominated transactions expected
to occur within the following 18 months. The purpose of
Photon Dynamics foreign currency program is to manage the
effect of exchange rate fluctuations on certain foreign currency
denominated revenues, cost and eventual cash flows. The Company
believes these financial instruments do not subject it to
speculative risk that would otherwise result from changes in
currency exchange rates. The Company does not use derivative
financial instruments for speculative or trading purposes.

The Companys derivative instruments are
recorded at fair value based on quoted market prices for
comparable instruments. Gains and losses are recorded
immediately in earnings.

The Company had no outstanding foreign exchange
forward contracts at September 30, 2004. At
September 30, 2003, the Company had foreign exchange
forward contracts maturing throughout fiscal 2004 to sell
$2.8 million in Japanese yen. See Note 7 for further
information related to derivatives.

Warranty.The
Companys warranty policy generally states that it will
provide warranty coverage for a period of one year from final
acceptance. The Company records the estimated cost of warranty
coverage,

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PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

primarily material and labor to repair and
service the equipment, upon product shipment, when the related
revenue is recognized. The Companys warranty obligation is
affected by product failure rates, material usage rates and the
efficiency by which the product failure is corrected.

Revenue Recognition.Photon Dynamics derives revenue primarily from the sale and
installation of equipment and spare part sales. The Company
recognizes revenue when persuasive evidence of an arrangement
exists, delivery has occurred or services have been rendered,
the selling price is fixed or determinable and collectibility is
reasonably assured.

The Company accounts for certain of its product
sales, including sales to a value-added reseller, as
arrangements with multiple deliverables in accordance with
Emerging Issues Task Force Issue 00-21 Revenue
Arrangements with Multiple Deliverables. For arrangements
with multiple deliverables, the Company recognizes revenue for
the delivered items if the delivered items have value to the
customer on a standalone basis, the amount of revenue for
delivered elements is not subject to refund, the Company has met
defined customer acceptance experience levels for the delivered
items, and the fair value of undelivered items, such as
installation and system upgrade rights, can be reliably
determined. The Company allocates revenue to the delivered items
based on the lesser of the amount due and billable upon shipment
and the allocated fair value, with the remaining amount
recognized after installation and acceptance when the final
amount becomes due. The Company recognizes all other product
sales upon customer acceptance. The Company recognizes revenue
from the sale of spare parts generally upon shipment.

Terms and conditions of the Companys sale
of products to its value-added reseller are generally consistent
with terms and conditions offered to other customers and title
typically transfers to the value-added reseller upon shipment.
The Company does not grant any rights of return, stock rotation
or price protection for its product sales to its value-added
reseller. Accordingly, sales transactions with the value-added
reseller are recorded in accordance with the policy stated above.

The Company records a provision based on
historical rates for estimated sales returns in the same period
as the related revenue is recorded, which is netted against
revenue.

The Companys products are generally subject
to warranty and such estimated costs are provided for in costs
of sales when product revenue is recognized. Installation and
other services are not essential to the functionality of the
products as these services do not alter the product
capabilities, do not require specialized skills or tools and can
be performed by other vendors.

Shipping Costs.The
Companys shipping and handling costs are included under
cost of sales for all periods presented. In those instances
where the Company does bill for shipping and handling, the
amounts billed are classified as revenue.

Advertising.Advertising costs are expensed as incurred. Advertising expense
was $109,000, $173,000 and $248,000 for fiscal 2004, 2003 and
2002, respectively.

Research and Development
Cost.Costs to develop the
Companys products, which include both hardware and
software components are expensed as incurred. Software
incorporated in the Companys products is an integral part
of the overall product design process and costs to develop
software, which is deemed to be incidental, are not tracked
separately. The Company does not sell or market any software
product on a standalone basis.

Interest Income.Interest Income was approximately $1.5 million,
$2.5 million and $3.4 million for fiscal 2004, 2003
and 2002, respectively.

Income Taxes.The
Company accounts for income taxes in accordance with the
liability method in accounting for income taxes. Under the
liability method, deferred tax assets and liabilities are
measured based

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PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

on differences between the financial reporting
and tax bases of assets and liabilities using enacted tax rates
and laws that will be in effect when differences are expected to
reverse (see Note 8).

Earnings Per Share.Basic net income (loss) per share is calculated using the
weighted average number of shares of common stock outstanding.
Diluted earnings per share is computed in the same manner and
also gives effect to all dilutive common equivalent shares
outstanding during the period. Common equivalent shares consist
of stock options issued to employees under employee stock option
plans and warrants (see Note 9).

Stock-Based Compensation
Plans.The Company accounts for its
stock-based employee compensation plans using the intrinsic
value method in accordance with the provisions of Accounting
Principles Board (APB) Opinion No. 25,
Accounting For Stock Issued to Employees
(APB 25) and related interpretations.

Pro forma information regarding net income and
earnings per share is required by Statement of Financial
Accounting Standards No. 123, Accounting for
Stock-Based Compensation (FAS 123) and
has been determined as if the Company had accounted for its
employee stock purchase plan and employee stock options granted
under the fair value method of FAS 123. The fair value of
each option grant is estimated on the date of grant using the
Black-Scholes option pricing model for the multiple option
approach with the following weighted-average assumptions:

|                     |                                  |      |  |      |   |      |  |      |   |  |  |      |  
|-------------------- | -------------------------------- | ---- |  | ---- | - | ---- |  | ---- | - |  |  | ---- | -
|                     |                                  | 2004 |  | 2003 |   | 2002
|                     |                                  |      |  |      |   |     
|Stock option plan:   |                                  |      |  |      |   |      |  |      |   |  |  |     
|                     | Expected stock price volatility  |      |  | 0.83 |   |      |  | 0.93 |   |  |  | 0.96 |  
|                     | Risk free interest rate          |      |  | 2.33 | % |      |  | 2.05 | % |  |  | 3.21 | %
|                     | Expected life of options (years) |      |  | 6    |   |      |  | 5    |   |  |  | 3    |  
|Stock purchase plan: |                                  |      |  |      |   |      |  |      |   |  |  |     
|                     | Expected stock price volatility  |      |  | 0.96 |   |      |  | 0.90 |   |  |  | 0.99 |  
|                     | Risk free interest rate          |      |  | 2.13 | % |      |  | 2.19 | % |  |  | 3.13 | %
|                     | Expected life of plan (years)    |      |  | 2    |   |      |  | 0.9  |   |  |  | 1.7  |  

SFAS 123 requires the use of option pricing
models that were not developed for use in valuing employee stock
options. The Black-Scholes option valuation model was developed
for use in estimating the fair value of traded options which
have no vesting restrictions and are fully transferable. In
addition, option valuation models require the input of highly
subjective assumptions including the expected stock price
volatility. Because the Companys employee stock option and
employee stock purchase plans have characteristics significantly
different from those of traded options, and because changes in
the subjective input assumptions can materially affect the fair
value estimate, in managements opinion, the existing
models may not necessarily provide a reliable single measure of
the fair value of such Company options.

55



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

For purposes of pro forma disclosures required by
FAS 123, the estimated fair value of the options is
amortized to expense over the options vesting periods
using the straight-line method. The Companys pro forma
information for the years ended September 30, 2004, 2003
and 2002 is as follows:

|                                                      |                                                                                                                   |                                       |        |        |   |      |         |        |   |   |         |        |  
|----------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------- | ------------------------------------- | ------ | ------ | - | ---- | ------- | ------ | - | - | ------- | ------ | -
|                                                      |                                                                                                                   |                                      
|                                                      |                                                                                                                   | Year Ended September 30,             
|                                                      |                                                                                                                   |                                      
|                                                      |                                                                                                                   | 2004                                  |        | 2003   |   | 2002
|                                                      |                                                                                                                   |                                       |        |        |   |     
|                                                      |                                                                                                                   |                                      
|                                                      |                                                                                                                   | (In thousands, except per share data)
|Net income (loss)  as reported                       |                                                                                                                   | $                                     | 11,064 |        |   | $    | (72,372 | )      |   | $ | (21,802 | )     
|                                                      | Plus: stock based employee compensation expense
    included in reported net income                               |                                       |        |       |   |      |         | 364    |   |   |         | 275    |  
|                                                      | Less: total stock-based employee compensation
    expense determined under fair value based method for all awards |                                       |        | (6,886 | ) |      |         | (3,991 | ) |   |         | (8,146 | )
|                                                      |                                                                                                                   |                                       |        |        |   |      |         |        |   |   |         |       
|Net income (loss)  pro forma                         |                                                                                                                   | $                                     | 4,178  |        |   | $    | (75,999 | )      |   | $ | (29,673 | )     
|                                                      |                                                                                                                   |                                       |        |        |   |      |         |        |   |   |         |       
|Basic net income (loss) per share  as
    reported   |                                                                                                                   | $                                     | 0.67   |        |   | $    | (4.50   | )      |   | $ | (1.37   | )     
|Diluted net income (loss) per share 
    as reported |                                                                                                                   | $                                     | 0.65   |        |   | $    | (4.50   | )      |   | $ | (1.30   | )     
|Basic net income (loss) per share  pro
    forma     |                                                                                                                   | $                                     | 0.25   |        |   | $    | (4.72   | )      |   | $ | (1.86   | )     
|Diluted net income (loss) per share 
    pro forma   |                                                                                                                   | $                                     | 0.24   |        |   | $    | (4.72   | )      |   | $ | (1.77   | )     

Reclassifications.Certain prior year and prior quarter balances have been
reclassified to conform to current financial statement
presentation. These reclassifications had no impact on
previously reported results of operations or shareholders
equity.

Recent Accounting
Pronouncements.In March 2004, the
FASB issued a proposed Statement, Share-Based Payment, an
amendment of FASB Statements Nos. 123 and 95, that
addresses the accounting for share-based payment transactions in
which a Company receives employee services in exchange for
either equity instruments of the Company or liabilities that are
based on the fair value of the Companys equity instruments
or that may be settled by the issuance of such equity
instruments. The proposed statement would eliminate the ability
to account for share-based compensation transactions using the
intrinsic method that Photon Dynamics currently uses and
generally would require that such transactions be accounted for
using a fair-value-based method and recognized as expense in the
Companys consolidated statements of operations. The
recommended effective date of the proposed standard is currently
for fiscal years beginning after June 15, 2005. Should this
proposed statement be finalized in its current form, it will
have a significant impact on the Companys consolidated
statements of operations as the Company will be required to
expense the fair value of its stock option grants and stock
purchases under our employee stock purchase plan.

In March 2004, the Emerging Issues Task Force
(EITF) reached a consensus on recognition and
measurement guidance previously discussed under EITF Issue
No. 03-01, The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments.
(EITF 03-01). The consensus clarifies the
meaning of other-than-temporary impairment and its application
to investments in debt and equity securities, in particular
investments within the scope of FASB Statement No. 115,
Accounting for Certain Investments in Debt and Equity
Securities, and investments accounted for under the cost
method. In September 2004, the Financial Accounting Standards
Board approved the issuance of a FASB Staff Position
(FSP) to delay the requirement to record impairment
losses under EITF 03-1. The approved delay applies to all
securities within the scope of EITF 03-1 and is expected to
end when new guidance is issued and comes into effect. Adoption
of this consensus is not expected to have a material impact on
our consolidated results of operations.

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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|         |                               
|-------- | ------------------------------
|Note 2  | Financial Statement Components

|              |                               |                                                 |        |      |         |        |        |   |         |        | 
|------------- | ----------------------------- | ----------------------------------------------- | ------ | ---- | ------- | ------ | ------ | - | ------- | ------ | 
|              |                               |                                                
|              |                               | September 30,                                  
|              |                               |                                                
|              |                               | 2004                                            |        | 2003
|              |                               |                                                 |        |     
|              |                               |                                                
|              |                               | (In thousands)                                 
|Balance Sheet |                               |                                                 |        |      |         |        |        |  
|              | Accounts receivable           |                                                 |        |      |         |        |        |   |        
|              |                               | Accounts receivable, gross                      |        | $    | 58,838  |        |        | $ | 11,128  |       
|              |                               | Allowance for doubtful accounts                 |        |      | (497    | )      |        |   | (726    | )     
|              |                               |                                                 |        |      |         |        |        |  
|              |                               |                                                 | Total  |      | $       | 58,341 |        |   | $       | 10,402 | 
|              |                               |                                                 |        |      |         |        |        |  
|              | Inventories:                  |                                                 |        |      |         |        |        |   |        
|              |                               | Raw materials                                   |        | $    | 15,529  |        |        | $ | 3,945   |       
|              |                               | Work-in-process                                 |        |      | 15,046  |        |        |   | 4,565   |       
|              |                               | Finished goods                                  |        |      | 1,141   |        |        |   | 1,377   |       
|              |                               |                                                 |        |      |         |        |        |  
|              |                               |                                                 | Total  |      | $       | 31,716 |        |   | $       | 9,887  | 
|              |                               |                                                 |        |      |         |        |        |  
|              | Land, property and equipment: |                                                 |        |      |         |        |        |   |        
|              |                               | Land and building                               |        | $    | 7,299   |        |        | $ | 7,299   |       
|              |                               | Equipment                                       |        |      | 17,647  |        |        |   | 13,751  |       
|              |                               | Office furniture and fixtures                   |        |      | 3,057   |        |        |   | 2,097   |       
|              |                               | Leasehold improvements                          |        |      | 8,934   |        |        |   | 2,619   |       
|              |                               |                                                 |        |      |         |        |        |  
|              |                               |                                                 | 36,937 |      |         |        | 25,766 |  
|              |                               | Less: accumulated depreciation and amortization |        |      | (16,600 | )      |        |   | (13,468 | )     
|              |                               |                                                 |        |      |         |        |        |  
|              |                               |                                                 | Total  |      | $       | 20,337 |        |   | $       | 12,298 | 
|              |                               |                                                 |        |      |         |        |        |  
|              | Intangible assets:            |                                                 |        |      |         |        |        |   |        
|              |                               | Core technology                                 |        | $    | 8,695   |        |        | $ | 7,997   |       
|              |                               | Developed technology                            |        |      | 6,865   |        |        |   | 4,734   |       
|              |                               | Backlog                                         |        |      | 557     |        |        |   | 557     |       
|              |                               | Non-compete agreement                           |        |      | 969     |        |        |   | 199     |       
|              |                               | Patents                                         |        |      | 123     |        |        |   | 123     |       
|              |                               | License agreement                               |        |      | 1,139   |        |        |   |        |       
|              |                               |                                                 |        |      |         |        |        |  
|              |                               |                                                 | 18,348 |      |         |        | 13,610 |  
|              |                               | Less: accumulated amortization                  |        |      | (4,059  | )      |        |   | (3,269  | )     
|              |                               | Less: accumulated impairment charges(1)         |        |      | (9,536  | )      |        |   | (7,447  | )     
|              |                               |                                                 |        |      |         |        |        |  
|              |                               |                                                 | Total  |      | $       | 4,753  |        |   | $       | 2,894  | 
|              |                               |                                                 |        |      |         |        |        |  
|              | Goodwill:                     |                                                 |        |      |         |        |        |   |        
|              |                               | Initial goodwill                                |        | $    | 37,389  |        |        | $ | 37,089  |       
|              |                               | Subsequent adjustments to goodwill              |        |      | (278    | )      |        |   | (278    | )     
|              |                               |                                                 |        |      |         |        |        |  
|              |                               |                                                 | 37,111 |      |         |        | 36,811 |  
|              |                               | Less: accumulated impairment charges(1)         |        |      | (36,958 | )      |        |   | (36,293 | )     
|              |                               |                                                 |        |      |         |        |        |  
|              |                               |                                                 | Total  |      | $       | 153    |        |   | $       | 518    | 
|              |                               |                                                 |        |      |         |        |        |  

57



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

|                                       |                                                                                        |                |   |       |       |  |   |       |       | 
|-------------------------------------- | -------------------------------------------------------------------------------------- | -------------- | - | ----- | ----- |  | - | ----- | ----- | 
|                                       |                                                                                        |               
|                                       |                                                                                        | September 30, 
|                                       |                                                                                        |               
|                                       |                                                                                        | 2004           |   | 2003 
|                                       |                                                                                        |                |   |      
|                                       |                                                                                        |               
|                                       |                                                                                        | (In thousands)
|Other current liabilities:             |                                                                                        |                |   |       |       |  |   |      
|                                       | Compensation                                                                           |                | $ | 3,984 |       |  | $ | 2,369 |      
|                                       | Commissions                                                                            |                |   | 197   |       |  |   | 1,128 |      
|                                       | Due to Akcron shareholders                                                             |                |   |      |       |  |   | 1,035 |      
|                                       | Obligation to a manufacturing subcontractor in
    connection with inventory purchases |                |   | 623   |       |  |   | 647   |      
|                                       | Accrued closing costs associated with
    discontinued operations                      |                |   | 449   |       |  |   | 666   |      
|                                       | Notes Payable (Note 14)                                                                |                |   | 519   |       |  |   | 576   |      
|                                       | Other accrued expenses                                                                 |                |   | 3,821 |       |  |   | 1,821 |      
|                                       |                                                                                        |                |   |       |       |  |   |      
|                                       |                                                                                        | Total          |   | $     | 9,593 |  |   | $     | 8,242 | 
|                                       |                                                                                        |                |   |       |       |  |   |      
|Accumulated other comprehensive income |                                                                                        |                |   |       |       |  |   |      
|                                       | Foreign currency translation adjustments                                               |                | $ | 533   |       |  | $ | 407   |      
|                                       | Unrealized gains (losses) on available for sale
    securities                         |                |   | (186  | )     |  |   | 191   |      
|                                       |                                                                                        |                |   |       |       |  |   |      
|                                       |                                                                                        | Total          |   | $     | 347   |  |   | $     | 598   | 
|                                       |                                                                                        |                |   |       |       |  |   |      

|                         |                                |                              |       |      |       |       |  |   |       |       |  |   |       |       | 
|------------------------ | ------------------------------ | ---------------------------- | ----- | ---- | ----- | ----- |  | - | ----- | ----- |  | - | ----- | ----- | 
|                         |                                |                             
|                         |                                | Year Ended September 30     
|                         |                                |                             
|                         |                                | 2004                         |       | 2003 |       | 2002 
|                         |                                |                              |       |      |       |      
|                         |                                |                             
|                         |                                | (In thousands)              
|Statements of Operations |                                |                              |       |      |       |       |  |   |       |       |  |  
|                         | Interest income and other, net |                              |       |      |       |       |  |   |       |       |  |   |      
|                         |                                | Interest income              |       | $    | 1,508 |       |  | $ | 2,548 |       |  | $ | 3,374 |      
|                         |                                | Interest expense             |       |      | (25   | )     |  |   | (11   | )     |  |   | (7    | )    
|                         |                                | Foreign exchange gain (loss) |       |      | (90   | )     |  |   | (425  | )     |  |   | (211  | )    
|                         |                                | Other(2)                     |       |      | 3,409 |       |  |   | 856   |       |  |   | (243  | )    
|                         |                                |                              |       |      |       |       |  |   |       |       |  |  
|                         |                                |                              | Total |      | $     | 4,802 |  |   | $     | 2,968 |  |   | $     | 2,913 | 
|                         |                                |                              |       |      |       |       |  |   |       |       |  |  



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | In fiscal 2002, 2003 and 2004, the Company
    recorded impairment charges against certain of its goodwill and
    intangible assets. In accordance with FAS 142 and Statement
    of Financial Accounting Standards No. 144 Accounting
    for the Impairment or Disposal of Long-Lived Assets
    (FAS144), these impairments established new cost
    bases for the related assets. See additional detail in
    Note 5.
|   
|(2) | In fiscal 2004, the Company recorded a technology
    license fee resulting from a litigation settlement in the first
    quarter of fiscal 2004, the terms of which were confidential.
    See additional detail in Note 11.                                                                                                                                                                                                  



|         |                        
|-------- | -----------------------
|Note 3  | Discontinued Operations



| |                                                       
| | ------------------------------------------------------
| | Printed Circuit Board Assembly Inspection
    Business

The Companys printed circuit board assembly
inspection products enabled printed circuit board assembly
inspection manufacturers to detect and identify defects, thereby
increasing yields and quality and reducing costs. The Company
previously sold its products for the printed circuit board
assembly industry primarily through sales representatives and
distributors. The Company generally recognized revenue from the
sale of its printed circuit board assembly inspection products
upon shipment as such product sales were not subject to customer
acceptance provisions. In January 2003, the Company implemented
a plan to exit the

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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

printed circuit board assembly inspection
business. Accordingly, the operating results of this former
business segment have been reclassified as a discontinued
operation for all periods presented. As of September 30,
2004, the Company has completed liquidation of the
operations remaining inventory through a third-party
auctioneer and is attempting to sublease the facilities
associated with the discontinued operations, but there can be no
assurances that the Company will be successful in recovering any
additional costs associated with this discontinued operation.

