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  **UNITED STATES SECURITIES AND EXCHANGE COMMISSION****Washington, D.C. 20549** **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, 2005****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** **Photon Dynamics, Inc.***(Exact name of registrant as specified in its charter)*   **California** **94-3007502***(State or other jurisdiction of* *(I.R.S. Employer**incorporation or organization)* *Identification No.)***5970 Optical Court****San Jose, CA 95138***(Address of principal executive offices, including zipcode)***(408) 226-9900***(Registrant’s telephone number, including area code)* **Securities registered pursuant to Section 12(b) of theAct:****None****Securities registered pursuant to Section 12(g) of theAct:****Common Stock, no par value per share***(Title of class)*     Indicate by check mark whether the registrant (1) has filedall reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrantwas required to file such reports) and (2) has been subjectto such filing requirements for the past90 days.     Yes þ          No o     Indicate by check mark if disclosure of delinquent filerspursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best ofregistrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of thisForm 10-K or any amendment to thisForm 10-K.     o     Indicate by check mark whether the registrant is an acceleratedfiler (as defined in Rule 12b-2 of theAct).     Yes þ          No o     Indicate by check mark whether the registrant is a shell company(as defined in Rule 12b-2 of the ExchangeAct).     Yes o          No þ     As of March 31, 2005, the aggregate market value of thevoting stock held by non-affiliates of the registrant, computedby reference to the last sale price of such stock as of suchdate on the NASDAQ National Market, was approximately$243,519,747. Excludes an aggregate of 4,199,017 shares ofcommon stock held by officers and directors and by each personknown by the registrant to own 5% or more of the outstandingcommon stock as of March 31, 2005. Exclusion of shares heldby any of these persons should not be construed to indicate thatsuch person possesses the power, direct or indirect, to director cause the direction of the management or policies of theregistrant, or that such person is controlled by or under commoncontrol with the registrant.     As of November 30, 2005, there were 17,014,181 sharesof the registrant’s Common Stock outstanding.**DOCUMENTS INCORPORATED BY REFERENCE**     Portions of the registrant’s definitive Proxy Statement forthe 2006 Annual Meeting of Shareholders to be filed with theSecurities and Exchange Commission pursuant toRegulation 14A not later than 120 days after the endof the fiscal year covered by this Form 10-K, areincorporated by reference in Part III, Items 10-14 ofthis Form 10-K.  

 
**PHOTON DYNAMICS, INC.****ANNUAL REPORT ON FORM 10-K****FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 2005****TABLE OF CONTENTS**             **Page**     ** PART I** 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** 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  43  Item 8.      Financial Statements and Supplementary    Data  45         REPORTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM  46         CONSOLIDATED BALANCE SHEETS  49         CONSOLIDATED STATEMENTS OF OPERATIONS  50         CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY  51         CONSOLIDATED STATEMENTS OF CASH FLOWS  52         NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  53  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** Item 10.      Directors and Executive Officers of the    Registrant  88  Item 11.      Executive Compensation  88  Item 12.      Security Ownership of Certain Beneficial    Owners and Management and Related Stockholder Matters  88  Item 13.      Certain Relationships and Related    Transactions  88  Item 14.      Principal Accounting Fees and Services  88 ** PART IV** Item 15.      Exhibits and Financial Statement    Schedules  88      Signatures  91  EXHIBIT 10.9 EXHIBIT 10.20.01 EXHIBIT 10.43 EXHIBIT 10.52 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-lookingstatements within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the SecuritiesExchange Act of 1934. All statements included or incorporated byreference in this Annual Report on Form 10-K other thanstatements of historical fact, are forward-looking statements.You can identify these and other forward-looking statements bythe use of words such as “may,” “will,”“could,” “anticipate,” “expect,”“intend,” “believe,” “continue” orthe negative of such terms, or other comparable terminology.Forward-looking statements also include the assumptionsunderlying or relating to such statements.*     *Our actual results could differ materially from thoseprojected in the forward-looking statements included herein as aresult of a number of factors, risks and uncertainties,including the risk factors set forth under the caption“Factors Affecting Operating Results” in Part IIItem 7 “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” in thisAnnual Report on Form 10-K and elsewhere in this AnnualReport on Form 10-K. The information included in thisAnnual Report on Form 10-K is as of the filing date withthe Securities and Exchange Commission and future events orcircumstances could differ significantly from theforward-looking statements included herein. Accordingly, wecaution readers not to place undue reliance on such statementsand we expressly assume no obligation to update theforward-looking statements included in this report after thedate hereof except as required by law.*
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**PART I****Item 1.*****Business*****Introduction**     Photon Dynamics, Inc. (“Photon Dynamics”) is aCalifornia corporation incorporated on May 12, 1986. We area leading global provider of yield management solutions to theflat panel display industry. Our portfolio of products, servicesand expertise is designed to deliver the yield-managementsolutions our customers need to effectively address their mostpressing thin-film transistor liquid-crystal displaymanufacturing challenges. Our unique portfolio of test, repairand inspection systems drive process control improvementsthroughout the manufacturing process — from earlyidentification and characterization of defects, to back-end celland module inspection. Manufacturers in the flat panel displayindustry use our solutions to collect data, analyze productquality and identify and repair product defects at criticalsteps in their manufacturing processes. Our customers use oursystems to increase manufacturing yields of high-performanceflat panel displays used in a number of products, includingnotebook and desktop computers, televisions and advanced mobileelectronic devices such as cellular phones, personal digitalassistants and portable video games.     Prior to fiscal 2003, we also were engaged in the printedcircuit board assembly inspection business and the cathode raytube display and high quality glass inspection business. Duringfiscal 2003, we implemented plans to exit these businesses andconsequently, we now operate in one reportable businesssegment — the flat panel display industry.Accordingly, the operating results of both the printed circuitboard assembly inspection business and the cathode ray tubedisplay and high quality glass inspection business segments havebeen presented as discontinued operations in our statements ofoperations. As a result, revenue from our flat panel displayproducts represents 100% of our revenue in all fiscal yearspresented. For further details of our discontinued operations,see Note 3 of our “Notes to Consolidated FinancialStatements” included under Part II Item 8.“Financial Statements and Supplementary Data.”     Additional information about Photon Dynamics, Inc. is availableon our website at *www.photondynamics.com.* We makeavailable free of charge, on or through our website, our AnnualReport on Form 10-K, our Quarterly Reports onForm 10-Q, our Current Reports on Form 8-K, and anyamendments to those reports filed or furnished pursuant toSection 13(a) or 15(d) of the Exchange Act, as soon asreasonably practicable after electronically filing such reportswith, or furnishing such reports to, the Securities and ExchangeCommission. Information contained on our website is notincorporated by reference in, or made part of this Annual Reporton Form 10-K or our other filings with or reports furnishedto the SEC.**Industry*****Flat Panel Display Industry Background***     Continuous innovations in microelectronics and materials sciencehave enabled flat panel displays with sharper resolution,brighter pixels and faster imaging to be produced in varyingsizes for differing applications. Similar innovations have ledto the introduction of a broad array of electronic devices withincreasing performance and decreasing size characteristics.Manufacturing these highly engineered products requires complex,multi-stage production processes, increasing the potential fordefects and errors associated with equipment failures,contamination of materials, drift in process parameters, humanerror and other related factors. These complexities are furthercomplicated by the flat panel display industry’s migrationtoward large-area mother glass for economical, high-volumeproduction of larger display panels. These manufacturingcomplexities increase investment in work-in-progress inventoriesand lengthen production cycles. Because of the high cost ofmaterials used in the manufacture of liquid crystal display(“LCD”), defective LCDs can be quite costly for LCDmanufacturers, and ultimately drive up both panel and endproduct costs. Reliable, repeatable methods of analyzingproduction-line data and repairing process-related defects aretherefore essential to enabling the production of larger,higher-quality LCDs at affordable price points.     To better manage and enhance their yields and reduce productcosts, manufacturers are increasing their emphasis on automatedtesting, inspection and repair at various points in themanufacturing process. As
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production processes become more complex and reducing materialand labor costs becomes increasingly important, we believe thatyield management solutions provide manufacturers with animportant competitive advantage.     Growth in the mobile electronic devices market, the desktopcomputer market and the television market have driven the demandfor flat panel displays, which offer reduced footprint, weight,power consumption and heat emission and better picture qualityas compared to cathode ray tube displays, the current standardtechnology for stationary display devices.     Active matrix liquid crystal display (“AMLCD”), themost prevalent and one of the highest performance flat paneldisplays available today, produces full color images andoperates at much faster refresh rates than earlier passivemonochrome liquid crystal displays. The color capability,resolution, speed and picture quality of active matrix liquidcrystal displays currently make these displays the preferredchoice for high-performance mobile applications, such asportable computers, multimedia, televisions and otherapplications requiring the display of video and graphics.     *Manufacture of Active Matrix Liquid Crystal Displays.* Themanufacture of active matrix liquid crystal displays is anextremely complex process, which has been developed and refinedfor different panel sizes and resolutions through research anddevelopment, pre-production prototyping and commercialproduction.     An AMLCD uses liquid crystal to control the passage of light.The basic structure of an AMLCD panel may be thought of as twoglass substrates sandwiching a layer of liquid crystal. Thefront glass substrate is fitted with a color filter, while theback glass substrate has transistors fabricated on it. Whenvoltage is applied to a transistor, the liquid crystal is bent,allowing light to pass through to form a pixel. A light sourceis located at the back of the panel and is called a backlightunit. The front glass substrate is fitted with a color filter,which gives each pixel its own color. The combination of thesepixels in different colors forms the image on the panel.     Substrate glass panels are initially manufactured in large glasspanels which are subsequently cut down to the size of the neededapplication. Each progressive increase in panel size is referredto by its “generation.” Generation 5 panels areapproximately 1,200 × 1,300 mm in size, Generation 6 panelsare approximately 1,500 × 1,800 mm in size, Generation 7panels are approximately 1,870 × 2,200 mm in size, andGeneration 7.5 and 8 are approximately 2,160 x 2,460 mm in size.Manufacturing an active matrix liquid crystal display involvesthree 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 forthe highest possible yields to decrease costs. Unlikesemiconductor fabs, where productivity can be increased byshrinking features and die size, AMLCD fab productivity isdriven by yield and substrate size, the latter being because theprocessing equipment cost increases are less than the plate areaincreases with each new generation.     At various points in the manufacturing process, the flat paneldisplay manufacturer uses test and inspection equipment toidentify defects to permit repair and to avoid wasting costlymaterials on continued