The following table summarizes the results of
discontinuing the printed circuit board assembly inspection
products reporting segment:

|                                  |                                                          |                          |        |       |       |      |         |        |        |   |         |        |        | 
|--------------------------------- | -------------------------------------------------------- | ------------------------ | ------ | ----- | ----- | ---- | ------- | ------ | ------ | - | ------- | ------ | ------ | 
|                                  |                                                          |                         
|                                  |                                                          | Year Ended September 30,
|                                  |                                                          |                         
|                                  |                                                          | 2004                     |        | 2003  |       | 2002
|                                  |                                                          |                          |        |       |       |     
|                                  |                                                          |                         
|                                  |                                                          | (In thousands)          
|Revenue                           |                                                          | $                        | 83     |       |       | $    | 4,320   |        |        | $ | 12,366  |       
|Cost of revenue                   |                                                          |                          |       |       |       |      | 11,661  |        |        |   | 9,605   |       
|                                  |                                                          |                          |        |       |       |      |         |        |        |   |         |       
|Gross margin                      |                                                          |                          | 83     |       |       |      | (7,341  | )      |        |   | 2,761   |       
|                                  |                                                          |                          |        |       |       |      |         |        |        |   |         |       
|Operating expenses:               |                                                          |                          |        |       |       |      |         |        |        |   |         |       
|                                  | Research and development                                 |                          |        | 21    |       |      |         | 3,695  |        |   |         | 4,367  |       
|                                  | Selling, general and administrative                      |                          |        | 1,624 |       |      |         | 6,827  |        |   |         | 6,925  |       
|                                  | Goodwill impairment charge                               |                          |        |      |       |      |         | 15,083 |        |   |         | 11,200 |       
|                                  | Impairment of purchased intangibles and fixed
    assets |                          |        |      |       |      |         | 5,445  |        |   |         | 1,017  |       
|                                  | Restructuring charges                                    |                          |        |      |       |      |         |       |        |   |         | 2,551  |       
|                                  | Acquired in-process research and development             |                          |        |      |       |      |         |       |        |   |         | 244    |       
|                                  | Amortization of intangible assets                        |                          |        |      |       |      |         | 195    |        |   |         | 1,042  |       
|                                  |                                                          |                          |        |       |       |      |         |        |        |   |         |       
|                                  |                                                          | Total operating expenses |        |       | 1,645 |      |         |        | 31,245 |   |         |        | 27,346 | 
|                                  |                                                          |                          |        |       |       |      |         |        |        |   |         |       
|Loss from discontinued operations |                                                          | $                        | (1,562 | )     |       | $    | (38,586 | )      |        | $ | (24,585 | )     
|                                  |                                                          |                          |        |       |       |      |         |        |        |   |         |       

The loss from discontinued operations for the
year ended September 30, 2004, includes litigation costs of
approximately $1.5 million for settlement of prior
inventory purchase commitments, the settlement of the
Thomason v. Photon Dynamics lawsuit (See
Note 11) and the legal expenses incurred as part of
the settlement.

The loss from discontinued operations for the
year ended September 30, 2003, includes a write-off of
inventory of approximately $7.6 million, a write-off of
accounts receivable of approximately $2.0 million, and a
write-off of licensed technology of approximately
$1.9 million. The fiscal 2003 loss also includes impairment
charges of approximately $15.1 million of goodwill,
$2.9 million of purchase intangibles and $2.5 million
of long-lived assets recorded during the three months ended
December 31, 2002, as a result of managements
assessment of indicators of impairment that existed prior to the
Companys formal decision to discontinue the operations of
this segment. Such impairment charges were recorded in
accordance with the provisions of FAS 142 and FAS 144.

The loss from discontinued operations for the
year ended September 30, 2002 includes a restructuring
charge of approximately $2.6 million recorded in the fourth
quarter of fiscal 2002 associated with a reduction in workforce,
consolidation and closing of facilities and a write-off of
related fixed assets. See Note 6 for additional details of
this restructuring reserve. The fiscal 2002 loss also includes
impairment charges of approximately $11.2 million of
goodwill and $1.0 million of purchased intangibles recorded
during the fourth quarter of 2002, as a result of
managements assessment of indicators of impairment related
to the acquisition of Intelligent Reasoning Systems, Inc.
(IRSI). Such impairment charges were recorded in
accordance with

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PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

the provisions of FAS 142 and FAS 121.
In addition, the Company recorded approximately $244,000 of
acquired in-process research and development charges related to
the acquisition of certain assets from Advanced Research
Technologies, Inc. (ART) related to ARTs
Infrared Screening and Inspection Solutions (ISIS)
Division.

The Company determined the fair values of the
assets impaired based on the estimated net realizable values of
the assets, taking into account independent appraisals of those
net realizable values.

The following summarizes the assets and
liabilities of the printed circuit board assembly inspection
products discontinued operations:

|                     |                           |                           |     |      |     |  |     |       |       | 
|-------------------- | ------------------------- | ------------------------- | --- | ---- | --- |  | --- | ----- | ----- | 
|                     |                           |                          
|                     |                           | September 30             
|                     |                           |                          
|                     |                           | 2004                      |     | 2003
|                     |                           |                           |     |     
|                     |                           |                          
|                     |                           | (In thousands)           
|ASSETS              
|Current assets:      |                           |                           |     |      |     |  |     |      
|                     | Accounts receivable, net  |                           | $   |     |     |  | $   | 104   |      
|                     | Other current assets      |                           |     | 908  |     |  |     | 1,268 |      
|                     |                           |                           |     |      |     |  |     |      
|                     |                           | Total assets              |     | $    | 908 |  |     | $     | 1,372 | 
|                     |                           |                           |     |      |     |  |     |      
|LIABILITIES         
|Current liabilities: |                           |                           |     |      |     |  |     |      
|                     | Accounts payable          |                           | $   | 5    |     |  | $   | 102   |      
|                     | Other current liabilities |                           |     | 707  |     |  |     | 819   |      
|                     |                           |                           |     |      |     |  |     |      
|                     |                           | Total current liabilities |     |      | 712 |  |     |       | 921   | 
|Other liabilities    |                           |                           | 113 |      |     |  | 193 |      
|                     |                           |                           |     |      |     |  |     |      
|                     |                           | Total liabilities         |     | $    | 825 |  |     | $     | 1,114 | 
|                     |                           |                           |     |      |     |  |     |      

Other current assets at September 30, 2004
include a receivable of approximately $733,000 against shares
that are being held in escrow related to the IRSI acquisition
(See Note 4), and $175,000 in security deposits on various
leases.

Other current liabilities at September 30,
2004 include approximately $79,000 related to current operating
lease obligations, approximately $90,000 related to accrued
legal costs and approximately $537,000 related to potential
vendor obligations. Other liabilities of approximately $113,000
relate entirely to non-current operating lease obligations.
Lease obligations are to be paid out through December 2006.

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PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

In the second quarter of fiscal 2003, in
accordance with Statement of Financial Accounting Standards
No. 146, Accounting for Costs Associated with Exit or
Disposal Activities (FAS146), the Company
recorded a liability of approximately $2.0 million for
costs associated with the discontinuation of the business,
including termination benefits of approximately $700,000 and
approximately $1.3 million of purchase obligations to
suppliers. The following summarizes the liability since
inception:

|                             |                               |                |      |             |  |       |       |     |  |   |        |     | 
|---------------------------- | ----------------------------- | -------------- | ---- | ----------- |  | ----- | ----- | --- |  | - | ------ | --- | 
|                             |                               | One-time       |      |             |  |      
|                             |                               | Termination    |      |             |  |      
|                             |                               | Benefits       |      | Other Costs |  | Total
|                             |                               |                |      |             |  |      
|                             |                               |               
|                             |                               | (In thousands)
|Inception of liability       |                               | $              | 696  |             |  | $     | 1,326 |     |  | $ | 2,022  |    
|Cash expenditures            |                               |                | (614 | )           |  |       | (447  | )   |  |   | (1,061 | )  
|Adjustments to the liability |                               |                | (82  | )           |  |       | (342  | )   |  |   | (424   | )  
|                             |                               |                |      |             |  |       |       |     |  |   |        |    
|                             | Balance at September 30, 2003 |                |      |            |  |       |       | 537 |  |   |        | 537 | 
|Cash expenditures            |                               |                |     |             |  |       |      |     |  |   |       |    
|Adjustments to the liability |                               |                |     |             |  |       |      |     |  |   |       |    
|                             |                               |                |      |             |  |       |       |     |  |   |        |    
|                             | Balance at September 30, 2004 |                | $    |            |  |       | $     | 537 |  |   | $      | 537 | 
|                             |                               |                |      |             |  |       |       |     |  |   |        |    

The balance of $537,000 remaining at
September 30, 2004, consists primarily of potential
obligations that the Company is currently negotiating.



| |                                                                        
| | -----------------------------------------------------------------------
| | Cathode Ray Tube Display and High Quality
    Glass Inspection Business

The Companys cathode ray tube display and
high quality glass inspection products allowed cathode ray tube
display manufacturers to locate and characterize defects and
glass manufacturers to detect and identify defects such as
scratches, pits, bubbles, stones, inclusions and distortions,
thereby increasing yields and quality and reducing costs. The
Company previously sold its products for the cathode ray tube
display and high quality glass inspection industry primarily
through sales representatives and distributors. The Company
generally recognized revenue from product sales upon customer
acceptance. In June 2003, the Company implemented a plan to exit
the cathode ray tube display and high quality glass inspection
business. Accordingly, the operating results of this former
business segment have been reclassified as a discontinued
operation for all periods presented and the Company now conducts
business in one segment.

The following table summarizes the results of
discontinuing the cathode ray tube display and high quality
glass inspection products reporting segment:

|                                           |                                                          |                          |     |      |      |      |        |       |       |   |        |       |       | 
|------------------------------------------ | -------------------------------------------------------- | ------------------------ | --- | ---- | ---- | ---- | ------ | ----- | ----- | - | ------ | ----- | ----- | 
|                                           |                                                          |                         
|                                           |                                                          | Year Ended September 30,
|                                           |                                                          |                         
|                                           |                                                          | 2004                     |     | 2003 |      | 2002
|                                           |                                                          |                          |     |      |      |     
|                                           |                                                          |                         
|                                           |                                                          | (In thousands)          
|Revenue                                    |                                                          | $                        |    |      |      | $    | 2,412  |       |       | $ | 7,518  |      
|Cost of revenue                            |                                                          |                          |    |      |      |      | 4,393  |       |       |   | 4,626  |      
|                                           |                                                          |                          |     |      |      |      |        |       |       |   |        |      
|Gross margin                               |                                                          |                          |    |      |      |      | (1,981 | )     |       |   | 2,892  |      
|                                           |                                                          |                          |     |      |      |      |        |       |       |   |        |      
|Operating expenses:                        |                                                          |                          |     |      |      |      |        |       |       |   |        |      
|                                           | Research and development                                 |                          |     |     |      |      |        | 701   |       |   |        | 3,574 |      
|                                           | Selling, general and administrative                      |                          |     | 38   |      |      |        | 2,533 |       |   |        | 2,765 |      
|                                           | Impairment of purchased intangibles and fixed
    assets |                          |     |      |      |      |        | 791   |       |   |        |      |      
|                                           | Gain on sale of fixed assets                             |                          |     | (209 | )    |      |        |      |       |   |        |      |      
|                                           |                                                          |                          |     |      |      |      |        |       |       |   |        |      
|                                           |                                                          | Total operating expenses |     |      | (171 | )    |        |       | 4,025 |   |        |       | 6,339 | 
|                                           |                                                          |                          |     |      |      |      |        |       |       |   |        |      
|Income (loss) from discontinued operations |                                                          | $                        | 171 |      |      | $    | (6,006 | )     |       | $ | (3,447 | )    
|                                           |                                                          |                          |     |      |      |      |        |       |       |   |        |      

61



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The income from discontinued operations for the
year ended September 30, 2004, includes a gain on the sale
of certain assets related to the former glass inspection
business. The loss from discontinued operations for the year
ended September 30, 2003, includes a write-off of inventory
of approximately $1.8 million, a write-off of accounts
receivable of approximately $152,000, and a write-off of fixed
assets of approximately $490,000. The fiscal 2003 loss also
includes approximately $460,000 in lease-related charges
associated with excess facilities, and approximately $979,000 in
employee severance and related benefit charges accounted for in
accordance with FAS 146. The Company has paid out
substantially all of the severance and related benefit amounts
as of September 30, 2003.

The following summarizes the assets and
liabilities of the cathode ray tube display and high quality
glass inspection discontinued operations:

|                     |                           |                           |   |      |     |  |   |       |       | 
|-------------------- | ------------------------- | ------------------------- | - | ---- | --- |  | - | ----- | ----- | 
|                     |                           |                          
|                     |                           | September 30             
|                     |                           |                          
|                     |                           | 2004                      |   | 2003
|                     |                           |                           |   |     
|                     |                           |                          
|                     |                           | (In thousands)           
|ASSETS              
|Current assets:      |                           |                           |   |      |     |  |   |      
|                     | Accounts receivable, net  |                           | $ |     |     |  | $ | 31    |      
|                     |                           |                           |   |      |     |  |   |      
|                     |                           | Total current assets      |   | $    |    |  |   | $     | 31    | 
|                     |                           |                           |   |      |     |  |   |      
|LIABILITIES         
|Current liabilities: |                           |                           |   |      |     |  |   |      
|                     | Other current liabilities |                           | $ | 797  |     |  | $ | 1,046 |      
|                     |                           |                           |   |      |     |  |   |      
|                     |                           | Total current liabilities |   | $    | 797 |  |   | $     | 1,046 | 
|                     |                           |                           |   |      |     |  |   |      

Other current liabilities at September 30,
2004 include approximately $193,000 related to warranty
obligations, approximately $256,000 related to operating lease
obligations and approximately $348,000 related to a loan payable
(See Note 14). Lease obligations are to be paid out through
March of 2008. Future minimum lease payments, due by fiscal year
are approximately: $91,000 in fiscal 2005, $83,000 in fiscal
2006, $76,000 in fiscal 2007 and $6,000 in fiscal 2008.

In the third quarter of fiscal 2003, in
accordance with FAS146, the Company recorded a liability of
approximately $1.9 million for costs associated with the
discontinuation of the business. The following summarizes the
liability since inception:

|                             |                                            |                |        |             |  |       |      |       |  |   |     |    |  |   |        |     | 
|---------------------------- | ------------------------------------------ | -------------- | ------ | ----------- |  | ----- | ---- | ----- |  | - | --- | -- |  | - | ------ | --- | 
|                             |                                            | One-time       |        | Contract    |  |       |      |      
|                             |                                            | Termination    |        | Termination |  | Other |      |      
|                             |                                            | Benefits       |        | Costs       |  | Costs |      | Total
|                             |                                            |                |        |             |  |       |      |      
|                             |                                            |               
|                             |                                            | (In thousands)
|Inception of liability       |                                            | $              | 1,116  |             |  | $     | 771  |       |  | $ | 11  |    |  | $ | 1,898  |    
|Cash expenditures            |                                            |                | (1,085 | )           |  |       | (171 | )     |  |   | (26 | )  |  |   | (1,282 | )  
|Adjustments to the liability |                                            |                |       |             |  |       |     |       |  |   | 50  |    |  |   | 50     |    
|                             |                                            |                |        |             |  |       |      |       |  |   |     |    |  |   |        |    
|                             | Balance of liability at September 30, 2003 |                |        | 31          |  |       |      | 600   |  |   |     | 35 |  |   |        | 666 | 
|Cash expenditures            |                                            |                | (31    | )           |  |       | (151 | )     |  |   | (35 | )  |  |   | (217   | )  
|                             |                                            |                |        |             |  |       |      |       |  |   |     |    |  |   |        |    
|                             | Balance of liability at September 30, 2004 |                | $      |            |  |       | $    | 449   |  |   | $   |   |  |   | $      | 449 | 
|                             |                                            |                |        |             |  |       |      |       |  |   |     |    |  |   |        |    

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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|         |                              
|-------- | -----------------------------
|Note 4  | Acquisitions and Dispositions



| |                                               
| | ----------------------------------------------
| | Year ended September 30, 2004
    dispositions

In May 2004, the Company sold all of its assets
in Korea related to its TFT-LCD Backlight Inverter business to
WOOYOUNG CO. LTD for approximately $481,000. The assets include
inventory and production equipment for which the Company had
previously recorded impairment charges, intellectual property
and certain employees related to the inverter business. For the
year ended September 30, 2004, the Company recorded a gain
on the transaction of approximately $419,000, which is included
in Operating income in the Consolidated Statements
of Operations.



| |                                               
| | ----------------------------------------------
| | Year ended September 30, 2004
    acquisitions

In June 2004, the Company acquired all of the
assets of Quantum Composers, Inc., related to the design and
manufacture of laser assembly products for flat panel display
LCD manufacturing and repair (the Quantum Assets).
Quantum Composers designed and sold pulse generator and laser
diagnostic systems and provided contract engineering and system
design services to the laser industry. The purchase price was
approximately $3.0 million, of which the Company paid
$1.0 million up front and issued $2.0 million of
non-interest bearing notes payable, due through June of 2007. In
addition, the Company assumed approximately $156,000 of
liabilities and incurred approximately $56,000 in
acquisition-related expenses, consisting primarily of
consulting, legal and accounting fees. The identifiable tangible
assets acquired consisted primarily of inventory.

In August 2004, the Company acquired all of the
assets of Tucson Optical Research Corporation (TORC)
related to the design and manufacture of pellicle products which
are used in the Companys modulators (the TORC
Assets). The purchase price was approximately
$1.3 million, of which the Company paid $625,000 up front
and issued $625,000 of non-interest bearing notes payable, due
through August of 2005. In addition, the Company incurred
approximately $25,000 in acquisition-related expenses,
consisting primarily of consulting, legal and accounting fees.
The identifiable tangible assets acquired consisted primarily of
inventory.



| |                                                        
| | -------------------------------------------------------
| | Year ended September 30, 2003 purchase
    acquisitions

In May 2003, the Company acquired all of the
assets of Summit Imaging, Inc. related to the design and
manufacture of cooled cameras specifically tailored
to the Companys product offerings (the Summit
Assets). Summit Imaging designed and manufactured
cooled cameras for the capital equipment industry.
The purchase price was $1.5 million of cash. In addition,
the Company assumed approximately $15,000 of liabilities and
incurred approximately $130,000 in acquisition-related expenses,
consisting primarily of consulting, legal and accounting fees.
The identifiable tangible assets acquired consisted primarily of
inventory.

In November 2002, the Company acquired rapid
thermal processing technology assets (the RTP
Assets) from Intevac, Inc. (Intevac). The
purchase price was $20.0 million of cash, of which
$18.0 million was paid to Intevac at closing and an
additional $2.0 million was placed into escrow to be
released either to the Company or to Intevac depending on the
occurrence of certain future events during the escrow period as
follows: $1.2 million related to the attainment of a
certain level of sales by the Company of equipment included in
the RTP Assets acquired from Intevac; $500,000 related to the
re-issuance of a former rapid thermal processing patent in Japan
for certain acquired technology; and $300,000 for
indemnification and reimbursement should Intevac breach any
representations and warranties under the acquisition agreement.