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manufacturing of a defective product. In addition, test andinspection systems can provide qualitative feedback to the flatpanel display manufacturer and enable the manufacturer toaddress yield problems where they originate and to optimize themanufacturing process.     *Challenges Faced by Flat Panel Display Manufacturers.* Theability of flat panel display manufacturers to improve yields ofactive matrix liquid crystal displays and other flat paneldisplays depends, in large part, on their ability to test,repair and inspect displays during the manufacturing process andto use the resulting data collection to refine the manufacturingprocess. The ability to test, repair and inspect helpsmanufacturers 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% to 60% 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 displaymanufacturers leverage the latest yield management and processtools. We focus specifically on delivering yield managementsolutions that enable manufacturers to collect data from theproduction line, analyze it, and quickly diagnose and repairprocess-related defects. We focus specifically on deliveringsolutions that help manufacturers decrease material costs andimprove throughput to gain that incremental yield edge socritical to success. Our offerings can be broadly classifiedinto two categories: Yield Management Products and CustomerService and Support.***Yield Management Products***     Our flat panel display yield management products include testand repair equipment that are used primarily in the Array phaseof production, and inspection equipment that is used primarilyin Cell and Module Assembly phases of production. Our testequipment can identify and characterize defects at early stagesof the manufacturing process so that the panels may be repairedbefore the next stage or, if necessary, discarded, minimizingthe loss of time and materials. Our test and repair systems usesimilar software-based controls, processing and graphical userinterfaces. Products can be networked together with our productsas well as complementary vendor products so that defect data canbe stored, analyzed and used throughout the
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manufacturing process. Our systems are also compatible with avariety of material handling automation systems. Our inspectionequipment can identify visual defects after cell assembly andalso during and after module assembly.     *Flat Panel Display Array Test Systems.* OurArrayCheckertmtest systems detect, locate, quantify and characterizeelectrical, contamination and other defects in active matrixliquid crystal displays after array fabrication. These systemsuse our proprietary non-contact voltage imaging technology toprovide a high-resolution voltage map of the entire display andour proprietary image analysis software converts this voltagemap into complete pixel defect data. TheArrayCheckertmtest systems determine whether individual pixels or lines ofpixels are functional and also finds more subtle defects such asvariations in individual pixel voltage. These defect data filesare then used for repair and statistical process control.     *Flat Panel Display Array Repair Systems.* OurArraySavertmrepair systems utilize multiple wavelength laser technology torepair defects in flat panel displays during and after arrayfabrication. Our systems can use defect data files downloadedfrom our array test systems or other test and inspection systemsto automatically position the panel for repair, therebyeliminating the time spent by operators locating defects.     TheArraySavertmsystem includes a high-precision materials handling platform anda user-friendly graphical interface allowing for highthroughput. Our high-precision materials handling platform fullyautomates the precise positioning of the plate for eachsuccessive repair, thereby substantially increasing throughput.Our graphical user interface and software supportssemi-automated setup of repair programs for common types ofdefects so that repairs can be executed rapidly and accurately.These programs provide a series of actions that the systemautomatically executes to repair the particular defect type.     *Flat Panel Display Inspection Systems.* OurPanelMastertminspection systems use our proprietary image analysis andmoiré interference canceling algorithms and technology toinspect flat panel displays for visual defects after cellassembly and also during and after module assembly. Our systemsuse multiple high-resolution cameras and computer workstationsto quantitatively measure visual characteristics and toprecisely locate and characterize line, cluster, pixel andblemish defects. Inspection data generated by the system isdisplayed on a video monitor for immediate interpretation andcan be stored or sent to a repair system to effect repairs. Thesystem is available either as a stand-alone unit or as a modularunit that can be integrated with manufacturers’ materialhandling equipment.***Customer Service and Support***     We enhance the value of our products through our customersupport programs, which provide comprehensive worldwide serviceand support across all of our product lines. With years ofexperience helping our customers increase yields across a myriadof production environments, our global yield management supportorganization is equipped to provide customers with a range ofpreventative and corrective services. These include design,development, and integration services associated with yieldmanagement, as well as comprehensive education, projectmanagement, process and applications consulting, productmaintenance, and life cycle optimization.**Customers**     We sell our products to manufacturers in the flat panel displayindustry. All of our flat panel display customers are located inKorea, Taiwan and Japan, where flat panel display production isconcentrated, and in China. We derive most of our revenue from asmall number of customers, and we expect this to continue forthe foreseeable future. Sales to our top three customersaccounted for 46%, 62% and 79% of revenue in fiscal 2005, 2004and 2003, respectively. During fiscal 2005, sales to LG PhillipsLCD, BOE-Hydis Technology Co., Ltd, Sharp Corporation, SamsungElectronics Co., Ltd. and Chi Mei Optoelectronics Corporationeach accounted for more than 10% of our total revenues. SeeNote 12 of our “Notes to Consolidated FinancialStatements” in Part II, Item 8. “FinancialStatements and Supplementary Data” for further information,which is incorporated here by reference, regarding sales to ourmajor customers.
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     Our business depends upon the capital expenditures of flat paneldisplay manufacturers, which in turn depend on the current andanticipated market demand for products utilizing flat paneldisplays. We do not consider our business to be seasonal innature, but it is cyclical with respect to the capital equipmentprocurement practices of flat panel display manufacturers and isimpacted by the investment patterns of these manufacturers indifferent global markets. Downturns in the industry or slowdownsin the worldwide economy could have a material adverse effect onour future business and financial results.**Sales, Service and Marketing**     Our sales, service and marketing strategy is to provide ourcustomers with increased manufacturing yields and throughput,improved quality and greater overall efficiency in theirmanufacturing process. Our sales, service and marketing effortsare focused on building long-term relationships with ourcustomers. We sell our products for the flat panel displayindustry directly to our customers in Korea, Taiwan, China andJapan. We also sold in Japan through Ishikawajima-Harima HeavyIndustries Co., Ltd. (“IHI”), a value-addeddistributor in Japan, until February 2004 when we terminated ourreseller agreement. We service our products worldwide directly.     Revenue from our flat panel display products represented 100% ofour revenue in fiscal 2005, 2004 and 2003, and all of thisrevenue was derived from sales to companies located outside ofthe United States. We believe that sales outside the UnitedStates will continue to comprise all of our revenues for theforeseeable future. Our future performance will depend, in part,on our ability to compete successfully in Asia. Our ability tocompete in this area of the world is dependent upon thecontinuation of favorable trading relationships betweencountries in the region and the United States, and ourcontinuing ability to maintain satisfactory relationships withflat panel display manufacturers in the region.     Our sales terms are typically 80% to 90% of the sales price dueupon shipment with the remaining amount due after installationand upon final customer acceptance. We typically provide alimited warranty on our products for a period of 12 monthsfrom final acceptance. Our field service personnel providecustomers with repair and maintenance services, primarilywarranty related. As of September 30, 2005, we had 106sales and service personnel, 85 of whom were located inAsia-Pacific region and 21 of whom were located in North America.     International sales expose us to risks that are not experiencedwith domestic sales, such as export license restrictions,political instability, trade restrictions and currencyfluctuations. These and other risks relating to our business aredetailed under the caption “Factors Affecting OperatingResults” in Part II, Item 7.“Management’s Discussion and Analysis of FinancialCondition and Results of Operations.” See Note 12 ofour “Notes to Consolidated Financial Statements”included under Part II, Item 8. “FinancialStatements and Supplementary Data” for additionalgeographic information, which is incorporated here by reference,including long-lived assets by geographic area as well asrevenue from external customers attributable to geographic areasduring the last three years.**Research and Development**     The market for integrated yield management systems ischaracterized by rapid and continuous technological developmentand product innovation. We believe that it is necessary tomaintain our competitive position through continued and timelydevelopment of new products and enhancements to existingproducts. Accordingly, we devote a significant portion of ourhuman and financial resources to research and development andseek to maintain close relationships with customers to remainresponsive to their needs. For information regarding ourresearch and development expenses during the last three years,see Part II, Item 7. “Management’sDiscussion and Analysis of Financial Condition and Results ofOperations” in this Annual Report on Form 10-K, whichis incorporated here by reference. As of September 30,2005, we employed approximately 162 research and developmentpersonnel.     We are focusing our current research and development onincreasing the performance of our array test, array repair andcell and module inspection systems, enabling manufacturers tominimize the loss of time and materials in production.
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     We are committing significant engineering efforts toward productimprovement and next generation product development. We willcontinue to invest in research and development to maintaintechnology leadership in our products. There can be no assurancethat we will be successful in the introduction, marketing andcost effective manufacture of any of our new products, that wewill be able to timely develop and introduce new products andenhance our existing products and processes to satisfy customerneeds or achieve market acceptance, or that the new markets forwhich we are developing new products or expect to sell currentproducts will develop sufficiently.**Manufacturing**     Our flat panel display products are primarily manufactured inSan Jose, California. We perform design, assembly andtesting in-house and utilize an outsourcing strategy for themanufacture of a majority of our components and subassemblies.Our in-house manufacturing activities consist primarily of finalassembly and test of components and subassemblies that areacquired through third-party vendors and integrating thosesubassemblies into our finished products. As ofSeptember 30, 2005, we employed approximately 91manufacturing personnel.     We schedule production based upon customer purchase orders andanticipated orders during the planning cycle. We generallyexpect to be able to accept a customer order, build the requiredmachinery and ship to the customer within approximately 26 to39 weeks. We maintain quality control through inspection ofcomponents, in-process inspection during equipment assembly andfinal inspection and operation of all manufactured equipmentprior to shipment. Although we assemble some components andfinal test our systems under limited clean room conditions, mostof our manufacturing occurs in standard manufacturing space.     Because of the long lead time required to manufacture a customerorder and the cyclical nature of the business, a significantincrease in orders could necessitate a build up in inventory andtherefore initially have a negative impact on cash. For example,during the last half of fiscal 2004, we experienced a majorproduction increase associated with our Generation 6 repairproducts. 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.**Suppliers**     Many of the parts, components and subassemblies (collectively“parts”) are standard commercial products, althoughcertain parts are made to our specifications. We use numerousvendors to supply parts for the manufacture and support of ourproducts; however, we obtain some parts for our systems from asingle source or a limited group of suppliers. For example, wecurrently obtain material handling platforms from a singlesource supplier. Although we seek to reduce dependence on oursingle source and limited group suppliers, alternative sourcesof supply for certain pieces of equipment may not be availableor may be available on unfavorable terms. The partial orcomplete loss of a single source or limited group of suppliersor any delay in shipment from a single source or limited groupof suppliers could at least temporarily harm our results ofoperations and damage customer relationships. Further, asignificant increase in the price of one or more of these piecesof equipment could harm our results of operations. To date wehave not experienced the loss of any single source or limitedgroup of suppliers or any related delays in shipment.**Intellectual Property**     We protect our proprietary technology through various methodssuch as patents and patent applications, trademarks,non-disclosure agreements and trade secrets. We have filed andobtained a number of patents in the United States and abroad andhave also jointly filed patent applications in Japan with IHI.As of October 28, 2005, we have been issued 73 patents inthe United States that are in force. The normal expiration datesof these patents range from 2006 to 2022. As of October 28,2005, there are 29 pending patent applications in the UnitedStates. As of October 28, 2005, we have been issued 41non-U.S. patents that are in force, the normal expirationdates beginning in 2010, and there are 78 non-U.S. pendingpatent applications.