In September 2003, the Company filed a claim
against the escrow for the full $2.0 million. In October
2003, the Company received $1.7 million on its claim
against the $2.0 million escrow related to the purchase of
the RTP Assets from Intevac. The claim for the remaining
$300,000 was resolved in favor of Intevac and,

63



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

accordingly, the Company recorded an additional
goodwill impairment charge in the three months ended
December 31, 2003.



| |                                                        
| | -------------------------------------------------------
| | Year ended September 30, 2002 purchase
    acquisitions

In September 2002, the Company acquired Akcron
Corporation LTD (Akcron), a designer and seller of
automated optical inspection equipment, image processing
hardware and software algorithms and high-performance liquid
crystal display backlight inverters for flat panel displays,
which has expanded the Companys cell and module inspection
capability. The purchase price was approximately
$4.2 million of which the Company paid cash of
$2.6 million at the closing of the acquisition, established
a $1.6 million liability for the remainder of the purchase
price, assumed $600,000 in liabilities and incurred $400,000 in
acquisition related charges consisting primarily of legal and
accounting fees. The remaining $1.6 million of cash due to
the Akcron shareholders was held by the Company to secure the
Companys rights to indemnification and reimbursement
should Akcron breach any of their representations and warranties
under the acquisition agreement. The Company made claims for
$320,000 for a breach of warranty related to the collectibility
of a receivable and $350,000 related to the non-occurrence of a
certain event. The remaining $1.0 million was paid to the
Akcron shareholders in November 2003.

In July 2002, the Company purchased certain
assets (the ISIS Assets) from Advanced Research
Technologies, Inc. (ART). The purchase price was
approximately $5.5 million in cash and the Company assumed
certain liabilities of $100,000 related to ARTs Infrared
Screening and Inspection Solutions (ISIS) Division.
The Company incurred $200,000 in acquisition related charges
consisting primarily of legal and accounting fees. All of the
assets purchased from ART were written off as part of the
discontinuation of the printed circuit board assembly inspection
business.



| |                                                        
| | -------------------------------------------------------
| | Purchase Price Allocation and Pro Forma
    Information

The acquisitions of TORC Assets, Quantum Assets,
Summit Assets, RTP Assets, Akcron and ISIS Assets were accounted
for under the purchase method of accounting. The purchase prices
were allocated by management to the assets acquired and
liabilities assumed taking into account an independent appraisal
of their respective fair values. To determine the value of the
developed and core technologies, the expected future cash flows
attributed to all existing technology were discounted, taking
into account risks related to the characteristics and
application of the technology, existing and future markets and
assessments of the life cycle stage of the technology. The value
of the non-compete agreements was valued at the cash paid up
front and the present value of the non-interest payments on the
notes issued. The value attributed to the RTP backlog was
related to purchase orders that had been received prior to the
close of the acquisition, determined as the expected discounted
cash flow resulting from the revenue related to the shipment of
such orders, less normal profit margins.

The value of in-process research and development
was determined based on the expected cash flow attributed to the
in-process projects, taking into account revenue that was
attributable to previously developed technology, the level of
effort to date in the in-process research and development, the
percentage of completion of the project and the level of risk
associated with the in-process technology. The projects
identified as in-process were those that were underway as of the
acquisition date and that will, after the applicable closing
date, require additional effort in order to establish
technological feasibility and have no alternative future uses.
These projects have identifiable technological risk factors that
indicate that even though successful completion is expected, it
is not assured. The value of in-process research and development
has been included in the Companys results of operations.

64



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The Company applied discount factors to the
projected cash flows of the acquired technology in order to
determine the present value, based on discount rates with
inherent risk and expected growth of the developed, core and
in-process technologies. The discount rates used for the
developed, core and in-process technologies for each acquisition
were as follows:

|                      |  |        |    |         |  |        |    |        |  |        |    |        |  |  |    |   |  |  |    |   |  |  |    |  
|--------------------- |  | ------ | -- | ------- |  | ------ | -- | ------ |  | ------ | -- | ------ |  |  | -- | - |  |  | -- | - |  |  | -- | -
|                      |  | TORC   |    | Quantum |  | Summit |    | RTP    |  | Akcron |    | ISIS  
|                      |  | Assets |    | Assets  |  | Assets |    | Assets |  | Assets |    | Assets
|                      |  |        |    |         |  |        |    |        |  |        |    |       
|Developed technology  |  |        |   |         |  |        | 25 | %      |  |        |   |        |  |  | 15 | % |  |  | 15 | % |  |  | 15 | %
|Core technology       |  |        | 25 | %       |  |        | 25 | %      |  |        | 50 | %      |  |  | 20 | % |  |  | 20 | % |  |  | 20 | %
|In-process technology |  |        |   |         |  |        | 30 | %      |  |        | 60 | %      |  |  | 25 | % |  |  | 25 | % |  |  | 25 | %

A summary of the allocation of the purchase
prices is as follows:

|                                                                       |       |                |       |         |  |        |       |        |  |        |     |        |  |   |       |        |  |   |       |       |  |   |       |       | 
|---------------------------------------------------------------------- | ----- | -------------- | ----- | ------- |  | ------ | ----- | ------ |  | ------ | --- | ------ |  | - | ----- | ------ |  | - | ----- | ----- |  | - | ----- | ----- | 
|                                                                       |       | TORC           |       | Quantum |  | Summit |       | RTP    |  | Akcron |     | ISIS  
|                                                                       |       | Assets         |       | Assets  |  | Assets |       | Assets |  | Assets |     | Assets
|                                                                       |       |                |       |         |  |        |       |        |  |        |     |       
|                                                                       |       |               
|                                                                       |       | (In thousands)
|Acquired core technology                                               |       | $              | 1,144 |         |  | $      | 699   |        |  | $      | 565 |        |  | $ | 3,764 |        |  | $ | 225   |       |  | $ | 196   |      
|Acquired developed technology                                          |       |                |      |         |  |        | 1,006 |        |  |        |    |        |  |   | 2,673 |        |  |   | 252   |       |  |   | 315   |      
|Patents                                                                |       |                |      |         |  |        |      |        |  |        |    |        |  |   |      |        |  |   |      |       |  |   | 123   |      
|Backlog                                                                |       |                |      |         |  |        |      |        |  |        |    |        |  |   | 557   |        |  |   |      |       |  |   |      |      
|Acquired in-process research and development                           |       |                |      |         |  |        | 210   |        |  |        | 625 |        |  |   | 1,849 |        |  |   | 410   |       |  |   | 244   |      
|Non-compete agreement                                                  |       |                |      |         |  |        | 769   |        |  |        | 199 |        |  |   |      |        |  |   |      |       |  |   |      |      
|Goodwill                                                               |       |                |      |         |  |        |      |        |  |        | 106 |        |  |   | 7,386 |        |  |   | 3,454 |       |  |   | 3,419 |      
|Net fair value of acquired tangible assets and
    assumed liabilities |       |                | 114   |         |  |        | 397   |        |  |        | 163 |        |  |   | 2,621 |        |  |   | 234   |       |  |   | 1,322 |      
|                                                                       |       |                |       |         |  |        |       |        |  |        |     |        |  |   |       |        |  |   |       |       |  |   |       |      
|                                                                       | Total |                | $     | 1,258   |  |        | $     | 3,081  |  |        | $   | 1,658  |  |   | $     | 18,850 |  |   | $     | 4,575 |  |   | $     | 5,619 | 
|                                                                       |       |                |       |         |  |        |       |        |  |        |     |        |  |   |       |        |  |   |       |       |  |   |       |      

The acquired core technology associated with the
TORC Assets is being amortized over four years. The acquired
core technology and acquired developed technology associated
with the Quantum Assets are being amortized over four years. The
acquired core technology associated with the Summit Assets is
being amortized over four years. The non-compete agreements from
the Summit Assets and Quantum Assets are being amortized over
two and three years, respectively. The RTP backlog was amortized
to cost of sales at the time revenue was recognized for the
related customer orders.

The purchase price for the Summit Assets and RTP
Assets resulted in the recognition of goodwill. The primary
factor contributing to the recognition of goodwill for Summit
Assets was the ability to integrate a workforce with technical
expertise. The primary factors contributing to the recognition
of goodwill for the RTP Assets included 1) an increase in
speed to market through acquisition of the business and
associated products and technology, 2) the integration of a
workforce with the technical expertise, and 3) a deeper
penetration of the Companys current customer base with a
broader portfolio of products. The Company expects that the
goodwill for both the Summit Assets and RTP Assets will be
deductible for tax purposes in the United States.

The purchase price of the TORC Assets and Quantum
Assets resulted in the fair value of the identifiable assets
acquired exceeding the cost of the acquired business by
approximately $2.2 million and $676,000, respectively. In
accordance with Statement of Financial Accounting Standards
No. 141 Business Combinations, the values of
the non-current assets acquired were reduced by a proportionate
part of the excess to determine the assigned values.

65



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PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The acquired core technology and acquired
developed technology associated with the Akcron Assets and RTP
Assets were partially written off and the goodwill associated
with the Akron Assets and RTP Assets was entirely written off as
part of the impairment of intangibles and goodwill impairment
charges taken in the fourth quarter of fiscal 2003. The
remaining acquired core technology and acquired developed
technology amounts were written off in the three months ended
December 31, 2003 as additional impairment charges. These
additional impairment charges were a result of the continuing
deterioration in business conditions that included emergence of
alternative and competing technologies, shrinkage of the
potential total market opportunity due to one of the primary
potential customers decision to pursue an alternative
technology and further softness in this particular sector of the
market since September 30, 2003. Accordingly, the Company
performed an impairment analysis for the remaining acquired
intangible assets as required by Statement of Financial
Accounting Standards No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets
(FAS 144).

The following pro forma information presents the
results of continuing operations of the Company for the years
ended September 30, 2004 and 2003 as if TORC Assets,
Quantum Assets, Summit Assets, RTP Assets and Akcron Assets had
been acquired as of the beginning of the fiscal year of
acquisition and the immediately preceding period. Pro forma
information related to ISIS Assets has been excluded from the
presentation as during 2003 the Company exited from such
businesses and the associated results of operations for all
periods presented have been included under loss from
discontinued operations. The pro forma information does not
purport to be indicative of what would have occurred had the
acquisition been made as of these dates or of results that may
occur in the future.

The pro forma results exclude nonrecurring
charges, such as the write-off of purchased in-process research
and development, which resulted directly from these
transactions. The unaudited pro forma information is as follows:

|                                                                  |                   |                                       |         |        |  |      |         |         |   |   |        |       |  
|----------------------------------------------------------------- | ----------------- | ------------------------------------- | ------- | ------ |  | ---- | ------- | ------- | - | - | ------ | ----- | -
|                                                                  |                   |                                      
|                                                                  |                   | Year Ended September 30,             
|                                                                  |                   |                                      
|                                                                  |                   | 2004                                  |         | 2003   |  | 2002
|                                                                  |                   |                                       |         |        |  |     
|                                                                  |                   |                                      
|                                                                  |                   | (Unaudited)                          
|                                                                  |                   |                                      
|                                                                  |                   | (In thousands, except per share data)
|Total revenue                                                     |                   | $                                     | 147,811 |        |  | $    | 71,734  |         |   | $ | 56,262 |      
|Net income (loss) from continuing operations                      |                   |                                       | 9,494   |        |  |      | (26,922 | )       |   |   | (117   | )    
|                                                                  | Net income (loss) |                                       |         | 13,690 |  |      |         | (24,010 | ) |   |        | 2,188 |  
|Pro forma income (loss) per share from continuing
    operations: |                   |                                       |         |        |  |      |         |         |   |   |        |      
|                                                                  | Basic             |                                       | $       | 0.57   |  |      | $       | (1.67   | ) |   | $      | (0.01 | )
|                                                                  | Diluted           |                                       | $       | 0.56   |  |      | $       | (1.67   | ) |   | $      | (0.01 | )
|Pro forma income (loss) per share:                                |                   |                                       |         |        |  |      |         |         |   |   |        |      
|                                                                  | Basic             |                                       | $       | 0.82   |  |      | $       | (1.49   | ) |   | $      | 0.14  |  
|                                                                  | Diluted           |                                       | $       | 0.80   |  |      | $       | (1.49   | ) |   | $      | 0.13  |  

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PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|         |                                                   
|-------- | --------------------------------------------------
|Note 5  | Goodwill and Other Purchased Intangible
    Assets



| |         
| | --------
| | Goodwill

Changes in the carrying amount of goodwill for
the years ended September 30, 2004 and 2003 are as follows:

|                                 |                                                 |                |       |              |   |       |        |         |   |   |        |         |  
|-------------------------------- | ----------------------------------------------- | -------------- | ----- | ------------ | - | ----- | ------ | ------- | - | - | ------ | ------- | -
|                                 |                                                 | Flat Panel     |       | Discontinued |   |      
|                                 |                                                 | Display        |       | Operations   |   | Total
|                                 |                                                 |                |       |              |   |      
|                                 |                                                 |               
|                                 |                                                 | (In thousands)
|Balance as of September 30, 2002 |                                                 | $              | 3,454 |              |   | $     | 15,083 |         |   | $ | 18,537 |        
|                                 | Goodwill on businesses acquired during the year |                |       | 7,492        |   |       |        |        |   |   |        | 7,492   |  
|                                 | Adjustments to goodwill, net                    |                |       | (418         | ) |       |        |        |   |   |        | (418    | )
|                                 | Goodwill impairment charge                      |                |       | (10,010      | ) |       |        | (15,083 | ) |   |        | (25,093 | )
|                                 |                                                 |                |       |              |   |       |        |         |   |   |        |        
|Balance as of September 30, 2003 |                                                 |                | 518   |              |   |       |       |         |   |   | 518    |        
|                                 | Adjustments to goodwill, net                    |                |       | 300          |   |       |        |        |   |   |        | 300     |  
|                                 | Goodwill impairment charge                      |                |       | (665         | ) |       |        |        |   |   |        | (665    | )
|                                 |                                                 |                |       |              |   |       |        |         |   |   |        |        
|Balance as of September 30, 2004 |                                                 | $              | 153   |              |   | $     |       |         |   | $ | 153    |        
|                                 |                                                 |                |       |              |   |       |        |         |   |   |        |        

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

In conjunction with the Companys
acquisition of Akcron in September 2002, the Company established
a $1.7 million liability for a portion of the purchase
price to be held by the Company as security for indemnification
should Akcron breach any of its representations and warranties.
For the year ended September 30, 2003, adjustments of
$770,000 were made to the Akcron liability, consisting of
$320,000 for a breach of warranty related to the collectibility
of a receivable and $350,000 related to the non-occurrence of a
certain event.

For the year ended September 30, 2003, the
Company recorded net adjustments of approximately $418,000 to
reduce goodwill, consisting of the aforementioned $350,000
reduction to the Akcron liability, which reduced the purchase
price with no change to the net assets acquired and reductions
of $83,000 and $62,000 to the purchase prices of Akcron and the
RTP Assets, respectively, for accrued acquisition costs which
were subsequently reduced. These reductions were offset by an
increase to the Summit Assets goodwill of approximately $47,000
and other miscellaneous adjustments that increased goodwill by a
net of approximately $5,000, primarily associated with the RTP
acquisition.

In the fourth quarter of fiscal 2003, as a result
of limited opportunities in the inverter market and uncertainty
with regard to flat panel manufacturers commitment to LTPS
technology, the Company performed an impairment analysis of the
$3.1 million and the $7.4 million of goodwill
associated with the Akcron and RTP reporting units,
respectively. The valuation was done as of July 1, 2003,
using established valuation techniques, specifically, the income
and market approaches. As a result of this analysis, the Company
recorded goodwill impairment charges of $2.7 million and
$7.3 million associated with Akcron and RTP, respectively.

In November 2002, as part of the acquisition of
the RTP Assets, $2.0 million was placed into escrow to be
released either to the Company or to Intevac depending on the
occurrence of certain future events during

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PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

the escrow period. In September 2003, the Company
filed a claim against the escrow for the full $2.0 million.
In October 2003, the Company received $1.7 million on its
claim against the $2.0 million escrow related to the RTP
Asset purchase from Intevac. The claim for the remaining
$300,000 was resolved in favor of Intevac. Because the Company
has written off all goodwill resulting from the acquisition of
the RTP Assets, the $300,000 resolved in favor of Intevac
resulted in an adjustment to record additional goodwill, which
was deemed to be impaired due to continuing deterioration in
business conditions during the three month period ended
December 31, 2003.

During the three months ended December 31,
2003, the Company recorded a goodwill impairment charge of
approximately $365,000 under the provisions of Statement of
Financial Accounting Standards No. 142, Goodwill and
Other Intangible Assets (FAS 142),
representing the remaining goodwill associated with its Akcron
reporting unit. This impairment charge was a result of the
continuing softness in the inverter market since
September 30, 2003. Accordingly the Company performed an
impairment analysis for the remaining acquired intangible assets
as required by FAS 144.

In accordance with FAS 142 and FAS144, these
fiscal 2003 and 2004 impairment charges established new cost
basis for the remaining goodwill assets. Goodwill as of
September 30, 2004 relates entirely to the Companys
purchase of assets from Summit Imaging.



| |                  
| | -----------------
| | Intangible Assets

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

|                                                                                          |  |            |        |            |  |         |        |                |  |             |     |         |  |       |       |   |  |   |      |   |  |   |      |   |  |   |        |  
|----------------------------------------------------------------------------------------- |  | ---------- | ------ | ---------- |  | ------- | ------ | -------------- |  | ----------- | --- | ------- |  | ----- | ----- | - |  | - | ---- | - |  | - | ---- | - |  | - | ------ | -
|                                                                                          |  | Developed  |        | Core       |  |         |        | License        |  | Non Compete |     |         |  |      
|                                                                                          |  | Technology |        | Technology |  | Patents |        | Agreement      |  | Contract    |     | Backlog |  | Total
|                                                                                          |  |            |        |            |  |         |        |                |  |             |     |         |  |      
|                                                                                          |  |            |        |            |  |         |        |                |  |             |     |        
|                                                                                          |  |            |        |            |  |         |        | (In thousands) |  |             |     |        
|Balance as of September 30, 2002                                                          |  | $          | 557    |            |  | $       | 2,878  |                |  | $           | 119 |         |  | $     |      |   |  | $ |     |   |  | $ |     |   |  | $ | 3,554  |  
|Acquired during the period                                                                |  |            | 2,673  |            |  |         | 4,329  |                |  |             |    |         |  |       |      |   |  |   | 199  |   |  |   | 557  |   |  |   | 7,758  |  
|Amortization during the period included in
    continuing operations                      |  |            | (552   | )          |  |         | (639   | )              |  |             | (3  | )       |  |       |      |   |  |   | (42  | ) |  |   |     |   |  |   | (1,236 | )
|Amortization during the period included in
    discontinued operations                    |  |            | (16    | )          |  |         | (173   | )              |  |             | (6  | )       |  |       |      |   |  |   |     |   |  |   |     |   |  |   | (195   | )
|Amortization of backlog to cost of revenue in
    continuing operations during the period |  |            |       |            |  |         |       |                |  |             |    |         |  |       |      |   |  |   |     |   |  |   | (557 | ) |  |   | (557   | )
|Impairment of purchased intangibles included in
    continuing operations                 |  |            | (1,537 | )          |  |         | (1,981 | )              |  |             | (30 | )       |  |       |      |   |  |   |     |   |  |   |     |   |  |   | (3,548 | )
|Impairment of purchased intangibles included in
    discontinued operations               |  |            | (470   | )          |  |         | (2,332 | )              |  |             | (80 | )       |  |       |      |   |  |   |     |   |  |   |     |   |  |   | (2,882 | )
|                                                                                          |  |            |        |            |  |         |        |                |  |             |     |         |  |       |       |   |  |   |      |   |  |   |      |   |  |   |        |  
|Balance as of September 30, 2003                                                          |  |            | 655    |            |  |         | 2,082  |                |  |             |    |         |  |       |      |   |  |   | 157  |   |  |   |     |   |  |   | 2,894  |  
|Acquired during the period                                                                |  |            | 987    |            |  |         | 1,843  |                |  |             |    |         |  |       | 1,138 |   |  |   | 770  |   |  |   |     |   |  |   | 4,737  |  
|Amortization during the period included in
    continuing operations                      |  |            | (221   | )          |  |         | (219   | )              |  |             |    |         |  |       | (190  | ) |  |   | (160 | ) |  |   |     |   |  |   | (789   | )
|Impairment of purchased intangibles included in
    continuing operations                 |  |            | (589   | )          |  |         | (1,500 | )              |  |             |    |         |  |       |      |   |  |   |     |   |  |   |     |   |  |   | (2,089 | )
|                                                                                          |  |            |        |            |  |         |        |                |  |             |     |         |  |       |       |   |  |   |      |   |  |   |      |   |  |   |        |  
|Balance as of September 30, 2004                                                          |  | $          | 832    |            |  | $       | 2,206  |                |  | $           |    |         |  | $     | 948   |   |  | $ | 767  |   |  | $ |     |   |  | $ | 4,753  |  
|                                                                                          |  |            |        |            |  |         |        |                |  |             |     |         |  |       |       |   |  |   |      |   |  |   |      |   |  |   |        |  

In the first quarter of fiscal 2003, based on
certain indicators of impairment in the printed circuit board
assembly inspection division, the Company performed an
impairment analysis of purchased intangible assets and certain
other long-lived assets associated with the printed circuit
board assembly inspection reporting unit.