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     Our patents relate to various aspects of our yield managementsolutions as set forth in the following table (as ofOctober 28, 2005):            **Patents in Force**     **U.S.** **Non-U.S.**         Yield Management Products  37   25     Other  36   16             Total  73   41             We intend to continue to pursue the legal protection of ourtechnology through intellectual property laws. However, wecannot be certain that the steps we have taken to protect ourintellectual property rights will be adequate or that thirdparties will not infringe or misappropriate our proprietaryrights.**Backlog**     Our backlog consists of unshipped system orders, unearnedrevenue and systems in deferred gross margin. As ofSeptember 30, 2005, our backlog was approximately$100.9 million, compared to approximately$82.5 million as of September 30, 2004. We expect toship or to recognize revenue on the majority of the September2005 backlog within the next six to twelve months. All ordersare subject to delay or cancellation with limited or no penaltyto the customer. Because of possible changes in product deliveryschedules and cancellation of product orders, among otherfactors, our backlog may vary significantly and, at anyparticular date, is not necessarily indicative of actual salesfor any succeeding period.**Competition**     The worldwide market for integrated yield management systems ishighly competitive. We face substantial competition fromestablished companies, many of which have greater financial,engineering and manufacturing resources, larger serviceorganizations and long-standing customer relationships with keyexisting and potential customers. We may also face futurecompetition from new market entrants from other overseas anddomestic sources.     Our competitors primarily are Micronics Japan Co. Ltd., AppliedKomatsu Technology, Inc. and Shimadzu Corporation in arraytesting, LaserFront Technologies, Inc., NTN Corporation, ContrelLimited, Charm Engineering Co., Ltd and Hoya ContinuumCorporation in array repair and several competitors in the celland module inspection market.     We expect our competitors to continue to improve the design andperformance of their products and to introduce new products withcompetitive price and performance characteristics. In addition,our customers may choose to develop proprietary technology thatmay obviate or lessen their need to purchase our products.Moreover, increased competitive pressure may necessitate pricebased competition, which could harm our business, financialcondition and results of operations.     We believe that we can compete effectively with our competitorsby building on our substantial installed customer base,providing technologically superior, competitively pricedproducts and emphasizing our easy-to-use user interfaces andcustomer support. However, realizing and maintaining suchadvantages will require a continued high level of investment byus in engineering, research and development, marketing andcustomer service and support. We may not have sufficientresources to continue to make such investments. Even ifsufficient funds are available, we may not be able to make thetechnological advances in a timely manner necessary to maintainsuch competitive advantages.     Significant competitive factors in the market for our yieldmanagement systems include system performance, ease of use,reliability, installed base and technical service and support.We believe that, while price and delivery are importantcompetitive factors, the customers’ overriding requirementis for systems that easily and effectively incorporate automatedand highly accurate inspection and repair capabilities intotheir existing manufacturing processes, thereby enhancingproductivity.
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     Our yield management systems for the flat panel display industryare intended to compete based upon performance and technicalcapabilities. These systems may compete with less expensive andmore labor-intensive manual inspection devices.**Employees**     As of September 30, 2005, we employed 420 persons. Noemployees are represented by a labor union or covered by acollective bargaining agreement. We consider our relationshipswith our employees to be good.     Competition is intense in the recruiting of personnel in theflat panel display industry. Our future success may depend inpart on our continued ability to hire and retain qualifiedmanagement and technical employees.**Business Combinations**     In addition to our efforts to develop new technologies frominternal sources, we may also seek to acquire new technologiesfrom external sources. Acquisitions involve numerous risks,including management issues and costs in connection withintegration of the operations, technologies and products of theacquired companies, possible write-downs of impaired assets, andthe potential loss of key employees of the acquired companies.     In August 2004, we acquired from Tucson Optical ResearchCorporation (“TORC”) all of the assets related to thedesign and manufacture of pellicle products which are used inour modulators. This acquisition has enabled us to reduceproduct costs of modulators used in our array checker productswhile improving performance.     In June 2004, we acquired from Quantum Composers, Inc. all ofthe assets related to the design and manufacture of laserassembly products used in our repair product line. Thisacquisition has enabled us to reduce product costs whileimproving performance.     In May 2003, we acquired substantially all of the assets ofSummit Imaging, Inc., a privately held designer and manufacturerof cooled cameras for the capital equipment industry. Thisacquisition has enabled us to reduce the costs of cameras usedin our flat panel display yield management products whileimproving performance.     In October 2002, we purchased certain assets from Intevac, Inc.related to Intevac’s Rapid Thermal Processing(“RTP”) Division. The rapid thermal processing systemsuse a patented technology designed to activate low temperaturepoly-silicon films utilizing a precise heating process criticalto the manufacture of advanced active matrix, thin filmtransistor liquid crystal displays and organic light emittingdiodes. This acquisition expanded our flat panel display productoffering. Due to deterioration of business conditions and lowerthan expected demand for low temperature poly-silicon filmtechnology, as of December 31, 2003, we determined that allthe goodwill and intangible assets associated with this RTPreporting unit had been impaired and, as a result, theircarrying value was reduced to zero. Due to deterioratingbusiness conditions and the emergence of alternative andcompeting technologies, we continued only to support RTP systemsin the field until March 31, 2005. We currently are notpursuing new business for systems upgrades or enhancements forthe foreseeable future.     For further details regarding our business combinations anddispositions, please see Note 4 of “Notes toConsolidated Financial Statements” included underPart II, Item 8. “Financial Statements andSupplementary Data.”