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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

As a result, the Company recorded impairment
charges of approximately $2.9 million related to the
unamortized portion of the acquired developed and core
technology intangible assets and approximately $2.9 million
related to certain other long-lived assets to reduce the
carrying values of purchased intangible assets and other
long-lived assets to their respective estimated values.

In the fourth quarter of fiscal 2003, as a result
of limited opportunities in the inverter market and uncertainty
with regard to flat panel manufacturers commitment to LTPS
technology, the Company performed an impairment analysis of
purchased intangible assets and certain other long-lived assets
associated with Akcron and the RTP reporting units which are
both part of the flat panel display reporting unit. As a result,
the Company recorded impairment charges of approximately
$3.5 million related to the unamortized portion of the
acquired developed technology, core technology and patent
intangible assets to reduce the carrying values of purchased
intangible assets to their respective estimated values.

During the three months ended March 31,
2004, the Company signed a Termination and Assignment Agreement
(the Agreement) with Ishikawajima-Harima Heavy
Industries (IHI), the Companys value-added
reseller of its flat panel display products in Japan. Under the
terms of the Agreement, all prior existing agreements between
IHI and the Company were terminated, including IHIs rights
to sell and support the Companys flat panel display
products on an exclusive basis in Japan. As part of this
termination agreement, IHI assigned to the Company the right to
use all intellectual property rights associated with the
Companys products held by IHI, including any patents and
patent applications associated with the intellectual property
rights. Additionally, as part of this termination agreement, IHI
retained rights to purchase systems from the Company for resale
to one particular customer in Japan for purchase orders issued
from the customer to IHI prior to April 1, 2005. The
Company paid to IHI $1.5 million, consisting of $339,000
for IHIs remaining field spares inventory and
$1.1 million for the aforementioned intellectual property
rights and other intangible assets. These intangible assets are
being amortized over three years, beginning in April 2004.

During the three months ended December 31,
2003, the Company recorded impairment charges of approximately
$2.1 million related to the remaining portion of the
acquired developed technology and core technology related to the
Akcron and RTP reporting units. These charges have been
reflected in the results of operations in the quarter ended
December 31, 2003 (See Note 4).

In accordance with FAS 142 and FAS144, these
fiscal 2003 and 2004 impairment charges established new cost
basis for the remaining goodwill assets.

Future estimated amortization expense relating to
intangible assets at September 30, 2004 is approximately
$1.5 million, $1.5 million, $1.2 million and
$558,000 in fiscal 2005 through 2009, respectively.

In accessing the recoverability of its intangible
assets, the Company must make assumptions regarding estimated
future cash flows and other factors to determine the fair value
of the respective assets. It is reasonably possible that these
estimates, or their related assumptions, may change in the
future, in which case the Company may be required to record
additional impairment charges for these assets.



|         |                      
|-------- | ---------------------
|Note 6  | Restructuring Charges

During the fourth quarter of fiscal 2002, the
Company implemented a restructuring plan to reduce its
workforce, consolidate and close certain facilities and
write-off related fixed assets. Prior to the date of the
financial statements, management approved and implemented the
plan and determined the benefits that would be offered to the
employees being terminated. All 29 of the affected employees
were notified of their termination prior to the date of the
financial statements and the benefits package was explained in
sufficient detail such that each affected employee was able to
determine the type and amount of benefits he or she was entitled
to receive. The reductions occurred primarily in the former
printed circuit board assembly business segment and related
sales and service. The Company recorded a restructuring charge
of $2.6 million, included in loss from discontinued
operations, which is comprised of approximately $550,000 for
employee severance

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PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

and related benefits, $1.3 million related
to excess facilities and $700,000 of abandoned assets with no
future economic benefit. The charge for excess facilities
relates to rent obligations under long term operating lease
agreements which are to be paid in cash through December 2006.
Approximately $235,000 of the employee severance and related
benefits were paid out on September 30, 2002. In the second
quarter of fiscal 2003, management settled all remaining
employee severance and related benefits. In the second quarter
of fiscal 2003, the Company renegotiated the terms of the lease
obligation related to one of the excess facilities, resulting in
a reduction to the liability of approximately $237,000. In the
third quarter of fiscal 2003, the Company subleased a portion of
one of the excess facilities, resulting in a reduction to the
liability of approximately $483,000. These benefits were taken
as part of the discontinued operations. As of September 30,
2004 and 2003, the remaining liability associated with the
restructuring plan was approximately $0 and $364,000,
respectively, with the 2003 balance consisting entirely of
operating lease obligations associated with excess facilities.



|         |                      
|-------- | ---------------------
|Note 7  | Financial Instruments



| |                                                
| | -----------------------------------------------
| | Cash Equivalents and Short-term
    Investments

The fair value of the Companys cash
equivalents approximates the carrying amount due to the
relatively short maturity of these items. The amortized costs
and estimated fair value of securities available-for-sale, by
type, as of September 30, 2004 and 2003 are as follows:

|                   |                                                |                                            |   |                |        |            |   |            |   |  |   |      |      |   |   |        |        | 
|------------------ | ---------------------------------------------- | ------------------------------------------ | - | -------------- | ------ | ---------- | - | ---------- | - |  | - | ---- | ---- | - | - | ------ | ------ | 
|                   |                                                |                                            |   | Gross          |        | Gross      |   |           
|                   |                                                | Amortized                                  |   | Unrealized     |        | Unrealized |   |           
|                   |                                                | Cost                                       |   | Gains          |        | Losses     |   | Fair Value
|                   |                                                |                                            |   |                |        |            |   |           
|                   |                                                |                                            |   |                |        |           
|                   |                                                |                                            |   | (In thousands) |        |           
|September 30, 2004 |                                                |                                            |   |                |        |            |   |            |   |  |   |      |      |   |   |       
|                   | Auction rate preferred securities              |                                            | $ | 24,370         |        |            | $ |           |   |  | $ |     |      |   | $ | 24,370 |       
|                   | Commercial paper and corporate debt securities |                                            |   | 34,488         |        |            |   |           |   |  |   | (186 | )    |   |   | 34,302 |       
|                   |                                                |                                            |   |                |        |            |   |            |   |  |   |      |      |   |   |       
|                   |                                                | Amounts included in short-term investments |   | $              | 58,858 |            |   | $          |  |  |   | $    | (186 | ) |   | $      | 58,672 | 
|                   |                                                |                                            |   |                |        |            |   |            |   |  |   |      |      |   |   |       
|September 30, 2003 |                                                |                                            |   |                |        |            |   |            |   |  |   |      |      |   |   |       
|                   | Auction rate preferred securities              |                                            | $ | 53,750         |        |            | $ |           |   |  | $ |     |      |   | $ | 53,750 |       
|                   | Commercial paper and corporate debt securities |                                            |   | 44,224         |        |            |   | 208        |   |  |   | (18  | )    |   |   | 44,414 |       
|                   |                                                |                                            |   |                |        |            |   |            |   |  |   |      |      |   |   |       
|                   | Amounts included in short-term investments     |                                            | $ | 97,974         |        |            | $ | 208        |   |  | $ | (18  | )    |   | $ | 98,164 |       
|                   |                                                |                                            |   |                |        |            |   |            |   |  |   |      |      |   |   |       

Net realized gains and losses for the years ended
September 30, 2004 and 2003 were not material to the
Companys financial position or results of operations and
have been included in Interest income and other, net
in the Consolidated Statements of Operations in the respective
period.

Photon Dynamics investment portfolio
consists of both corporate and government securities that have a
maximum maturity of 4.25 years. The longer the duration of
these securities, the more susceptible they are to changes in
market interest rates and bond yields. As yields increase, those
securities with a lower yield-at-cost show a mark-to market
unrealized loss. All unrealized losses are due to changes in
interest rates and bond yields. The Company believes it has the
ability to realize the full value of all these investments upon
maturity. The following table summarizes the fair value and
gross unrealized losses of our long-term investments,

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PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

aggregated by investment instrument and length of
time that the individual securities have been in a continuous
unrealized loss position at September 30, 2004:

|                 |       |                 |        |            |  |   |     |      |  
|---------------- | ----- | --------------- | ------ | ---------- |  | - | --- | ---- | -
|                 |       |                
|                 |       | Total in a Loss
|                 |       | Position(1)    
|                 |       |                
|                 |       |                 |        | Gross     
|                 |       |                 |        | Unrealized
|                 |       | FMV             |        | Losses    
|                 |       |                 |        |           
|                 |       |                
|                 |       | (In thousands) 
|Corporate equity |       | $               | 14,789 |            |  | $ | (93 | )   
|Municipal bonds  |       |                 | 15,907 |            |  |   | (93 | )   
|                 |       |                 |        |            |  |   |     |     
|                 | Total |                 | $      | 30,696     |  |   | $   | (186 | )
|                 |       |                 |        |            |  |   |     |     



---



|    |                                                                                                                                                                                                                                        
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Of the total gross unrealized losses,
    approximately $28,000 of gross unrealized losses relates
    primarily to corporate equity with a fair value of
    $4.6 million that have been in a loss position for
    12 months or more.

The contractual maturities of debt securities
classified as available-for-sale as of September 30, 2004,
regardless of the consolidated balance sheet classification, are
as follows:

|                                     |                                      |                |        |            |  |   |        |        | 
|------------------------------------ | ------------------------------------ | -------------- | ------ | ---------- |  | - | ------ | ------ | 
|                                     |                                      |                |        | Estimated 
|                                     |                                      | Cost           |        | Fair Value
|                                     |                                      |                |        |           
|                                     |                                      |               
|                                     |                                      | (In thousands)
|Due within one year                  |                                      | $              | 24,370 |            |  | $ | 24,370 |       
|Due after one year through two years |                                      |                | 27,988 |            |  |   | 27,802 |       
|Due after two years                  |                                      |                | 6,500  |            |  |   | 6,500  |       
|                                     |                                      |                |        |            |  |   |        |       
|                                     | Total cost and estimated fair values |                | $      | 58,858     |  |   | $      | 58,672 | 
|                                     |                                      |                |        |            |  |   |        |       



| |                                     
| | ------------------------------------
| | Derivative Financial
    Instruments

Under its foreign currency risk management
strategy, the Company may utilize derivative instruments to
protect its interests from unanticipated fluctuations in
earnings and cash flows caused by volatility in currency
exchange rates. This financial exposure is monitored and managed
by the Company as an integral part of its overall risk
management program which focuses on the unpredictability of
financial markets and seeks to reduce the potentially adverse
effects that the volatility of these markets may have on its
operating results.

The Company accounts for its derivatives
instruments according to Statement of Financial Accounting
Standards No. 133, Accounting for Derivative
Instruments and Hedging Activities
(FAS 133), which requires that all derivatives
be recorded on the balance sheet at fair value. Changes in the
fair value of derivatives which do not qualify or are not
effective as hedges must be recognized currently in earnings.
The Company does not use derivative financial instruments for
speculative or trading purposes, nor does it hold or issue
leveraged derivative financial instruments.

The Companys international sales are
primarily denominated in U.S. dollars. For foreign currency
denominated sales, however, the volatility of the foreign
currency markets represents risk to the Companys margins.
The Company defines its exposure as the risk of changes in the
functional-currency-equivalent cash flows (generally
U.S. dollars) attributable to changes in the related
foreign currency exchange rates. The Company records the
mark-to-market change in fair value of its derivative
instruments within Other current liabilities in the
Companys Consolidated Balance Sheet. The Company did not
have any forward sales contracts at September 30, 2004. At
September 30, 2003, the Company had foreign exchange
forward contracts maturing throughout fiscal 2004 to sell
approximately $2.8 million in foreign currencies, primarily
Japanese Yen. The Company did not qualify these forward sales
contract as hedging instruments, as defined by FAS 133,
and, as such, recorded the changes in the fair value of these
derivatives immediately in Interest

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PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

income and other, net in the Consolidated
Statements of Operations. The Company recorded a net gain of
approximately $208,000 from changes in fair values of these
foreign currency exchange contracts in fiscal year 2004 and a
net loss of approximately $208,000 in fiscal year 2003. These
gains and losses are included in Interest income and
other, net in the Consolidated Statements of Operations.
The fair value of these open contracts at September 30,
2004 and 2003 were approximately $0 and $208,000, respectively,
and were included in Other current liabilities in
the Consolidated Balance Sheet. The Company did not have any
forward sales contracts in fiscal 2002.



|         |             
|-------- | ------------
|Note 8  | Income Taxes

The provision for income taxes related to
continuing operations consists of the following:

|          |         |                            |   |      |     |      |   |    |    |  |   |    |    | 
|--------- | ------- | -------------------------- | - | ---- | --- | ---- | - | -- | -- |  | - | -- | -- | 
|          |         |                           
|          |         | Year Ended September 30,  
|          |         |                           
|          |         | 2004                       |   | 2003 |     | 2002
|          |         |                            |   |      |     |     
|          |         |                           
|          |         | (In thousands)            
|Current:  |         |                            |   |      |     |      |   |    |    |  |   |   
|          | Federal |                            | $ | 191  |     |      | $ |   |    |  | $ |   |   
|          | State   |                            |   | 3    |     |      |   |   |    |  |   |   |   
|          | Foreign |                            |   | 412  |     |      |   | 56 |    |  |   | 85 |   
|Deferred: |         |                            |   |      |     |      |   |    |    |  |   |   
|          | Federal |                            |   |     |     |      |   |   |    |  |   |   |   
|          |         |                            |   |      |     |      |   |    |    |  |   |   
|          |         | Provision for income taxes |   | $    | 606 |      |   | $  | 56 |  |   | $  | 85 | 
|          |         |                            |   |      |     |      |   |    |    |  |   |   

Income (loss) before income taxes related to
continuing operations consists of the following:

|                                  |  |                          |        |      |  |      |         |   |  |   |       | 
|--------------------------------- |  | ------------------------ | ------ | ---- |  | ---- | ------- | - |  | - | ----- | 
|                                  |  |                         
|                                  |  | Year Ended September 30,
|                                  |  |                         
|                                  |  | 2004                     |        | 2003 |  | 2002
|                                  |  |                          |        |      |  |     
|                                  |  |                         
|                                  |  | (In thousands)          
|Domestic                          |  | $                        | 18,889 |      |  | $    | (17,848 | ) |  | $ | 5,683 | 
|Foreign                           |  |                          | (5,828 | )    |  |      | (9,876  | ) |  |   | 632   | 
|                                  |  |                          |        |      |  |      |         |   |  |   |       | 
|Income (loss) before income taxes |  | $                        | 13,061 |      |  | $    | (27,724 | ) |  | $ | 6,315 | 
|                                  |  |                          |        |      |  |      |         |   |  |   |       | 

72



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The significant components of the Companys
deferred income tax assets are as follows:

|                         |                                                |                               |         |        |        |  |         |        |        | 
|------------------------ | ---------------------------------------------- | ----------------------------- | ------- | ------ | ------ |  | ------- | ------ | ------ | 
|                         |                                                |                              
|                         |                                                | September 30,                
|                         |                                                |                              
|                         |                                                | 2004                          |         | 2003  
|                         |                                                |                               |         |       
|                         |                                                |                              
|                         |                                                | (In thousands)               
|Deferred tax assets:     |                                                |                               |         |        |        |  |         |       
|                         | Net operating loss carryforwards               |                               | $       | 31,875 |        |  | $       | 26,334 |       
|                         | Research credit carryforwards                  |                               |         | 9,834  |        |  |         | 8,225  |       
|                         | Canadian research and development expenditures |                               |         | 3,722  |        |  |         | 2,826  |       
|                         | Purchased intangibles                          |                               |         | 696    |        |  |         | 17,280 |       
|                         | Inventory write-downs                          |                               |         | 3,244  |        |  |         | 3,003  |       
|                         | Depreciation                                   |                               |         | 1,572  |        |  |         | 837    |       
|                         | Allowance for doubtful accounts                |                               |         | 202    |        |  |         | 204    |       
|                         | Expenses not currently deductible              |                               |         | 5,374  |        |  |         | 3,255  |       
|                         | Deferred revenue                               |                               |         | 7,173  |        |  |         | 1,852  |       
|                         |                                                |                               |         |        |        |  |         |       
|                         |                                                | Total deferred tax assets     |         |        | 63,692 |  |         |        | 63,816 | 
|Valuation allowance      |                                                |                               | (63,692 | )      |        |  | (63,816 | )     
|                         |                                                |                               |         |        |        |  |         |       
|Net deferred tax assets  |                                                |                               |        |        |        |  |        |       
|Deferred tax liabilities |                                                |                               |        |        |        |  |        |       
|                         |                                                |                               |         |        |        |  |         |       
|                         |                                                | Total net deferred tax assets |         | $      |       |  |         | $      |       | 
|                         |                                                |                               |         |        |        |  |         |       

Deferred tax assets reflect net operating loss
and credit carryforwards and the net tax effects of temporary
differences between the carrying amounts of assets and
liabilities for financial reporting purposes and the amounts
used for income tax purposes.

The valuation allowance decreased by
approximately $0.1 million in fiscal 2004 and increased by
approximately $29.8 million in fiscal 2003. As of
September 30, 2004, approximately $15.2 million of the
valuation allowance is related to the benefits of stock option
deductions, which will be credited to paid-in capital when
realized. The current year unrealized benefit generated is
approximately $2.5 million.

As of September 30, 2004, the Company has
federal and state net operating loss carryforwards of
approximately $68.3 million and $12.0 million,
respectively. The federal net operating loss carryforwards will
begin expiring in fiscal year 2012 if not utilized. The state
net operating loss carryforwards will expire at various times
beginning in fiscal year 2012 if not utilized. The Company also
has federal and state research and development tax credit
carryforwards of $4.5 million and $3.4 million,
respectively. The federal credits will begin expiring in fiscal
year 2010 and will continue to expire on an annual basis through
fiscal year 2024 if not utilized. The state credits have an
indefinite carryforward period.

The Company has cumulative foreign loss
carryforwards for Canadian income tax purposes of approximately
$10.1 million. These foreign loss carryforwards will begin
expiring in fiscal year 2005 and will continue to expire through
2010 if not utilized.

The Company has cumulative Canadian scientific
research and development expenditures (SR&D)
available for deduction in future years of approximately of
$10.6 million. These deductible SR&D can be carried
forward to reduce future Canadian taxable income indefinitely.
The Company also has SR&D credit carryforwards of
$2.8 million, which will expire in fiscal year 2005 and
will continue to expire on an annual basis through fiscal year
2013.

73



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PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Under certain provisions of the Internal Revenue
Code of 1986, as amended, the availability of the Companys
domestic net operating loss and tax credit carryforwards may be
subject to limitation if it should be determined that there has
been a change in ownership of more than 50% of the value of the
Companys stock. Such determination could limit the
utilization of net operating loss and tax credit carryforwards.

The reconciliation of the U.S. federal
statutory income tax rate to the Companys effective income
tax rate is as follows:

|                                                                  |  |                          |        |      |  |      |         |   |  |   |         |  
|----------------------------------------------------------------- |  | ------------------------ | ------ | ---- |  | ---- | ------- | - |  | - | ------- | -
|                                                                  |  |                         
|                                                                  |  | Year Ended September 30,
|                                                                  |  |                         
|                                                                  |  | 2004                     |        | 2003 |  | 2002
|                                                                  |  |                          |        |      |  |     
|                                                                  |  |                         
|                                                                  |  | (In thousands)          
|Expected provision (benefit) at federal statutory
    rate        |  | $                        | 4,084  |      |  | $    | (9,723  | ) |  | $ | 2,181   |  
|Foreign income taxes                                              |  |                          | 410    |      |  |      | 56      |   |  |   | 85      |  
|Election to treat subsidiary stock purchase as
    asset purchase |  |                          |       |      |  |      |        |   |  |   | 11,906  |  
|Losses (benefited)/not benefited 
    Discontinued operations    |  |                          |       |      |  |      | (18,171 | ) |  |   | (11,423 | )
|Losses (benefited)/not benefited                                  |  |                          | (3,889 | )    |  |      | 26,993  |   |  |   | (2,868  | )
|Other individually immaterial items                               |  |                          | 1      |      |  |      | 901     |   |  |   | 204     |  
|                                                                  |  |                          |        |      |  |      |         |   |  |   |         |  
|                                                                  |  | $                        | 606    |      |  | $    | 56      |   |  | $ | 85      |  
|                                                                  |  |                          |        |      |  |      |         |   |  |   |         |  



|         |                                               
|-------- | ----------------------------------------------
|Note 9  | Shareholders Equity and Employee
    Benefits

Common Stock.In
August 2002, the Companys Board of Directors approved a
stock repurchase program authorizing the Company to repurchase
up to an aggregate of $25.0 million of the Companys
common stock. The repurchase program was terminated on
January 15, 2003. The repurchases were made from time to
time on the open market at prevailing prices, in negotiated
transactions off the market or pursuant to a 10b5-1 plan adopted
by the Company. The 10b5-1 plan allowed the Company to
repurchase its shares during a period in which the Company was
in possession of material non-public information, provided that
the Company communicated share repurchase instructions to the
broker at a time when it was not in possession of such material
non-public information. As of September 30, 2002 the
Company had repurchased 350,900 shares for an aggregate
repurchase price of approximately $6.9 million. During the
period October 1, 2002 through January 15, 2003, the
Company repurchased 903,032 shares for an aggregate
repurchase price of approximately $17.7 million. The
Company repurchased a total of 1,253,932 shares for an
aggregate repurchase price of approximately $24.6 million
under this program.

Warrants.In
connection with the acquisition of IRSI in July 2001, the
Company assumed the terms of a warrant originally issued by IRSI
to Leader Technologies Ltd. The original terms of the warrant
provided the holder with the right to
purchase 1,300,000 shares of Series E Preferred
Stock of IRSI at a purchase price of $1.20 per share. Upon
the closing of the acquisition and pursuant to the terms
therein, the warrant became exercisable for 28,766 shares
of the Companys common stock at a purchase price of
$54.23 per share. The warrant expires on March 1, 2005.

Stock Option Plans.Under the Companys 1995 and 2001 stock option plans, the
Board of Directors may, at its discretion, grant incentive or
non-qualified stock options to employees, officers, directors
and consultants at prices no less than 100% of the fair market
value of shares at the date of grant. The plans also permit the
grant of stock bonus awards to qualified individuals. Options
generally vest over a period of 50 months commencing from
the date of grant and expire ten years after the options are
granted.

On January 26, 2004, at the Companys
Annual Meeting of Shareholders, the Companys shareholders
approved an increase of 400,000 shares reserved for grant
under the Companys Amended and Restated 1995 Stock Option
Plan from a total of 2,990,943 shares to
3,390,943 shares and an increase of 250,000 shares

74



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PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

authorized for issuance under the Companys
1995 Employee Stock Purchase Plan from a total of
1,250,000 shares to 1,500,000 shares.

The activity under the option plans, combined, is
as follows:

|                               |  |           |          |             |  |                  |           |   |  |   |       | 
|------------------------------ |  | --------- | -------- | ----------- |  | ---------------- | --------- | - |  | - | ----- | 
|                               |  | Available |          | Options     |  | Weighted-Average
|                               |  | for Grant |          | Outstanding |  | Exercise Price  
|                               |  |           |          |             |  |                 
|Balances at September 30, 2001 |  |           | 360,032  |             |  |                  | 1,961,809 |   |  |   | 19.74 | 
|Additional shares reserved     |  |           | 650,000  |             |  |                  |          |   |  |   |      | 
|Options granted                |  |           | (667,107 | )           |  |                  | 667,107   |   |  |   | 29.38 | 
|Options canceled/expired       |  |           | 559      |             |  |                  | (114,089  | ) |  |   | 26.09 | 
|Options exercised              |  |           |         |             |  |                  | (288,004  | ) |  |   | 13.33 | 
|                               |  |           |          |             |  |                  |           |   |  |   |       | 
|Balances at September 30, 2002 |  |           | 343,484  |             |  |                  | 2,226,823 |   |  |   | 23.11 | 
|Additional shares reserved     |  |           | 400,000  |             |  |                  |          |   |  |   |      | 
|Options granted                |  |           | (789,083 | )           |  |                  | 789,083   |   |  |   | 21.20 | 
|Options canceled/expired       |  |           | 770,746  |             |  |                  | (786,231  | ) |  |   | 14.25 | 
|Options exercised              |  |           |         |             |  |                  | (479,037  | ) |  |   | 28.73 | 
|                               |  |           |          |             |  |                  |           |   |  |   |       | 
|Balances at September 30, 2003 |  |           | 725,147  |             |  |                  | 1,750,638 |   |  |   | 22.14 | 
|Additional shares reserved     |  |           | 400,000  |             |  |                  |          |   |  |   |      | 
|Options granted                |  |           | (618,550 | )           |  |                  | 618,550   |   |  |   | 31.72 | 
|Options canceled/expired       |  |           | 352,407  |             |  |                  | (352,407  | ) |  |   | 13.27 | 
|Options exercised              |  |           |         |             |  |                  | (384,572  | ) |  |   | 22.74 | 
|                               |  |           |          |             |  |                  |           |   |  |   |       | 
|Balances at September 30, 2004 |  |           | 859,004  |             |  |                  | 1,632,209 |   |  | $ | 27.73 | 
|                               |  |           |          |             |  |                  |           |   |  |   |       | 

The following table summarizes information about
stock options outstanding as of September 30, 2004:

|                        |       |               |  |               |   |               |  |                     |       |                                |  |                   |  |        |           |                   |  |  |      |  |  |   |       |  |  |  |         |  |  |   |       | 
|----------------------- | ----- | ------------- |  | ------------- | - | ------------- |  | ------------------- | ----- | ------------------------------ |  | ----------------- |  | ------ | --------- | ----------------- |  |  | ---- |  |  | - | ----- |  |  |  | ------- |  |  | - | ----- | 
|                        |       |               |  |               |   |               |  |                     |       |                               
|                        |       |               |  |               |   |               |  | Options Outstanding |       | Options Vested and Exercisable
|                        |       |               |  |               |   |               |  |                     |       |                               
|                        |       |               |  |               |   |               |  | Number of Shares    |       | Weighted-Average               |  | Weighted-Average  |  |        |           | Weighted-Average 
|                        |       |               |  |               |   |               |  | Outstanding at      |       | Remaining                      |  | Exercise Price at |  | Number |           | Exercise Price at
|                        |       | September 30, |  | Contract Life |   | September 30, |  | Vested and          |       | September 30,                 
|Range of Exercise Price |       | 2004          |  | (In years)    |   | 2004          |  | Exercisable         |       | 2004                          
|                        |       |               |  |               |   |               |  |                     |       |                               
|$                       | 3.00  |               |  |               | - |               |  | $                   | 6.13  |                                |  |                   |  |        | 49,176    |                   |  |  | 4.08 |  |  | $ | 4.76  |  |  |  | 49,176  |  |  | $ | 4.76  | 
|                        | 10.63 |               |  |               | - |               |  |                     | 16.88 |                                |  |                   |  |        | 143,983   |                   |  |  | 6.18 |  |  |   | 14.90 |  |  |  | 133,291 |  |  |   | 14.75 | 
|                        | 17.75 |               |  |               | - |               |  |                     | 23.63 |                                |  |                   |  |        | 219,325   |                   |  |  | 7.01 |  |  |   | 19.18 |  |  |  | 139,179 |  |  |   | 19.47 | 
|                        | 24.43 |               |  |               | - |               |  |                     | 26.24 |                                |  |                   |  |        | 274,260   |                   |  |  | 7.94 |  |  |   | 25.51 |  |  |  | 131,624 |  |  |   | 25.64 | 
|                        | 27.58 |               |  |               | - |               |  |                     | 29.31 |                                |  |                   |  |        | 370,926   |                   |  |  | 9.01 |  |  |   | 28.36 |  |  |  | 73,266  |  |  |   | 28.73 | 
|                        | 29.69 |               |  |               | - |               |  |                     | 47.31 |                                |  |                   |  |        | 561,289   |                   |  |  | 8.51 |  |  |   | 36.31 |  |  |  | 238,841 |  |  |   | 39.82 | 
|                        | 59.00 |               |  |               | - |               |  |                     | 59.00 |                                |  |                   |  |        | 13,250    |                   |  |  | 5.74 |  |  |   | 59.00 |  |  |  | 13,250  |  |  |   | 59.00 | 
|                        |       |               |  |               |   |               |  |                     |       |                                |  |                   |  |        |           |                   |  |  |      |  |  |  
|$                       | 3.00  |               |  |               | - |               |  | $                   | 59.00 |                                |  |                   |  |        | 1,632,209 |                   |  |  | 7.97 |  |  | $ | 27.73 |  |  |  | 778,627 |  |  | $ | 26.56 | 
|                        |       |               |  |               |   |               |  |                     |       |                                |  |                   |  |        |           |                   |  |  |      |  |  |  

The weighted average fair value of options
granted in fiscal 2004, 2003 and 2002 was $21.63, $15.14 and
$17.33, respectively. Options exercisable were 778,627, 769,177
and 906,589 as of September 30, 2004, 2003 and 2002,
respectively.

Employee Purchase
Plan.The Companys employee
stock purchase plan provides that eligible employees may
contribute up to 10% of their base earnings, through accumulated
payroll deductions, toward the semi-annual purchase of the
Companys common stock. Participants purchase shares on the
last day of each offering period. The price at which shares are
purchased is equal to 85% of the lower of the fair market value

75



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

of a share of common stock on the first day of
the two-year offering period or the purchase date. In fiscal
2004, 2003, and 2002, employees purchased 84,785, 96,601 and
48,087 shares, respectively. At September 30, 2004,
846,868 shares were reserved and available for issuance
under the plan. The weighted-average fair value of shares issued
in fiscal 2004, 2003, and 2002 was $15.80, $9.40 and $16.92
respectively.

Other Employee Benefits
Plans.The Company has a retirement
savings plan that qualifies as a deferred salary arrangement
under Section 401(k) of the Internal Revenue Code. In
fiscal 2004 and 2003, but not fiscal 2002, the Company matched
50% on the first 7% up to $3,500 per year of an eligible
employees contribution. The total charge to operations
under the 401(k) program was approximately $411,000, $282,000,
and $0 in fiscal 2004, 2003 and 2002, respectively.

During fiscal 2004, the Company recorded
approximately $206,000 in stock ownership expense related to
options granted to a consultant. The fair value of these options
was computed using the Black-Scholes option-pricing model. The
Options are subject to variable accounting and will be revalued
until they are fully vested and exercised. During fiscal 2003,
the Company recorded approximately $174,000 in stock ownership
expense related to the acceleration of options for two former
officers of the Company. The stock ownership expense for this
option acceleration was computed using intrinsic value in
accordance with APB 25. During fiscal 2003, the Company
recorded approximately $190,000 in stock ownership expense
related to options granted to a consultant who was subsequently
hired by the Company. The fair value was computed using the
Black-Scholes option-pricing model. The options are subject to
variable accounting and would be revalued until they are fully
vested and exercised.

Shares Reserved.The
Company has reserved shares of common stock for future issuance
as follows:

|                                        |       |               |           |           | 
|--------------------------------------- | ----- | ------------- | --------- | --------- | 
|                                        |       | September 30,
|                                        |       | 2004         
|                                        |       |              
|Stock options outstanding               |       |               | 1,632,209 |          
|Stock options, available for grant      |       |               | 859,004   |          
|Shares for employee stock purchase plan |       |               | 846,868   |          
|Warrants                                |       |               | 28,766    |          
|                                        |       |               |           |          
|                                        | Total |               |           | 3,366,847 | 
|                                        |       |               |           |          



|          |                            
|--------- | ---------------------------
|Note 10  | Net Income (Loss) Per Share

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

76



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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

|                    |                                                                                 |                                              |   |        |       |      |   |         |       |   |   |         |       |     
|------------------- | ------------------------------------------------------------------------------- | -------------------------------------------- | - | ------ | ----- | ---- | - | ------- | ----- | - | - | ------- | ----- | ----
|                    |                                                                                 |                                             
|                    |                                                                                 | Year Ended September 30,                    
|                    |                                                                                 |                                             
|                    |                                                                                 | 2004                                         |   | 2003   |       | 2002
|                    |                                                                                 |                                              |   |        |       |     
|                    |                                                                                 |                                             
|                    |                                                                                 | (In thousand, except per share data)        
|Numerator:          |                                                                                 |                                              |   |        |       |      |   |         |       |   |   |        
|                    | Net income (loss) from continuing operations
    before discontinued operations |                                              | $ | 12,455 |       |      | $ | (27,780 | )     |   | $ | 6,230   |      
|                    | Net loss from discontinued operations                                           |                                              |   | (1,391 | )     |      |   | (44,592 | )     |   |   | (28,032 | )    
|                    |                                                                                 |                                              |   |        |       |      |   |         |       |   |   |        
|                    | Net income (loss)                                                               |                                              | $ | 11,064 |       |      | $ | (72,372 | )     |   | $ | (21,802 | )    
|                    |                                                                                 |                                              |   |        |       |      |   |         |       |   |   |        
|Denominator:        |                                                                                 |                                              |   |        |       |      |   |         |       |   |   |        
|                    | Weighted average shares for basic net income
    (loss) per share               |                                              |   | 16,631 |       |      |   | 16,089  |       |   |   | 15,923  |      
|                    | Effect of dilutive securities:                                                  |                                              |   |        |       |      |   |         |       |   |   |         |      
|                    |                                                                                 | Employee stock options                       |   |        | 456   |      |   |         |      |   |   |         | 868   |     
|                    |                                                                                 |                                              |   |        |       |      |   |         |       |   |   |        
|                    | Weighted average shares for diluted net income
    per share                    |                                              |   | 17,087 |       |      |   | 16,089  | (1)   |   |   | 16,791  |      
|                    |                                                                                 |                                              |   |        |       |      |   |         |       |   |   |        
|Earnings per share: |                                                                                 |                                              |   |        |       |      |   |         |       |   |   |        
|                    | Basic net income (loss) per share:                                              |                                              |   |        |       |      |   |         |       |   |   |         |      
|                    |                                                                                 | Net income (loss) from continuing operations |   | $      | 0.75  |      |   | $       | (1.73 | ) |   | $       | 0.39  |     
|                    |                                                                                 | Net loss from discontinued operations        |   |        | (0.08 | )    |   |         | (2.77 | ) |   |         | (1.76 | )   
|                    |                                                                                 |                                              |   |        |       |      |   |         |       |   |   |        
|                    |                                                                                 | Net income (loss) per share                  |   | $      | 0.67  |      |   | $       | (4.50 | ) |   | $       | (1.37 | )   
|                    |                                                                                 |                                              |   |        |       |      |   |         |       |   |   |        
|                    | Diluted net income (loss) per share:                                            |                                              |   |        |       |      |   |         |       |   |   |         |      
|                    |                                                                                 | Net income (loss) from continuing operations |   | $      | 0.73  |      |   | $       | (1.73 | ) |   | $       | 0.37  |     
|                    |                                                                                 | Net loss from discontinued operations        |   |        | (0.08 | )(2) |   |         | (2.77 | ) |   |         | (1.67 | )(2)
|                    |                                                                                 |                                              |   |        |       |      |   |         |       |   |   |        
|                    |                                                                                 | Net income (loss) per share                  |   | $      | 0.65  |      |   | $       | (4.50 | ) |   | $       | (1.30 | )   
|                    |                                                                                 |                                              |   |        |       |      |   |         |       |   |   |        



---



|    |                                                                                                                                                                                                                                                                                                                                               
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The effect of dilutive securities from employee
    stock options and warrants to purchase 479,000 shares
    at September 30, 2003, was not included in the computation
    of diluted earnings per share as the effect is antidilutive due
    to net losses.                                                                               
|   
|(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 and warrants to purchase 456,000 and
    868,000 shares in its calculation of 2004 and 2002 diluted
    net loss from discontinued operations, respectively.

At September 30, 2004, 2003 and 2002,
options to purchase 243,000, 982,000 and
275,000 shares, respectively, were not included in the
computation of diluted earnings per share because the exercise
price was greater than the average market price of common shares
for the respective periods.



|          |                              
|--------- | -----------------------------
|Note 11  | Commitments and Contingencies



| |           
| | ----------
| | Facilities

In August 2003, the Company signed a lease
agreement for a 128,520 square-foot building in
San Jose, California into which it consolidated its
San Jose facilities in the second quarter of fiscal 2004.
The lease on the prior San Jose location terminated
concurrently with the inception date of the new lease. The new
facility

77



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PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

is leased under a non-cancelable operating lease
that expires in 2010, with two renewal options at fair market
value for additional five year periods. In fiscal 2002, the
Company renewed the lease on its Markham, Ontario (Canada)
facilities under a non-cancelable operating lease that expires
in fiscal 2007. The Company leases its Austin, Texas facility
under a non-cancelable operating lease that expires in fiscal
2005. The Company also leases office facilities in various
foreign locations under non-cancelable operating leases that
range in terms from one to two years. The Company also leases
equipment under operating leases.

Total rent expense under all operating leases was
approximately $2.4 million, $1.8 million and
$1.6 million for the years ended September 30, 2004,
2003 and 2002, respectively.

Future minimum lease commitments under operating
leases at September 30, 2004, net of expected sublease
income, are approximately $3.6 million, $3.4 million,
$3.0 million, $2.7 million, and $2.6 million in
fiscal 2005 through 2009, respectively. Sublease income is
approximately $141,000, $141,000 and $35,000 in fiscal 2005
through 2007, respectively.



| |               
| | --------------
| | Line of Credit

In March 2000, the Company entered into a bank
line of credit (line of credit) which had an initial
term of one year. The Company has renegotiated the line of
credit on an annual basis and currently has a $4.0 million
borrowing capacity on the line of credit with an interest rate
of floating prime, expiring in October 2005. The line of credit
is secured by substantially all of the Companys assets and
contains certain financial and other covenants. At
September 30, 2004, no amounts were outstanding under the
line of credit.



| |                    
| | -------------------
| | Purchase Agreements

The Company maintains certain open inventory
purchase commitments with its suppliers to ensure a smooth and
continuous supply chain for key components. The Companys
liability in these purchase commitments is generally restricted
to a forecasted time horizon as mutually agreed upon between the
parties. The Companys open inventory purchase commitments
were $27.3 million as of September 30, 2004.



| |                
| | ---------------
| | Retention Bonus

The Company entered into an agreement with
certain key employees of Summit Imaging, Inc. whereby the
Company will pay incentive bonuses to retain the identified
employees. The agreement provides for a total bonus payment of
$1.5 million, to be paid out in four annual installments
beginning on April 1, 2004. As of September 30, 2004
and 2003, the Company had accrued approximately $188,000 and
$170,000, respectively, through charges to earnings which is
included in Other current liabilities in the
financial statements.

The Company entered into an agreement with
certain key employees of Quantum Composers, Inc. whereby the
Company will pay incentive bonuses to retain the identified
employees. The agreement provides for a total bonus payment of
$398,000, to be paid out in four annual installments. As of
September 30, 2004, the Company had accrued approximately
$71,000, through charges to earnings which is included in
Other current liabilities in the financial
statements.

The Company entered into an agreement with
certain key employees of Tucson Optical Research Corporation
whereby the Company will pay incentive bonuses to retain the
identified employees. The agreement provides for a total bonus
payment of $200,000, to be paid out in four annual installments.
As of September 30, 2004, the Company had accrued
approximately $11,000, through charges to earnings which is
included in Other current liabilities in the
financial statements.