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**Executive Officers of the Registrant**     Our executive officers, their ages and their positions as ofNovember 30, 2005, are as follows:       **Name** **Age** **Position**         Malcolm J. Thompson  60      Executive Chairman of the Board of Directors    Jeffrey A. Hawthorne  48      Chief Executive Officer, President and Director    Maureen L. Lamb  44      Chief Financial Officer and Secretary    Steve Song  50      Vice President, Worldwide Sales    Mark Merrill  42      Vice President, Marketing     *Malcolm J. Thompson*has been a member of our Board ofDirectors since 1992 and has served as the Executive Chairman ofour Board of Directors since October 2003. Since April 2003,Dr. Thompson has served as the interim Chief ExecutiveOfficer of Vitex Systems, Inc., a provider of components forflat panel displays. From November 2001 to May 2002, he was amember of the Technical Advisory Board of Novalux, Inc., alaser module provider for optical networks. From 1998 throughNovember 2001, he was President and Chief Executive Officer ofNovalux, Inc., a provider of laser modules for optical networks.From 1996 to 1998, he was President and Chief Executive Officerof dpiX, Inc., a digital image capture and display productscompany, and from 1981 to 1996, he was the Chief Technologistfor Xerox PARC. He also has served as Chairman of the Board ofthe United States Display Consortium, an industry-governmentconsortium of over 135 member companies. Dr. Thompsonreceived a B.S. and a Ph.D. in Applied Physics from theUniversity of Brighton, Sussex in the United Kingdom.     *Jeffrey A. Hawthorne*has been our President and ChiefExecutive Officer since October 2003, and has been a member ofour Board of Directors since December 2003. From July 2003 toOctober 2003, Mr. Hawthorne was our Chief OperatingOfficer. From November 2001 to July 2003, Mr. Hawthorne wasour Vice President and President, Image Processing SystemsDivision. Mr. Hawthorne joined us in 1991 and has held aseries of other management positions including Vice President,Development from September 1994 to November 2001.Mr. Hawthorne received a B.S. degree in Engineering Physicsfrom the University of Colorado and an M.S. degree in OpticalEngineering from the University of Rochester.     *Maureen L. Lamb*has been our Chief Financial Officer andSecretary since May 2005. From August 1994 until May 2005, sheserved in various positions at KLA-Tencor Corporation, asemiconductor capital equipment manufacturer. Her most recentposition at KLA-Tencor Corporation was Vice President ofFinance. Ms. Lamb also held the positions of CorporateController and Director of Financial Planning and Analysisduring her tenure at KLA-Tencor Corporation. Prior to joiningKLA-Tencor, Ms. Lamb held various financial and managementpositions. Her last was with Aquaterr Instruments Corporation,as Co-Owner. Aquaterr Instruments provided sensors to theAgricultural Industry. Ms. Lamb received an A.B. degreefrom Harvard College and a MBA degree from The Wharton School atthe University of Pennsylvania.     *Steve Song*has been our Vice President, Worldwide Salessince November 2003. From August 1998 to November 2003,Mr. Song was our Vice President of Sales. Mr. Songjoined us in April 1994 as our Korean sales and support manager.He was promoted to director of Korean operations in August 1995and established our Korean subsidiary. Mr. Song received aB.S. degree in Electrical Engineering from Korea University inSeoul, Korea.     *Mark Merrill*has been our Vice President, Marketing sinceJuly 2004. Mr. Merrill has over 15 years of experiencein the industry and joined Photon Dynamics from KLA-Tencor,Corporation, a semiconductor capital equipment company, where hewas employed from 1990 to 2004 and assumed increasing levels ofresponsibility culminating in his appointment as thecompany’s Chief Marketing Officer. In addition to hisaffiliation with KLA-Tencor Corporation, from 2001 to 2002Mr. Merrill was vice president of Product and MarketDevelopment, Inc., a consulting firm, where he consulted withventure capital firms and their start-up companies in multipleindustries. Previously, Mr. Merrill also was anapplications and software engineer at Ultratech Stepper, Inc., asemiconductor capital equipment company. He holds a B.S. degreein Electronic
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Engineering, from Maharishi International University andattended the Stanford/ AEA Executive Institute at StanfordUniversity.**Item 2.*****Properties***     Information regarding our principal properties atSeptember 30, 2005 is as follows:                 **Location** **Type** **Principal Use** **Footage** **Ownership**             San Jose, California  Office and plant   Manufacturing   22,000   Owned     San Jose, California  Office and 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   Sublet   50,000   Leased     Hsin Chu, Taiwan  Office  Sales, service, marketing, administration, research  10,255   Leased     Daejeon, Korea  Office  Sales, service, marketing, administration, research  6,049   Leased      We also lease office space for other, smaller research, salesand service offices in Bozeman, Montana; Tucson, Arizona;Colorado Springs, Colorado; Tokyo, Japan; Mie, Japan; Seoul,Korea; Paju, Korea; Kumi, Korea; Cheonan, Korea; Tainan City,Taiwan; TaiChung, Taiwan; and Beijing, China.     Our operating leases expire at various times through December2010, with most having renewal options at the fair market valuefor additional periods up to five years. The lease on ourSan Jose headquarters expires in December 2010. Additionalinformation on these leases is included in Note 11 of the“Notes to Consolidated Financial Statements” inPart II, Item 8. “Financial Statements andSupplementary Data.” We believe our properties areadequately maintained and suitable for their intended use andthat our production facilities have adequate capacity for ourcurrent needs.**Item 3.*****Legal Proceedings***     Photon Dynamics and certain of our directors and officers havebeen 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 ofSanta Clara. The plaintiff, who previously served as one ofour officers, has asserted several causes of action arising outof alleged misrepresentations made to plaintiff regarding theexistence and enforcement of our insider trading policy. Theplaintiff is seeking damages in excess of $8 million forour alleged refusal to allow plaintiff to sell shares of ourstock in May of 2000, plus unspecified emotional distress andpunitive damages. On December 2, 2005, the Court denied ourmotion for summary judgment. The trial of this case is scheduledto begin on January 17, 2006. We believe theplaintiff’s case is without merit and intend to defend thisaction vigorously. Although we cannot predict the outcome ofthis litigation, we believe that any adverse judgment in thislitigation could have a material adverse effect on our financialcondition, results of operations, and cash flow.     We were named as a defendant in a lawsuit captioned Sanmina SCICorporation v. Photon Dynamics, Inc., No. CV013715, filed on February 3, 2004 in the Superior Court ofthe State of California, County of Santa Clara. Theplaintiff in this action, which previously was a third-partymanufacturer of Photon Dynamics, asserted several causes ofaction arising out of our alleged nonperformance of ourmanufacturing outsourcing agreement with the plaintiff andsought approximately $3.1 million in compensatory damagesand punitive damages for an unknown amount. We responded to thecomplaint on March 19, 2004, by filing an answer and crosscomplaint seeking damages of at least $135,000. We amended ourcross complaint on June 26, 2004. We settled this disputewith Sanmina SCI Corporation in March 2005, pursuant to which wepaid Sanmina SCI Corporation $1.4 million, and the courtdismissed the matter on April 1, 2005.
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     From time to time we are subject to other legal proceedings andclaims, either asserted or unasserted, which arise in theordinary course of business. While the outcome of theseproceedings and claims cannot be predicted with certainty,management does not believe that the outcome of any of theselegal matters will have a material adverse effect on our resultsof 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 holdersduring the quarter ended September 30, 2005.**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 is traded on the Nasdaq National Market underthe symbol “PHTN.” The following table sets forth thehigh and low closing sales prices of our common stock as tradedon the Nasdaq National Market for the periods indicated.                   **December 31,** **March 31,** **June 30,** **September 30,****Fiscal 2005 Quarter Ended** **2004** **2005** **2005** **2005**             High $24.90  $25.52  $22.00  $24.67     Low $16.71  $18.73  $17.47  $17.84                    **December 31,** **March 31,** **June 30,** **September 30,****Fiscal 2004 Quarter Ended** **2003** **2004** **2004** **2004**             High $41.90  $45.82  $38.81  $34.99     Low $28.13  $28.22  $27.41  $19.60      The closing price for our common stock as reported by the NasdaqNational Market on December 1, 2005 was $18.81 pershare. As of December 1, 2005, there were approximately143 shareholders of record of our common stock.     We have never declared or paid any cash dividends to ourshareholders and we have agreed not to pay cash dividends underour current bank line of credit. We do not presently plan to paycash dividends in the foreseeable future and intend to retainany future earnings for reinvestment in our business.
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**Item 6.*****Selected Financial Data***     The following selected consolidated summary financial datashould be read in conjunction with Part II, Item 8.“Financial Statements and Supplementary Data,” andwith Part I, Item 7. “Management’sDiscussion and Analysis of Financial Condition and Results ofOperations” in this Annual Report on Form 10-K. Theconsolidated statements of operations data for the years endedSeptember 30, 2005, 2004 and 2003, and the consolidatedbalance sheet data as of September 30, 2005 and 2004 arederived from the audited consolidated financial statementsincluded elsewhere in this report. The consolidated statementsof operations data for the years ended September 30, 2002and 2001, and the consolidated balance sheet data as ofSeptember 30, 2003, 2002 and 2001 are derived from auditedconsolidated financial statements not included in this report.     In fiscal 2003, we discontinued operations in two businesssegments — the printed circuit board assemblyinspection business and the cathode ray tube display and highquality glass inspection business. Accordingly, the operatingresults of these businesses have been reclassified asdiscontinued operations for all periods presented.                        **Year Ended September 30,**     **2005** **2004** **2003** **2002** **2001**             **(In thousands, except per share data)****Statements of Operations Data:**                        Revenue $125,813  $141,870  $67,196  $49,342  $38,319     Income (loss) from operations  (21,161)  6,860   (30,692)  3,402   (7,304)    Income (loss) from continuing operations before discontinued    operations and cumulative effect of a change in accounting    principle  (19,567)(1)  11,085(2)  (27,780)(3)  6,230(4)  (2,349)(5)    Income (loss) from discontinued operations  256   (1,391)  (44,592)  (28,032)  (4,218)    Income (loss) before cumulative effect of a change in accounting    principle  (19,311)  9,694   (72,372)  (21,802)  (6,567)    Cumulative effect of change in accounting principle  —   —   —   —   (6,560)(6)    Net income (loss) $(19,311) $9,694  $(72,372) $(21,802) $(13,127)    Income (loss) per share from continuing operations before    discontinued operations and cumulative effect of a change in    accounting principle:                         Basic $(1.16)(1) $0.67(2) $(1.73)(3) $0.39(4) $(0.18)(5)     Diluted $(1.16)(1) $0.65(2) $(1.73)(3) $0.37(4) $(0.18)(5)    Income (loss) per share from discontinued operations:                         Basic $0.02  $(0.08) $(2.77) $(1.76) $(0.32)     Diluted $0.02  $(0.08) $(2.77) $(1.67) $(0.32)    Income (loss) per share before cumulative effect of a change in    accounting principle:                         Basic $(1.14) $0.58  $(4.50) $(1.37) $(0.50)     Diluted $(1.14) $0.57  $(4.50) $(1.30) $(0.50)    Cumulative effect per share of a change in accounting principle,    net of tax benefit:                         Basic $—  $—  $—  $—  $(0.50)(6)     Diluted $—  $—  $—  $—  $(0.50)(6)    Net income (loss) per share:                         Basic $(1.14)(1) $0.58(2) $(4.50)(3) $(1.37)(4) $(1.00)(5)     Diluted $(1.14)(1) $0.57(2) $(4.50)(3) $(1.30)(4) $(1.00)(5)
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                       **Year Ended September 30,**     **2005** **2004** **2003** **2002** **2001**             **(In thousands, except per share data)****Balance Sheet Data:**                        Cash, cash equivalents and short-term investments $93,026  $84,155  $116,469  $170,143  $84,091     Working capital  116,488   132,335   125,624   190,188   99,457     Total assets  183,684   207,900   161,919   249,159   158,635     Other non-current liabilities  1,008   1,528   193   1,465   359     Shareholders’ equity  142,594   159,959   144,143   226,143   143,308  (1)     Includes a restructuring charge of $1.2 million related to    the restructure of the Company’s Markham, Canada location,    an impairment charge of $637,000 related primarily to impairment    of test beds and charges for amortization of intangibles of    $1.5 million. (2)     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 charges for    amortization of intangibles of $789,000. (3)     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 charges for amortization    of intangibles of $1.2 million. (4)     Includes an acquired in-process research and development charge    of $410,000 in connection with the acquisition of Akcron. (5)     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. (6)     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 andresults of operations should be read in conjunction with ourConsolidated Financial Statements and the related Notes toConsolidated Financial Statements in Item 8,“Financial Statements and Supplementary Data” in thisAnnual Report on Form 10-K. This discussion