78



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                     
| | --------------------
| | Warranty Obligations

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

Changes in the Companys product liability
during fiscal 2004 and 2003 were as follows:

|                  |                                                                             |                |       |        |   |   |       |        |  
|----------------- | --------------------------------------------------------------------------- | -------------- | ----- | ------ | - | - | ----- | ------ | -
|                  |                                                                             | Fiscal         |       | Fiscal
|                  |                                                                             | 2004           |       | 2003  
|                  |                                                                             |                |       |       
|                  |                                                                             |               
|                  |                                                                             | (In thousands)
|Beginning balance |                                                                             | $              | 2,363 |        |   | $ | 2,383 |       
|                  | Estimated warranty cost of new shipments during
    the period              |                |       | 6,744  |   |   |       | 2,883  |  
|                  | Warranty charges during the period                                          |                |       | (4,588 | ) |   |       | (2,523 | )
|                  | Changes in liability for pre-existing warranties,
    including expirations |                |       | 1,675  |   |   |       | (530   | )
|                  | Liability assumed as a result of the acquisition
    of the RTP Assets      |                |       |       |   |   |       | 150    |  
|                  |                                                                             |                |       |        |   |   |       |       
|Ending balance    |                                                                             | $              | 6,194 |        |   | $ | 2,363 |       
|                  |                                                                             |                |       |        |   |   |       |       



| |                  
| | -----------------
| | Legal Proceedings

The Company and certain of its directors and
officers have been named as defendants in a lawsuit captioned
Amtower v. Photon Dynamics, Inc., No. CV797876, filed on
April 30, 2001 in the Superior Court of the State of
California, County of Santa Clara. The plaintiff, who
previously served as one of the Companys officers, has
asserted several causes of action arising out of alleged
misrepresentations made to plaintiff regarding the existence and
enforcement of the Companys insider trading policy. The
plaintiff is seeking damages of approximately $17.7 million
for defendants alleged refusal to allow plaintiff to sell
shares of the Companys stock in May of 2000, plus
unspecified emotional distress and punitive damages. On
December 6, 2001, the court granted defendants motion
to dismiss the complaint for failure to allege facts sufficient
to state a cause of action, with leave to file an amended
complaint. On January 17, 2002, plaintiff filed his amended
complaint and defendants again moved to dismiss the action. On
June 27, 2002, the court issued an order granting in part
and denying in part the motion, and further granted plaintiff an
opportunity to restate certain claims. On October 1, 2002,
plaintiff filed his Second Amended Complaint, which was heard on
April 8, 2003, and defendants again moved to dismiss the
action. On April 21, 2003, the court granted in part and
denied in part the Companys motion. The pleadings have
been finalized and certain claims against the Company and the
individual defendants will proceed. The parties currently are
engaged in discovery, and a court-mandated mediation session on
July 30, 2004 did not resolve the case. Trial is scheduled
to commence on March 7, 2005. The Company believes the
plaintiffs case is without merit and intends to defend
this action vigorously. Although the Company cannot predict the
outcome of this litigation, the Company believes that any
adverse judgment in this litigation could have a material
adverse effect on the Companys financial condition or
results of operations.

The Company has been named as a defendant in a
lawsuit captioned Sanmina SCI Corporation v. Photon
Dynamics, Inc., No. CV 013715, filed on February 3,
2004 in the Superior Court of the State of California, County of
Santa Clara. The plaintiff in this action, who previously
was a third-party manufacturer of the Company, has asserted
several causes of action arising out of the alleged
nonperformance by the Company of the manufacturing outsourcing
agreement between the Company and the plaintiff, and is seeking
approximately $3.1 million in compensatory damages and
punitive damages in a unknown amount. The Company responded to
the complaint on March 19, 2004, by filing an answer and
cross complaint seeking damages of at

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PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

least $135,000. The Company amended its cross
complaint on June 26, 2004. The parties attempted to
mediate this dispute, which attempt was not successful. The
parties are currently engaged in discovery. Although the Company
cannot predict the outcome of this litigation, the Company
believes that any adverse judgment in this litigation would not
have a material adverse effect on the Companys financial
condition or results of operations.

The Company was named as defendant in a lawsuit
captioned Thomason v. Photon Dynamics, Inc. et al.,
No. 02CC03568, filed on February 28, 2002 in the
Superior Court of the State of California, County of Orange. The
plaintiff in this action purported to assert that he was wrongly
not allowed to exercise certain stock options and sought damages
of approximately $1.1 million and punitive damages in an
unknown sum. On April 23, 2004, the parties to the
litigation settled all litigation between them and the Company
paid $750,000 to the plaintiff as part of the settlement
agreement. The charge for this settlement is included in
discontinued operations for the Printed Circuit Board Assembly
Inspection Business in the Consolidated Statements of Operations.

The Company filed a lawsuit captioned Photon
Dynamics, Inc. vs. PanelVision Technology and Guillermo
Toro-Lira, No. CO202563PJH on May 28, 2002, in the
U.S. District Court for the Northern District of
California, County of Santa Clara. The Company was alleging
infringement of a U.S. Patent owned by it and was seeking
full compensatory damages and an injunction against the
defendants. On July 17, 2002, the defendants answered the
Companys complaint and asserted a counterclaim alleging
damages of at least $6.0 million in compensatory damages
for loss of business. On January 23, 2003, the Company
added Shimadzu Corporation as an additional defendant. On
April 23, 2003, the defendants added additional
counterclaims against the Company alleging violations of the
antitrust laws and requesting the damages sought to be trebled.
Subsequently, the court bifurcated the antitrust claims of
Toro-Lira and Shimadzu Corporation against the Company, thus
deferring any consideration of these claims until the conclusion
of the patent infringement issues. On October 16, 2003, the
parties to the litigation settled all litigation between them
regarding US Patent 5,081,687, US Reissue Patent No.37,847 and
Japanese Patent 3292990. Pursuant to the agreement between the
parties, Shimadzu Corporation, companies affiliated with
Shimadzu, and customers of Shimadzu are irrevocably licensed
world-wide under US Patent 5,081,687, US Reissue Patent
No. 37,847 and Japanese Patent 3292990 and any
corresponding patents to manufacture, use, and sell e-beam based
panel test equipment designed by or for Shimadzu. All other
terms of the settlement agreement are confidential. The proceeds
of this settlement are included in Interest income and
other, net, in the Consolidated Statements of Operations.

Photon Dynamics is named from time to time as a
party to other lawsuits in the normal course of its business.
Litigation, in general, and intellectual property and securities
litigation in particular, can be expensive and disruptive to
normal business operations. Moreover, the results of complex
legal proceedings are difficult to predict. We believe that we
have defenses in each of the matters and are vigorously
contesting each of these matters.



|          |                                                 
|--------- | ------------------------------------------------
|Note 12  | Segment Reporting and Geographic
    Information

Statement of Accounting Financial Standards
No. 131, Disclosures About Segments of an Enterprise
and Related Information, establishes standards for
reporting information about operating segments. Operating
segments are defined as components of an enterprise about which
separate financial information is available that is evaluated
regularly by the chief operating decision maker, or decision
making group, in deciding how to allocate resources and in
assessing performance of the company. The Companys chief
operating decision maker is considered to be the Companys
Chief Executive Officer (CEO). The CEO reviews the
Companys financial information presented on a consolidated
basis substantially similar to the accompanying consolidated
financial statements. Therefore, the Company has concluded that
it operates in

80



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PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

one segment, the manufacture and servicing of
flat panel display products, and accordingly has provided only
the required enterprise wide disclosures.

The Company sells its products for the flat panel
display industry directly to customers in Korea, Taiwan, China
and Japan. The Company also, on a limited basis, sells in Japan
through a value-added distributor, Ishikawajima-Harima Heavy
Industries Co., Ltd. (IHI). For geographical
reporting, revenue is attributed to the geographic location to
which the product was shipped. Long-lived assets consist
primarily of property, plant and equipment, and are attributed
to the geographic location in which they are located.

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

|         |        |                          |   |        |         |      |   |        |        |  |   |        |        | 
|-------- | ------ | ------------------------ | - | ------ | ------- | ---- | - | ------ | ------ |  | - | ------ | ------ | 
|         |        |                         
|         |        | Year Ended September 30,
|         |        |                         
|         |        | 2004                     |   | 2003   |         | 2002
|         |        |                          |   |        |         |     
|         |        |                         
|         |        | (In thousands)          
|Revenue: |        |                          |   |        |         |      |   |        |        |  |   |       
|         | Korea  |                          | $ | 68,510 |         |      | $ | 47,024 |        |  | $ | 28,132 |       
|         | Taiwan |                          |   | 62,132 |         |      |   | 19,125 |        |  |   | 16,546 |       
|         | Japan  |                          |   | 11,017 |         |      |   | 1,047  |        |  |   | 4,664  |       
|         | China  |                          |   | 1,610  |         |      |   |       |        |  |   |       |       
|         |        |                          |   |        |         |      |   |        |        |  |   |       
|         |        | Total                    |   | $      | 143,269 |      |   | $      | 67,196 |  |   | $      | 49,342 | 
|         |        |                          |   |        |         |      |   |        |        |  |   |       

The following is a summary of revenue by product
line (as a percentage of total revenue):

|         |                  |                          |  |      |     |      |  |    |     |   |  |    |     |  
|-------- | ---------------- | ------------------------ |  | ---- | --- | ---- |  | -- | --- | - |  | -- | --- | -
|         |                  |                         
|         |                  | Year Ended September 30,
|         |                  |                         
|         |                  | 2004                     |  | 2003 |     | 2002
|         |                  |                          |  |      |     |     
|Revenue: |                  |                          |  |      |     |      |  |    |     |   |  |   
|         | ArrayCheckerTM   |                          |  | 75   | %   |      |  | 81 | %   |   |  | 72 | %  
|         | ArraySaverTM     |                          |  | 19   | %   |      |  | 4  | %   |   |  | 15 | %  
|         | RTP systems      |                          |  | 1    | %   |      |  | 6  | %   |   |  | 0  | %  
|         | Spares and other |                          |  | 5    | %   |      |  | 9  | %   |   |  | 13 | %  
|         |                  |                          |  |      |     |      |  |    |     |   |  |   
|         |                  | Total                    |  |      | 100 | %    |  |    | 100 | % |  |    | 100 | %
|         |                  |                          |  |      |     |      |  |    |     |   |  |   

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

|           |  |                          |    |      |  |      |    |   |  |  |    |  
|---------- |  | ------------------------ | -- | ---- |  | ---- | -- | - |  |  | -- | -
|           |  |                         
|           |  | Year Ended September 30,
|           |  |                         
|           |  | 2004                     |    | 2003 |  | 2002
|           |  |                          |    |      |  |     
|           |  |                         
|           |  | (Percent of revenue)    
|Customer A |  |                          | 39 | %    |  |      | 43 | % |  |  | 48 | %
|Customer B |  |                          | *  |      |  |      | 23 | % |  |  | *  |  
|Customer C |  |                          | 14 | %    |  |      | *  |   |  |  | *  |  
|Customer E |  |                          | *  |      |  |      | 13 | % |  |  | 13 | %
|Customer F |  |                          | 10 | %    |  |      | *  |   |  |  | *  |  
|Customer H |  |                          | 10 | %    |  |      | *  |   |  |  | *  |  



---



|  |                                                                          
|- | -------------------------------------------------------------------------
|* | Customer accounted for less than 10% of total
    revenue for the period.

81



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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

|           |  |                |    |      |  |  |    |  
|---------- |  | -------------- | -- | ---- |  |  | -- | -
|           |  |               
|           |  | September 30, 
|           |  |               
|           |  | 2004           |    | 2003
|           |  |                |    |     
|           |  |               
|           |  | (Percent of   
|           |  | gross accounts
|           |  | receivable)   
|Customer A |  |                | 29 | %    |  |  | 25 | %
|Customer C |  |                | 16 | %    |  |  | *  |  
|Customer D |  |                | 13 | %    |  |  | *  |  
|Customer F |  |                | 12 | %    |  |  | *  |  
|Customer H |  |                | *  |      |  |  | 58 | %



---



|  |                                                                                            
|- | -------------------------------------------------------------------------------------------
|* | Customer accounted for less than 10% of total
    gross accounts receivable for the period.

Long-lived assets by geographical area were as
follows:

|              |       |                |        |        |  |   |        |        | 
|------------- | ----- | -------------- | ------ | ------ |  | - | ------ | ------ | 
|              |       |               
|              |       | Year Ended    
|              |       | September 30, 
|              |       |               
|              |       | 2004           |        | 2003  
|              |       |                |        |       
|              |       |               
|              |       | (In thousands)
|United States |       | $              | 22,889 |        |  | $ | 13,709 |       
|Canada        |       |                | 1,947  |        |  |   | 1,815  |       
|Other         |       |                | 407    |        |  |   | 186    |       
|              |       |                |        |        |  |   |        |       
|              | Total |                | $      | 25,243 |  |   | $      | 15,710 | 
|              |       |                |        |        |  |   |        |       



|          |                           
|--------- | --------------------------
|Note 13  | Related Party Transactions

A full recourse loan of $250,000 plus accrued
interest of approximately $45,000 was outstanding at
September 30, 2003, from a former officer of the Company.
The loan, secured by shares of the Companys stock held by
the individual, was repaid in full in fiscal 2004. There were no
loans due from any other employees of the Company as of
September 30, 2004.

During fiscal 2004 and 2003, the Company paid
$138,000 and $18,000, respectively, to one board member for
consulting services rendered to the Company. During fiscal 2004
and 2003, the Company recorded approximately $206,000 and
$190,000, respectively, in stock ownership expense related to
options granted to this consultant.



|          |              
|--------- | -------------
|Note 14  | Notes Payable

Photon Dynamics Canada, Inc. had a loan payable
of approximately $341,000 to the National Research Council of
Canada (NRC). The loan amount was advanced to IPS under a
program for pre-commercialization assistance in the development
of glass inspection technology. Under this agreement, IPS would
repay the NRC based on a percentage of gross revenue earned, on
a quarterly basis, beginning on October 1, 2002 and up to
and including July 1, 2004. The amount repayable to NRC was
capped at 150% of the contribution amount received by IPS. At
September 30, 2004 and 2003, approximately $348,000 and
$316,000, respectively, was outstanding and was classified in
Other current liabilities in the Consolidated
Balance Sheet. As a result of the discontinuation of the high
quality glass and cathode ray tube inspection business, the loan
is to be repaid in full in fiscal 2005.

82



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##### Table of Contents



PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

In the third quarter of fiscal 2004, the Company
issued a $2.0 million promissory note in connection with
the acquisition of Quantum Composers, Inc. The note is
non-interest bearing and matures on June 25, 2007. The
discount on the note of $127,000 was calculated based on an
imputed interest rate of 6%. The outstanding balance on the
promissory note, net of unamortized discount, was approximately
$1.9 million at September 30, 2004.

In the fourth quarter of fiscal 2004, the Company
issued a $625,000 promissory note in connection with the
acquisition of TORC. The note is non-interest bearing and
matures on August 6, 2005. The discount on the note of
$17,000 was calculated based on an imputed interest rate of 3%.
The outstanding balance on the promissory note, net of
unamortized discount, was approximately $608,000 at
September 30, 2004.

Akcron Corporation, Ltd. had two revolving credit
agreements for unsecured borrowings in local currency up to
approximately $260,000. The first agreement expired in October
2003, and the second in March 2004. The agreements provided for
borrowings at 7.5% and 1.5%, and included financial and other
covenants with which Akcron was in compliance at
September 30, 2003. Approximately $261,000 was outstanding
under these agreements at the end of fiscal 2003 and was
included in Other current liabilities in the
Consolidated Balance Sheet. These agreements were repaid in full
in fiscal 2004.

The following table summarizes the notes payable
that we have at September 30, 2004.

|              |  |                             |       |      |  |      |       |      |  |      |       |      |  |            |   |  |  |   |   |  |  |   |   |  |  |   |   | 
|------------- |  | --------------------------- | ----- | ---- |  | ---- | ----- | ---- |  | ---- | ----- | ---- |  | ---------- | - |  |  | - | - |  |  | - | - |  |  | - | - | 
|              |  |                            
|              |  | Payments Due by Fiscal Year
|              |  |                            
|              |  | Total                       |       | 2005 |  | 2006 |       | 2007 |  | 2008 |       | 2009 |  | Thereafter
|              |  |                             |       |      |  |      |       |      |  |      |       |      |  |           
|Notes payable |  | $                           | 2,829 |      |  | $    | 1,446 |      |  | $    | 1,383 |      |  | $          |  |  |  | $ |  |  |  | $ |  |  |  | $ |  | 



|          |                                                             
|--------- | ------------------------------------------------------------
|Note 15  | Quarterly Consolidated Results of Operations
    (Unaudited)

The following tables contain selected unaudited
consolidated statements of operations data for each quarter of
fiscal 2004 and 2003:

|                    |                                              |                                       |        |           |        |          |        |               |        |   |        |       |        |   |        |       |        | 
|------------------- | -------------------------------------------- | ------------------------------------- | ------ | --------- | ------ | -------- | ------ | ------------- | ------ | - | ------ | ----- | ------ | - | ------ | ----- | ------ | 
|                    |                                              |                                      
|                    |                                              | Three Months Ended                   
|                    |                                              |                                      
|                    |                                              | December 31,                          |        | March 31, |        | June 30, |        | September 30,
|                    |                                              | 2003                                  |        | 2004      |        | 2004     |        | 2004         
|                    |                                              |                                       |        |           |        |          |        |              
|                    |                                              |                                      
|                    |                                              | (In thousands, except per share data)
|Revenue             |                                              | $                                     | 24,499 |           |        | $        | 26,478 |               |        | $ | 38,452 |       |        | $ | 53,840 |      
|Cost of revenue     |                                              |                                       | 13,412 |           |        |          | 14,183 |               |        |   | 20,711 |       |        |   | 35,663 |      
|                    |                                              |                                       |        |           |        |          |        |               |        |   |        |       |        |   |        |      
|Gross margin        |                                              |                                       | 11,087 |           |        |          | 12,295 |               |        |   | 17,741 |       |        |   | 18,177 |      
|Operating expenses: |                                              |                                       |        |           |        |          |        |               |        |   |        |       |        |   |        |      
|                    | Research and development                     |                                       |        | 5,810     |        |          |        | 6,144         |        |   |        | 8,031 |        |   |        | 9,716 |       
|                    | Selling, general and administrative          |                                       |        | 4,598     |        |          |        | 3,966         |        |   |        | 4,594 |        |   |        | 4,622 |       
|                    | Goodwill impairment charge                   |                                       |        | 665       |        |          |        |              |        |   |        |      |        |   |        |      |       
|                    | Impairment of purchased intangibles          |                                       |        | 2,089     |        |          |        |              |        |   |        |      |        |   |        |      |       
|                    | Impairment of fixed assets                   |                                       |        | 234       |        |          |        |              |        |   |        |      |        |   |        |      |       
|                    | (Gain) loss on sale of fixed assets          |                                       |        | (10       | )      |          |        | (20           | )      |   |        | (419  | )      |   |        | 22    |       
|                    | Acquired in-process research and development |                                       |        |          |        |          |        |              |        |   |        | 210   |        |   |        |      |       
|                    | Amortization of intangible assets            |                                       |        | 201       |        |          |        | 60            |        |   |        | 155   |        |   |        | 373   |       
|                    |                                              |                                       |        |           |        |          |        |               |        |   |        |       |        |   |        |      
|                    |                                              | Total operating expenses              |        |           | 13,587 |          |        |               | 10,150 |   |        |       | 12,571 |   |        |       | 14,733 | 

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PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

|                                                              |         |                                       |        |           |  |          |        |               |   |   |       |        |   |   |       |        | 
|------------------------------------------------------------- | ------- | ------------------------------------- | ------ | --------- |  | -------- | ------ | ------------- | - | - | ----- | ------ | - | - | ----- | ------ | 
|                                                              |         |                                      
|                                                              |         | Three Months Ended                   
|                                                              |         |                                      
|                                                              |         | December 31,                          |        | March 31, |  | June 30, |        | September 30,
|                                                              |         | 2003                                  |        | 2004      |  | 2004     |        | 2004         
|                                                              |         |                                       |        |           |  |          |        |              
|                                                              |         |                                      
|                                                              |         | (In thousands, except per share data)
|Income (loss) from operations                                 |         |                                       | (2,500 | )         |  |          | 2,145  |               |   |   | 5,170 |        |   |   | 3,444 |       
|Interest income and other, net                                |         |                                       | 3,771  |           |  |          | 334    |               |   |   | 389   |        |   |   | 308   |       
|                                                              |         |                                       |        |           |  |          |        |               |   |   |       |        |   |   |       |       
|Income before income taxes                                    |         |                                       | 1,271  |           |  |          | 2,479  |               |   |   | 5,559 |        |   |   | 3,752 |       
|Provision for income taxes                                    |         |                                       | 362    |           |  |          | 64     |               |   |   | 134   |        |   |   | 46    |       
|                                                              |         |                                       |        |           |  |          |        |               |   |   |       |        |   |   |       |       
|Income from continuing operations                             |         |                                       | 909    |           |  |          | 2,415  |               |   |   | 5,425 |        |   |   | 3,706 |       
|Income (loss) from discontinued operations                    |         |                                       | 47     |           |  |          | (1,276 | )             |   |   | (265  | )      |   |   | 103   |       
|                                                              |         |                                       |        |           |  |          |        |               |   |   |       |        |   |   |       |       
|Net income                                                    |         | $                                     | 956    |           |  | $        | 1,139  |               |   | $ | 5,160 |        |   | $ | 3,809 |       
|                                                              |         |                                       |        |           |  |          |        |               |   |   |       |        |   |   |       |       
|Net income per share from continuing operations:              |         |                                       |        |           |  |          |        |               |   |   |       |        |   |   |       |       
|                                                              | Basic   |                                       | $      | 0.06      |  |          | $      | 0.15          |   |   | $     | 0.33   |   |   | $     | 0.22   | 
|                                                              |         |                                       |        |           |  |          |        |               |   |   |       |        |   |   |       |       
|                                                              | Diluted |                                       | $      | 0.05      |  |          | $      | 0.14          |   |   | $     | 0.32   |   |   | $     | 0.22   | 
|                                                              |         |                                       |        |           |  |          |        |               |   |   |       |        |   |   |       |       
|Net income (loss) per share from discontinued
    operations: |         |                                       |        |           |  |          |        |               |   |   |       |        |   |   |       |       
|                                                              | Basic   |                                       | $      | 0.00      |  |          | $      | (0.08         | ) |   | $     | (0.02  | ) |   | $     | 0.01   | 
|                                                              |         |                                       |        |           |  |          |        |               |   |   |       |        |   |   |       |       
|                                                              | Diluted |                                       | $      | 0.00      |  |          | $      | (0.07         | ) |   | $     | (0.02  | ) |   | $     | 0.01   | 
|                                                              |         |                                       |        |           |  |          |        |               |   |   |       |        |   |   |       |       
|Net income per share:                                         |         |                                       |        |           |  |          |        |               |   |   |       |        |   |   |       |       
|                                                              | Basic   |                                       | $      | 0.06      |  |          | $      | 0.07          |   |   | $     | 0.31   |   |   | $     | 0.23   | 
|                                                              |         |                                       |        |           |  |          |        |               |   |   |       |        |   |   |       |       
|                                                              | Diluted |                                       | $      | 0.06      |  |          | $      | 0.07          |   |   | $     | 0.30   |   |   | $     | 0.22   | 
|                                                              |         |                                       |        |           |  |          |        |               |   |   |       |        |   |   |       |       
|Weighted average number of shares:                            |         |                                       |        |           |  |          |        |               |   |   |       |        |   |   |       |       
|                                                              | Basic   |                                       |        | 16,461    |  |          |        | 16,572        |   |   |       | 16,663 |   |   |       | 16,826 | 
|                                                              | Diluted |                                       |        | 17,174    |  |          |        | 17,172        |   |   |       | 17,071 |   |   |       | 16,977 | 

|                    |                                              |                                       |        |           |       |          |       |               |       |   |        |       |        |   |        |        |        | 
|------------------- | -------------------------------------------- | ------------------------------------- | ------ | --------- | ----- | -------- | ----- | ------------- | ----- | - | ------ | ----- | ------ | - | ------ | ------ | ------ | 
|                    |                                              |                                      
|                    |                                              | Three Months Ended                   
|                    |                                              |                                      
|                    |                                              | December 31,                          |        | March 31, |       | June 30, |       | September 30,
|                    |                                              | 2002                                  |        | 2003      |       | 2003     |       | 2003         
|                    |                                              |                                       |        |           |       |          |       |              
|                    |                                              |                                      
|                    |                                              | (In thousands, except per share data)
|Revenue             |                                              | $                                     | 19,162 |           |       | $        | 9,058 |               |       | $ | 17,996 |       |        | $ | 20,980 |       
|Cost of revenue     |                                              |                                       | 11,569 |           |       |          | 7,909 |               |       |   | 11,789 |       |        |   | 12,804 |       
|                    |                                              |                                       |        |           |       |          |       |               |       |   |        |       |        |   |        |       
|Gross margin        |                                              |                                       | 7,593  |           |       |          | 1,149 |               |       |   | 6,207  |       |        |   | 8,176  |       
|Operating expenses: |                                              |                                       |        |           |       |          |       |               |       |   |        |       |        |   |        |       
|                    | Research and development                     |                                       |        | 4,487     |       |          |       | 5,419         |       |   |        | 6,313 |        |   |        | 6,567  |       
|                    | Selling, general and administrative          |                                       |        | 3,068     |       |          |       | 3,776         |       |   |        | 3,176 |        |   |        | 3,743  |       
|                    | Goodwill impairment charge                   |                                       |        |          |       |          |       |              |       |   |        |      |        |   |        | 10,010 |       
|                    | Impairment of purchased intangibles          |                                       |        |          |       |          |       |              |       |   |        |      |        |   |        | 3,548  |       
|                    | Acquired in-process research and development |                                       |        | 1,849     |       |          |       |              |       |   |        | 625   |        |   |        |       |       
|                    | Amortization of intangible assets            |                                       |        | 260       |       |          |       | 367           |       |   |        | 408   |        |   |        | 201    |       
|                    |                                              |                                       |        |           |       |          |       |               |       |   |        |       |        |   |        |       
|                    |                                              | Total operating expenses              |        |           | 9,664 |          |       |               | 9,562 |   |        |       | 10,522 |   |        |        | 24,069 | 

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PHOTON DYNAMICS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

|                                                              |                                            |                                       |        |           |   |          |        |               |   |  |        |        |   |  |         |         |  
|------------------------------------------------------------- | ------------------------------------------ | ------------------------------------- | ------ | --------- | - | -------- | ------ | ------------- | - |  | ------ | ------ | - |  | ------- | ------- | -
|                                                              |                                            |                                      
|                                                              |                                            | Three Months Ended                   
|                                                              |                                            |                                      
|                                                              |                                            | December 31,                          |        | March 31, |   | June 30, |        | September 30,
|                                                              |                                            | 2002                                  |        | 2003      |   | 2003     |        | 2003         
|                                                              |                                            |                                       |        |           |   |          |        |              
|                                                              |                                            |                                      
|                                                              |                                            | (In thousands, except per share data)
|Loss from operations                                          |                                            |                                       | (2,071 | )         |   |          | (8,413 | )             |   |  | (4,315 | )      |   |  | (15,893 | )      
|Interest income and other, net                                |                                            |                                       | 824    |           |   |          | 717    |               |   |  | 955    |        |   |  | 472     |        
|                                                              |                                            |                                       |        |           |   |          |        |               |   |  |        |        |   |  |         |        
|Loss before income taxes                                      |                                            |                                       | (1,247 | )         |   |          | (7,696 | )             |   |  | (3,360 | )      |   |  | (15,421 | )      
|Provision for income taxes                                    |                                            |                                       | 11     |           |   |          | 37     |               |   |  | 3      |        |   |  | 5       |        
|                                                              |                                            |                                       |        |           |   |          |        |               |   |  |        |        |   |  |         |        
|Loss from continuing operations                               |                                            |                                       | (1,258 | )         |   |          | (7,733 | )             |   |  | (3,363 | )      |   |  | (15,426 | )      
|                                                              | Income (loss) from discontinued operations |                                       |        | (23,760   | ) |          |        | (15,280       | ) |  |        | (5,607 | ) |  |         | 55      |  
|                                                              |                                            |                                       |        |           |   |          |        |               |   |  |        |        |   |  |         |        
|                                                              | Net loss                                   |                                       | $      | (25,018   | ) |          | $      | (23,013       | ) |  | $      | (8,970 | ) |  | $       | (15,371 | )
|                                                              |                                            |                                       |        |           |   |          |        |               |   |  |        |        |   |  |         |        
|Net loss per share from continuing operations:                |                                            |                                       |        |           |   |          |        |               |   |  |        |        |   |  |         |        
|                                                              | Basic                                      |                                       | $      | (0.08     | ) |          | $      | (0.49         | ) |  | $      | (0.21  | ) |  | $       | (0.95   | )
|                                                              |                                            |                                       |        |           |   |          |        |               |   |  |        |        |   |  |         |        
|                                                              | Diluted                                    |                                       | $      | (0.08     | ) |          | $      | (0.49         | ) |  | $      | (0.21  | ) |  | $       | (0.95   | )
|                                                              |                                            |                                       |        |           |   |          |        |               |   |  |        |        |   |  |         |        
|Net income (loss) per share from discontinued
    operations: |                                            |                                       |        |           |   |          |        |               |   |  |        |        |   |  |         |        
|                                                              | Basic                                      |                                       | $      | (1.47     | ) |          | $      | (0.96         | ) |  | $      | (0.35  | ) |  | $       | 0.00    |  
|                                                              |                                            |                                       |        |           |   |          |        |               |   |  |        |        |   |  |         |        
|                                                              | Diluted                                    |                                       | $      | (1.47     | ) |          | $      | (0.96         | ) |  | $      | (0.35  | ) |  | $       | 0.00    |  
|                                                              |                                            |                                       |        |           |   |          |        |               |   |  |        |        |   |  |         |        
|Net loss per share:                                           |                                            |                                       |        |           |   |          |        |               |   |  |        |        |   |  |         |        
|                                                              | Basic                                      |                                       | $      | (1.55     | ) |          | $      | (1.44         | ) |  | $      | (0.56  | ) |  | $       | (0.95   | )
|                                                              |                                            |                                       |        |           |   |          |        |               |   |  |        |        |   |  |         |        
|                                                              | Diluted                                    |                                       | $      | (1.55     | ) |          | $      | (1.44         | ) |  | $      | (0.56  | ) |  | $       | (0.95   | )
|                                                              |                                            |                                       |        |           |   |          |        |               |   |  |        |        |   |  |         |        
|Weighted average number of shares:                            |                                            |                                       |        |           |   |          |        |               |   |  |        |        |   |  |         |        
|                                                              | Basic                                      |                                       |        | 16,156    |   |          |        | 15,944        |   |  |        | 16,003 |   |  |         | 16,176  |  
|                                                              | Diluted                                    |                                       |        | 16,156    |   |          |        | 15,944        |   |  |        | 16,003 |   |  |         | 16,176  |  

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|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with
    Accountants on Accounting and Financial Disclosure

There were no changes in or disagreements with
Ernst & Young LLP on accounting and financial
disclosure required to be reported under this Item 9.






|         |                        
|-------- | -----------------------
|Item 9A. | Controls and Procedures

Evaluation of Disclosure Controls and
Procedures.Based on our
managements evaluation (with the participation of our
chief executive officer and chief financial officer), as of the
end of the period covered by this report, our chief executive
officer and chief financial officer have concluded that, subject
to limitations described below, our disclosure controls and
procedures (as defined in Securities Exchange Act
Rules 13a-15(e) and 15d-15(e)) are effective to provide
reasonable assurance that the information required to be
disclosed by us in reports that we file or submit under the
Securities Exchange Act of 1934 is recorded, processed,
summarized and reported within the time periods specified in
Securities and Exchange Commission rules and forms.

Identification of Material
Weaknesses.During the fourth fiscal
quarter our financial resources became significantly strained
due to the combination of the following factors: (a) the
operational workload associated with the major production ramp
we experienced; (b) the increasing demands in preparation
for our fiscal year 2005 compliance with Section 404 of the
Sarbanes Oxley Act of 2002; and (c) the full impact of the
transfer of certain operational activities to our Japanese
subsidiary resulting from the termination of our relationship
with IHI in February 2004. As a result, in our fiscal 2005
planning process we identified that it would be advisable to
hire additional resources in the areas of cost accounting,
general accounting and international accounting. We had
previously added resources in our third fiscal quarter and early
in our fourth fiscal quarter in the areas of revenue accounting,
tax and SEC compliance and reporting. Although we recognized the
advisability of adding more resources, we did not believe at
that time that the lack of such resources would have a material
impact on our ability to produce accurate financial statements.
However, throughout the year end close and audit processes, a
number of issues were discovered by us and our independent
auditors which resulted in adjustments in our financial
statements. Upon discovery of these issues, we performed
additional procedures to ensure the accuracy of our financial
statements. In addition, we analyzed the nature of the
adjustments and identified the associated internal control
weaknesses. Additionally, we have reviewed the internal controls
associated with other processes and have concluded that the
adjustments discovered throughout the year end close and audit
process were the result of material weaknesses in our internal
control over the financial close process. The material
weaknesses consist of failures to ensure:



| |   |                                                                                                                                                                                                                                                                            
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | an appropriate level of review of those
    significant financial statement accounts requiring a higher
    degree of judgment and estimates, in part due to the need for
    more personnel as well as more highly skilled and trained
    personnel in certain positions;
|
| |  | a formal review process of the financial
    statements and supporting schedules of our international
    subsidiaries; and                                                                                                                                                
|
| |  | consistent processes and controls over revenue
    transactions entered into and recorded by our Japanese
    subsidiary with those processes and controls in place in the U.S.                                                                                            

In addition to the material weaknesses identified
above, we also identified a number of internal control
deficiencies that we have concluded do not constitute material
weaknesses.

During the course of the year end audit,
differences between amounts recorded by us in the financial
statements and amounts that our independent auditors believed
were required to be recorded under U.S. generally accepted
accounting principles in our financial statements were recorded
by management. We reviewed the nature of the material weaknesses
and the impact of such issues on prior quarters and concluded
that the material weaknesses did not exist in prior quarters and
therefore the adjustments we recorded only affected the fourth
quarter.

We are currently searching for qualified
candidates for those positions identified as being advisable
additions and strengthening the controls around those processes
determined to be material weaknesses or

86



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##### Table of Contents



internal control deficiencies. We currently are
unable to determine when these material weaknesses and internal
control deficiencies will be fully remediated. However, we do
not believe that we will be able to do so by the end of our
first quarter of fiscal 2005, and expect to report in our
Quarterly Report on Form 10-Q for the first quarter of
fiscal 2005 that material weaknesses and internal control
deficiencies continue to exist.


Changes in Internal Control over Financial
Reporting.Other than as set forth
above, there was no change in our internal control over
financial reporting during the quarter ended September 30,
2004, that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.

Limitations on the Effectiveness of Disclosure
Controls and Procedures.Our
management, including the chief executive officer and chief
financial officer, do not expect that our disclosure controls
and procedures or internal control over financial reporting will
prevent all error and all fraud. A control system no matter how
well designed and implemented, can provide only reasonable, not
absolute, assurance that the control systems objectives
will be met. Further, the design of a control system must
reflect the fact that there are resource constraints, and the
benefits of controls must be considered relative to their costs.
Because of the inherent limitations in all control systems, no
evaluation of controls can provide absolute assurance that all
control issues within a company are detected. The inherent
limitations include the realities that judgments in
decision-making can be faulty, and that breakdowns can occur
because of simple error or mistakes. Controls can also be
circumvented by the individual acts of some persons, by
collusion of two or more people or by management override of the
controls. Because of the inherent limitations in a
cost-effective control system, misstatements due to error or
fraud may occur and not be detected.






|         |                  
|-------- | -----------------
|Item 9B. | Other Information

Not applicable.




PART III

Certain information required by Part III of
this Form 10-K is omitted from this report because
registrant will file a definitive Proxy Statement within
120 days after the end of its fiscal year pursuant to
Regulation 14A for its 2005 Annual Meeting of Shareholders
to be held in March 2005 (the Proxy Statement), and
the information included therein is incorporated herein by
reference.






|         |                                                       
|-------- | ------------------------------------------------------
|Item 10. | Directors and Executive Officers of the
    Registrant

Information with respect to Directors and
Executive Officers may be found under the caption
Executive Officers of the Registrant at the end of
Item 1 of this Annual Report on Form 10-K, and in the
section entitled Proposal 1  Election of
Directors appearing in the Proxy Statement. Such
information is incorporated herein by reference. Information
with respect to compliance with Section 16(a) of the
Securities Exchange Act of 1934 and our code of ethics may be
found in the sections entitled Security Ownership of
Certain Beneficial Owners and Management and
Proposal 1  Election of
Directors  Code of Business Conduct and Ethics,
respectively, appearing in the Proxy Statement. Such information
is incorporated herein by reference.






|         |                       
|-------- | ----------------------
|Item 11. | Executive Compensation

The information required by this Item is
incorporated herein by reference to the information from the
Proxy Statement under the section entitled Executive
Compensation.






|         |                                                                                                       
|-------- | ------------------------------------------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
    Owners and Management and Related Stockholder
    Matters

The information required by this Item is
incorporated herein by reference to the information from the
Proxy Statement under the section entitled Security
Ownership of Certain Beneficial Owners and Management and
Proposal 2  Approval of Amended and
Restated 1995 Stock Option Plan, as amended  Equity
Compensation Plan Information.

87



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##### Table of Contents








|         |                                                   
|-------- | --------------------------------------------------
|Item 13. | Certain Relationships and Related
    Transactions

The information required by this Item is
incorporated herein by reference to the information from the
Proxy Statement under the section entitled Executive
Compensation  Certain Relationships and Related
Transactions.






|         |                                           
|-------- | ------------------------------------------
|Item 14. | Principal Accounting Fees and
    Services

The information required by this Item is
incorporated by herein by reference to the information from the
Proxy Statement under the section entitled
Proposal 4  Ratification of Selection of
Independent Auditors.

Consistent with Section 10A(i)(2) of the
Securities Exchange Act of 1934, as added by Section 202 of
the Sarbanes-Oxley Act of 2002, we are responsible for listing
the non-audit services approved by our Audit Committee to be
performed by Ernst & Young LLP, our external auditor.
Non-audit services are defined as services other than those
provided in connection with an audit or a review of our
financial statements. In the period covered by this report, our
Audit Committee pre-approved the following non-audit services
rendered, currently being rendered, or to be rendered, to us by
Ernst & Young LLP:



| |   |                                                                                                                                                                                                                     
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | all work required to be performed by Ernst &
    Young LLP in connection with preparing and giving consents
    required to be given in connection with our filings with the
    Securities and Exchange Commission;
|
| |  | tax services rendered in connection with a
    Section 382 Study;                                                                                                                                                   
|
| |  | services to be rendered, which shall not include
    legal services, in connection with the dissolution
    of the subsidiary in Shanghai, China;                                                                 
|
| |  | tax services rendered in connection with
    ex-patriot work;                                                                                                                                                       
|
| |  | preparation of certain foreign tax returns, and
    tax advice in preparing for and in connection therewith;                                                                                                        
|
| |  | services rendered in connection with the
    Securities and Exchange Commissions review of our Annual
    Report on Form 10-K for the fiscal year ended
    September 30, 2003; and                                
|
| |  | accounting advice on the proper recording of
    various transactions entered into, or to be entered into, by us.                                                                                                   




PART IV






|         |                                               
|-------- | ----------------------------------------------
|Item 15. | Exhibits and Financial Statement
    Schedules



| |     |                        
| | --- | -----------------------
| | (a) | 1. Financial Statements

See Index to Consolidated Financial Statements in
Item 8 of this Annual Report on Form 10-K, which is
incorporated herein by reference.



| |  |                                 
| |  | --------------------------------
| |  | 2. Financial Statement Schedules

The following financial statement schedule is
filed as part of this annual report on Form 10-K. All other
financial statement schedules have been omitted because they are
either not applicable or the required information is shown in
the consolidated financial statements or notes thereto.

88



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SCHEDULE II

PHOTON DYNAMICS, INC.

VALUATION AND QUALIFYING ACCOUNT

|                                 |      |                          |   |            |  |            |  |            |     |            |  |   |  |  |  |       |     |  |   |       | 
|-------------------------------- | ---- | ------------------------ | - | ---------- |  | ---------- |  | ---------- | --- | ---------- |  | - |  |  |  | ----- | --- |  | - | ----- | 
|                                 |      |                         
|                                 |      | Year Ended September 30,
|                                 |      |                         
|                                 |      | Balance at               |   |            |  | Charged to |  |            |     | Balance at
|                                 |      | Beginning                |   | Charged to |  | Other      |  |            |     | End of    
|                                 |      | of Period                |   | Expense    |  | Accounts   |  | Deductions |     | Period    
|                                 |      |                          |   |            |  |            |  |            |     |           
|                                 |      |                         
|                                 |      | (In thousands)          
|Allowance for doubtful accounts: |      |                          |   |            |  |            |  |            |     |            |  |   |  |  |  |       |     |  |   |      
|                                 | 2004 |                          | $ | 726        |  |            |  |           | (1) |            |  |  |  |  |  | 229   | (2) |  | $ | 497   | 
|                                 | 2003 |                          | $ | 1,466      |  |            |  | 3,132      | (1) |            |  |  |  |  |  | 3,872 | (2) |  | $ | 726   | 
|                                 | 2002 |                          | $ | 1,897      |  |            |  | 111        | (1) |            |  |  |  |  |  | 542   | (2) |  | $ | 1,466 | 



---



|    |                                                                                                                                                                  
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Includes charges to expense from discontinued
    operations of approximately $0, $2.9 million and $34,000 in
    fiscal 2004, 2003 and 2002, respectively.      
|   
|(2) | Includes write-offs of uncollectible accounts
    from discontinued operations of approximately $0,
    $3.9 million and $0 in 2004, 2003 and 2002, respectively.

89



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##### Table of Contents



3. Exhibits

|       |    |          |  |                                                                                                                                                                                                                                                                                                          
|------ | -- | -------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Number |    | Exhibit 
|       |    |         
|       | 2  | .3(E)    |  | Agreement and Plan of Merger, dated as of
    July 6, 2001, by and among the Registrant; Iris
    Acquisition, LLC, a Texas limited liability company; Intelligent
    Reasoning Systems, Inc., a Texas corporation; and Clinton Bybee
    (as the Shareholders Agent), as amended on July 12,
    2001.
|       | 3  | .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(A)*   |  | Form of Indemnification Agreement between the
    Registrant and each of its executive officers and directors.                                                                                                                                                                                           
|       | 10 | .2(A)*   |  | 1987 Stock Option Plan and Form of Stock Option
    Agreement.                                                                                                                                                                                                                                           
|       | 10 | .3.1(B)  |  | Lease agreement between Berg & Berg
    Developers and the Registrant dated August 6, 1996.                                                                                                                                                                                                              
|       | 10 | .3.2(H)  |  | First Amendment to Lease between Mission West
    Properties, L.P. II and the Registrant dated
    December 7, 2001.                                                                                                                                                                                     
|       | 10 | .8(M)*   |  | Offer Letter between the Registrant and Elwood
    Spedden dated February 4, 2003.                                                                                                                                                                                                                       
|       | 10 | .9(D)*   |  | Agreement Regarding Change of Control between the
    Registrant and Jeffrey Hawthorne dated October 15, 1995.                                                                                                                                                                                           
|       | 10 | .10(P)   |  | Lease Agreement between Corridor Park
    Pointe II, L.P. and Intelligent Reasoning Systems, Inc.,
    dated May 21, 1999.                                                                                                                                                                               
|       | 10 | .11(P)   |  | First Amendment to Lease Agreement between
    Corridor Park Pointe II, L.P. and Intelligent Reasoning
    Systems, Inc. dated November 9, 1999.                                                                                                                                                         
|       | 10 | .12(P)   |  | Second Amendment to Lease Agreement between
    Corridor Park Pointe II, L.P. and Intelligent Reasoning
    Systems, Inc. dated March 15, 2000.                                                                                                                                                          
|       | 10 | .13(F)   |  | Agreement for Purchase and Sale of Commercial
    Property between the Registrant and Integrated Power Chip
    Corporation dated February 12, 2001.                                                                                                                                                     
|       | 10 | .15(G)   |  | Image Processing Systems Inc. Amended Share
    Incentive Plan.                                                                                                                                                                                                                                          
|       | 10 | .16(P)   |  | Series E Stock Purchase Warrant for Leader
    Technologies LTD, dated March 1, 2000.                                                                                                                                                                                                                    
|       | 10 | .17(I)   |  | Manufacturing Services Agreement, dated as of
    December 10, 2001 by and between the Registrant and
    Sanmina-SCI Corporation.                                                                                                                                                                       
|       | 10 | .18(H)   |  | Real Estate Sublease by and between the
    Registrant and Sanmina-SCI Corporation dated December 10,
    2001.                                                                                                                                                                                          
|       | 10 | .19(H)   |  | Amended and Restated Agreement for Purchase of
    Inventory by and between the Registrant and Sanmina-SCI
    Corporation dated January 29, 2002.                                                                                                                                                       
|       | 10 | .20(L)*  |  | Amended and Restated 1995 Stock Option Plan, as
    amended.                                                                                                                                                                                                                                             
|       | 10 | .20.1*   |  | Form of Stock Option Agreement under 1995 Stock
    Option Plan, as amended.                                                                                                                                                                                                                             
|       | 10 | .21(L)*  |  | 1995 Employee Stock Purchase Plan, as amended.                                                                                                                                                                                                                                                           
|       | 10 | .22(M)*  |  | 2001 Equity Incentive Plan, as amended.                                                                                                                                                                                                                                                                  
|       | 10 | .22.1*   |  | 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 | .26(V)   |  | Third Amendment to Lease Agreement between the
    Registrant and Mission West Properties L.P. II dated as of
    August 2003.                                                                                                                                                                           
|       | 10 | .29(R)*  |  | Offer Letter between the Registrant and Richard
    Okumoto dated April 21, 2003.                                                                                                                                                                                                                        
|       | 10 | .30(V)*  |  | Consulting Agreement between the Registrant and
    Malcolm Thompson dated July 28, 2003.                                                                                                                                                                                                                

90



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##### Table of Contents



|       |    |         |  |                                                                                                                                                                                  
|------ | -- | ------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Number |    | Exhibit
|       |    |        
|       | 10 | .31(V)* |  | Amendment to Consulting Agreement between the
    Registrant and Malcolm Thompson dated September 1, 2003.                                                                       
|       | 10 | .33(S)* |  | Separation Agreement, dated December 4,
    2003, between Elwood Spedden and Photon Dynamics, Inc.                                                                               
|       | 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(T)* |  | Consulting Agreement, dated March 18, 2004,
    between the Registrant and Malcolm Thompson.                                                                                     
|       | 10 | .36(T)  |  | Termination and Assignment Agreement, dated
    February 27, 2004, between Photon Dynamics, Inc. and
    Ishikawajima-Harima Heavy Industries Co. Ltd.                           
|       | 10 | .37(U)  |  | Confidential Mutual Settlement Agreement and
    Mutual General Release of All Claims, dated April 22, 2004,
    between Photon Dynamics, Inc. and Robert L. Thomason, et. al.   
|       | 10 | .38*    |  | Offer Letter between the Registrant and Mark
    Merrill dated April 27, 2004.                                                                                                   
|       | 10 | .39*    |  | Executive Officer Bonus Compensation Plan.                                                                                                                                       
|       | 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 on the Registrants
    Registration Statement on Form SB-2 (Commission File
    No. 33-98232-LA) as filed with the Securities and Exchange
    Commission (the SEC) on November 15, 1995 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 Annual Report on Form 10-KSB for the
    fiscal year ended September 30, 1998 as filed with the SEC
    on December 18, 1998, and incorporated herein by reference.                                    
|   
|(D) |  | Previously filed as an exhibit to the
    Registrants Annual Report on Form 10-KSB for the
    fiscal year ended September 30, 1999 as filed with the SEC
    on October 27, 1999, and incorporated herein by reference.                                     
|   
|(E) |  | Previously filed as an exhibit to the
    Registrants Current Report on Form 8-K 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 on Form 10-Q for the
    quarter ended March 31, 2001 as filed with the SEC on
    May 4, 2001, and incorporated herein by reference.                                                 
|   
|(G) |  | Previously filed as an exhibit to the
    Registrants Registration Statement on Form S-8 as
    filed with the SEC on January 24, 2001, and incorporated
    herein by reference.                                                                            
|   
|(H) |  | Previously filed as an exhibit to the
    Registrants Registration Statement on Form S-1
    (Commission File No. 333-76650) as filed with the SEC on
    January 14, 2002, as amended, and incorporated by reference
    herein.                            
|   
|(I) |  | Previously filed as an exhibit to the
    Registrants Current Report on Form 8-K as filed with
    the SEC on January 7, 2002, and incorporated herein by
    reference. Confidential treatment has been granted for portions
    of this exhibit.           
|   
|(K) |  | Previously filed as an exhibit to the
    Registrants Current Report on Form 8-K/ A as filed
    with the SEC on July 29, 2002, and incorporated herein by
    reference.                                                                                    

91



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##### Table of Contents





|    |  |                                                                                                                                                                                                                                                                                                       
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(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 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 appendix to the
    Registrants Definitive Proxy Statement as filed with the
    SEC on November 8, 1999 and incorporated herein by
    reference.                                                                                                                            
|   
|(O) |  | Previously filed as an exhibit to the
    Registrants Registration Statement on Form S-3 as
    filed with the SEC on November 7, 2000 and incorporated
    herein by reference.                                                                                                                     
|   
|(P) |  | Previously filed as an exhibit to the
    Registrants Annual Report on Form 10-K for the fiscal
    year ended September 30, 2001 as filed with the SEC on
    December 6, 2001, and incorporated here 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 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 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 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 as filed with SEC on
    May 14, 2004, and incorporated herein by reference.
    Confidential treatment has been granted for portions of
    Exhibit 10.36.        
|   
|(U) |  | Previously filed as an exhibit to the
    Registrants Quarterly Report Form on Form 10-Q for
    the quarter ended June 30, 2004 as filed with SEC on
    August 16, 2004, and incorporated herein by reference.
    Confidential treatment has been requested for portions of this
    exhibit.     
|   
|(V) |  | Previously filed as an exhibit to the
    Registrants Annual Report on Form 10-K for the fiscal
    year ended September 30, 2003 as filed with the SEC on
    December 24, 2003, and incorporated here 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.

(b) Exhibits

See Item 15(a) above.

(c) Financial Statement Schedules

See Item 15(a) above.

92



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##### Table of Contents






SIGNATURES

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



| |                      
| | ---------------------
| | PHOTON DYNAMICS, INC.



| |     |                         
| | --- | ------------------------
| | By: | /s/ JEFFREY A. HAWTHORNE

| |                                          
| | -----------------------------------------
| |                                          
| | Jeffrey A. Hawthorne                     
| | President and Chief Executive
    Officer

Dated: December 14, 2004

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENT, that each
person whose signature appears below constitutes and appoints
Jeffrey A. Hawthorne and Richard Okumoto, and each of them,
acting individually, as his attorney-in-fact, each with full
power of substitution and resubstitution, for him and in his
name, place and stead, in any and all capacities, to sign any
and all amendments to this annual report on Form 10-K, and
to file the same, with all exhibits thereto, and other documents
in connection therewith, with the Securities and Exchange
Commission, granting unto said attorneys-in-fact and agents, and
each of them, full power and authority to do and perform each
and every act and thing requisite and necessary to be done in
connection therewith and about the premises, as fully to all
intents and purposes as he might or could do in person, hereby
ratifying and confirming all that said attorneys-in-fact and
agents, or any of them, or their or his substitute or
substitutes, may lawfully do or cause to be done by virtue
hereof.

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 and Chief Executive Officer
    and Director
    (Principal Executive Officer) |  | December 14, 2004
|                                            
|/s/ RICHARD OKUMOTORichard Okumoto           |  | Chief Financial Officer and Secretary (Principal
    Financial and Accounting Officer)   |  | December 14, 2004
|                                            
|/s/ MALCOLM J. THOMPSONMalcolm J. Thompson   |  | Chairman of the Board and Director                                                       |  | December 14, 2004
|                                            
|Nicholas Brathwaite                          |  | Director                                                                                 |  |                  
|                                            
|/s/ MICHAEL J. KIMMichael J. Kim             |  | Director                                                                                 |  | December 14, 2004
|                                            
|/s/ E. FLOYD KVAMMEE. Floyd Kvamme           |  | Director                                                                                 |  | December 14, 2004

93



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##### Table of Contents






EXHIBIT INDEX

|       |    |          |  |                                                                                                                                                                                                                                                                                                          
|------ | -- | -------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Number |    | Exhibit 
|       |    |         
|       | 2  | .3(E)    |  | Agreement and Plan of Merger, dated as of
    July 6, 2001, by and among the Registrant; Iris
    Acquisition, LLC, a Texas limited liability company; Intelligent
    Reasoning Systems, Inc., a Texas corporation; and Clinton Bybee
    (as the Shareholders Agent), as amended on July 12,
    2001.
|       | 3  | .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(A)*   |  | Form of Indemnification Agreement between the
    Registrant and each of its executive officers and directors.                                                                                                                                                                                           
|       | 10 | .2(A)*   |  | 1987 Stock Option Plan and Form of Stock Option
    Agreement.                                                                                                                                                                                                                                           
|       | 10 | .3.1(B)  |  | Lease agreement between Berg & Berg
    Developers and the Registrant dated August 6, 1996.                                                                                                                                                                                                              
|       | 10 | .3.2(H)  |  | First Amendment to Lease between Mission West
    Properties, L.P. II and the Registrant dated
    December 7, 2001.                                                                                                                                                                                     
|       | 10 | .8(M)*   |  | Offer Letter between the Registrant and Elwood
    Spedden dated February 4, 2003.                                                                                                                                                                                                                       
|       | 10 | .9(D)*   |  | Agreement Regarding Change of Control between the
    Registrant and Jeffrey Hawthorne dated October 15, 1995.                                                                                                                                                                                           
|       | 10 | .10(P)   |  | Lease Agreement between Corridor Park
    Pointe II, L.P. and Intelligent Reasoning Systems, Inc.,
    dated May 21, 1999.                                                                                                                                                                               
|       | 10 | .11(P)   |  | First Amendment to Lease Agreement between
    Corridor Park Pointe II, L.P. and Intelligent Reasoning
    Systems, Inc. dated November 9, 1999.                                                                                                                                                         
|       | 10 | .12(P)   |  | Second Amendment to Lease Agreement between
    Corridor Park Pointe II, L.P. and Intelligent Reasoning
    Systems, Inc. dated March 15, 2000.                                                                                                                                                          
|       | 10 | .13(F)   |  | Agreement for Purchase and Sale of Commercial
    Property between the Registrant and Integrated Power Chip
    Corporation dated February 12, 2001.                                                                                                                                                     
|       | 10 | .15(G)   |  | Image Processing Systems Inc. Amended Share
    Incentive Plan.                                                                                                                                                                                                                                          
|       | 10 | .16(P)   |  | Series E Stock Purchase Warrant for Leader
    Technologies LTD, dated March 1, 2000.                                                                                                                                                                                                                    
|       | 10 | .17(I)   |  | Manufacturing Services Agreement, dated as of
    December 10, 2001 by and between the Registrant and
    Sanmina-SCI Corporation.                                                                                                                                                                       
|       | 10 | .18(H)   |  | Real Estate Sublease by and between the
    Registrant and Sanmina-SCI Corporation dated December 10,
    2001.                                                                                                                                                                                          
|       | 10 | .19(H)   |  | Amended and Restated Agreement for Purchase of
    Inventory by and between the Registrant and Sanmina-SCI
    Corporation dated January 29, 2002.                                                                                                                                                       
|       | 10 | .20(L)*  |  | Amended and Restated 1995 Stock Option Plan, as
    amended.                                                                                                                                                                                                                                             
|       | 10 | .20.1*   |  | Form of Stock Option Agreement under 1995 Stock
    Option Plan, as amended.                                                                                                                                                                                                                             
|       | 10 | .21(L)*  |  | 1995 Employee Stock Purchase Plan, as amended.                                                                                                                                                                                                                                                           
|       | 10 | .22(M)*  |  | 2001 Equity Incentive Plan, as amended.                                                                                                                                                                                                                                                                  
|       | 10 | .22.1*   |  | 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 | .26(V)   |  | Third Amendment to Lease Agreement between the
    Registrant and Mission West Properties L.P. II dated as of
    August 2003.                                                                                                                                                                           
|       | 10 | .29(R)*  |  | Offer Letter between the Registrant and Richard
    Okumoto dated April 21, 2003.                                                                                                                                                                                                                        
|       | 10 | .30(V)*  |  | Consulting Agreement between the Registrant and
    Malcolm Thompson dated July 28, 2003.                                                                                                                                                                                                                
|       | 10 | .31(V)*  |  | Amendment to Consulting Agreement between the
    Registrant and Malcolm Thompson dated September 1, 2003.                                                                                                                                                                                               



---



##### Table of Contents



|       |    |         |  |                                                                                                                                                                                  
|------ | -- | ------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Number |    | Exhibit
|       |    |        
|       | 10 | .33(S)* |  | Separation Agreement, dated December 4,
    2003, between Elwood Spedden and Photon Dynamics, Inc.                                                                               
|       | 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(T)* |  | Consulting Agreement, dated March 18, 2004,
    between the Registrant and Malcolm Thompson.                                                                                     
|       | 10 | .36(T)  |  | Termination and Assignment Agreement, dated
    February 27, 2004, between Photon Dynamics, Inc. and
    Ishikawajima-Harima Heavy Industries Co. Ltd.                           
|       | 10 | .37(U)  |  | Confidential Mutual Settlement Agreement and
    Mutual General Release of All Claims, dated April 22, 2004,
    between Photon Dynamics, Inc. and Robert L. Thomason, et. al.   
|       | 10 | .38*    |  | Offer Letter between the Registrant and Mark
    Merrill dated April 27, 2004.                                                                                                   
|       | 10 | .39*    |  | Executive Officer Bonus Compensation Plan.                                                                                                                                       
|       | 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 on the Registrants
    Registration Statement on Form SB-2 (Commission File
    No. 33-98232-LA) as filed with the Securities and Exchange
    Commission (the SEC) on November 15, 1995 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 Annual Report on Form 10-KSB for the
    fiscal year ended September 30, 1998 as filed with the SEC
    on December 18, 1998, and incorporated herein by reference.                                    
|   
|(D) |  | Previously filed as an exhibit to the
    Registrants Annual Report on Form 10-KSB for the
    fiscal year ended September 30, 1999 as filed with the SEC
    on October 27, 1999, and incorporated herein by reference.                                     
|   
|(E) |  | Previously filed as an exhibit to the
    Registrants Current Report on Form 8-K 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 on Form 10-Q for the
    quarter ended March 31, 2001 as filed with the SEC on
    May 4, 2001, and incorporated herein by reference.                                                 
|   
|(G) |  | Previously filed as an exhibit to the
    Registrants Registration Statement on Form S-8 as
    filed with the SEC on January 24, 2001, and incorporated
    herein by reference.                                                                            
|   
|(H) |  | Previously filed as an exhibit to the
    Registrants Registration Statement on Form S-1
    (Commission File No. 333-76650) as filed with the SEC on
    January 14, 2002, as amended, and incorporated by reference
    herein.                            
|   
|(I) |  | Previously filed as an exhibit to the
    Registrants Current Report on Form 8-K as filed with
    the SEC on January 7, 2002, and incorporated herein by
    reference. Confidential treatment has been granted for portions
    of this exhibit.           
|   
|(K) |  | Previously filed as an exhibit to the
    Registrants Current Report on Form 8-K/ A 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 for
    the quarter ended March 31, 2003 as filed with the SEC on
    May 9, 2003, and incorporated herein by reference.                                            



---



##### Table of Contents





|    |  |                                                                                                                                                                                                                                                                                                       
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(N) |  | Previously filed as an appendix to the
    Registrants Definitive Proxy Statement as filed with the
    SEC on November 8, 1999 and incorporated herein by
    reference.                                                                                                                            
|   
|(O) |  | Previously filed as an exhibit to the
    Registrants Registration Statement on Form S-3 as
    filed with the SEC on November 7, 2000 and incorporated
    herein by reference.                                                                                                                     
|   
|(P) |  | Previously filed as an exhibit to the
    Registrants Annual Report on Form 10-K for the fiscal
    year ended September 30, 2001 as filed with the SEC on
    December 6, 2001, and incorporated here 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 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 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 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 as filed with SEC on
    May 14, 2004, and incorporated herein by reference.
    Confidential treatment has been granted for portions of
    Exhibit 10.36.        
|   
|(U) |  | Previously filed as an exhibit to the
    Registrants Quarterly Report Form on Form 10-Q for
    the quarter ended June 30, 2004 as filed with SEC on
    August 16, 2004, and incorporated herein by reference.
    Confidential treatment has been requested for portions of this
    exhibit.     
|   
|(V) |  | Previously filed as an exhibit to the
    Registrants Annual Report on Form 10-K for the fiscal
    year ended September 30, 2003 as filed with the SEC on
    December 24, 2003, and incorporated here 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.