containsforward-looking statements within the meaning ofSection 27A of the Securities Act of 1933 andSection 21E of the Securities Exchange Act of 1934. Actualresults could differ materially from those projected in theforward-looking statements as a result of a number of factors,risks and uncertainties, including the risk factors set forth inthis discussion, especially under the caption “FactorsAffecting Operating Results,” and elsewhere in this AnnualReport on Form 10-K. Generally, the use of words such as“may,” “will,” “could,”“anticipate,” “expect,” “intend,”“believe,” “continue” or the negative ofsuch terms, or other comparable terminology and similarexpressions identify forward-looking statements. The informationincluded in this Form 10-K is as of the filing date withthe Securities and Exchange Commission and future events orcircumstances could differ significantly from theforward-looking statements included herein. Accordingly, wecaution readers not to place undue reliance on suchstatements.***Overview*****Our Company***     We are a leading provider of yield management solutions to theflat panel display industry. Our customers use our systems toincrease manufacturing yields of high performance flat paneldisplays used in a number of
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products, including notebook and desktop computers, televisionsand advanced mobile electronic devices such as cellular phones,personal digital assistants and portable video games. Our test,repair and inspection systems are used by manufacturers tocollect data, analyze product quality and identify and repairproduct defects at critical steps in the active matrix liquidcrystal display manufacturing process.     We sell our products to manufacturers in the flat panel displayindustry. Our flat panel display customers are located in Korea,Taiwan and Japan, where flat panel display production isconcentrated, and in China. We derive most of our revenue from asmall number of customers, and we expect this to continue forthe foreseeable future.     Our products are primarily manufactured in San Jose,California. Our manufacturing activities consist primarily offinal assembly and test of components and subassemblies, whichare purchased from third party vendors. We schedule productionbased upon customer purchase orders and anticipated ordersduring the planning cycle. We generally expect to be able toaccept a customer order, build the required machinery and shipto 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 itis cyclical with respect to the capital equipment procurementpractices of flat panel display manufacturers and is impacted bythe investment patterns of these manufacturers in differentglobal markets. A substantial percentage of our revenue isderived from the sale of a small number of yield managementsystems ranging in price from approximately $300,000 to$2.8 million. Therefore, the timing of the sale of a singlesystem 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 displayindustry. Previously, we also produced printed circuit boardassembly inspection products and cathode ray tube display andhigh quality glass inspection products. However, we determinedto exit these markets as we believed that they did not have thepotential to be profitable for us. Consequently, during fiscal2003, we implemented plans to exit these businesses.Accordingly, the operating results of these former businessesare reclassified as discontinued operations for all periodspresented.     During fiscal 2004, we suspended operations in the lowtemperature poly-silicon (“LTPS”) technology andinverter markets in the first quarter of fiscal 2004. Althoughwe did not actively pursue new LTPS business opportunities, wecontinued to support LTPS systems in the field with parts andservice through March 31, 2005. Having completedsubstantially all our customer commitments, we wrote off theremaining assets associated with the LTPS technology ofapproximately $382,000 in the three months ended March 31,2005. We currently are not actively pursuing new business forsystems, upgrades or enhancements for the foreseeable future. Inour third quarter of fiscal 2004, we sold all assets related tothe inverter business. For additional information, please referto Note 4: “Acquisitions and Dispositions” in“Notes to Consolidated Financial Statements” inPart II, Item 8.     Our transition to the singular focus on our core business ofdeveloping yield management solutions for the flat panel displayindustry has given us a clear strategy and direction. Beginningin fiscal 2005, our emphasis was to strengthen our marketposition, our product focus, our operations and our fiscalperformance. Our management team has been focused on severalimperatives to support these objectives: • *Product Focus:* We continue to improve our product    performance in defect detection, repair success, cost of    ownership, ease of use and throughput for each of our product    generations. We seek to couple this improved system performance    with our expert applications engineering services to provide the    best possible business solutions to our customers.
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 • *Quality Focus:* We are continuing to implement processes    to drive product quality improvement and ease of use for our    customers.  • *Technology Leadership:* We are continuing to emphasize our    research and development to maintain our technology leadership    in our products. We have formed an advance technology    organization to focus on our    ArrayCheckertm    product, our camera development for all of our products, and our    repair and defect classification algorithms for the    ArraySavertm    and    PanelMastertm    products.  • *Financial Improvement:* We continue our efforts to improve    financial performance. To achieve these goals, we will continue    to look for vertical integration opportunities, source certain    raw materials and certain system integration in Asia, and expand    sales and marketing of our service product offerings.     Additionally, we also focused additional resources to strengthenour reporting structure, processes, and corporate governancewithin our organization. This effort required significantresources to complete, much of which were non-recurring costs.     In fiscal 2006, our emphasis will be to focus two key areas toimprove our results of operations: •     Gross margin improvement, and  •     Strengthening market leadership in our yield management    portfolio of products, including both hardware and software    products.***Acquisitions and Dispositions***     *Acquisition of TORC Assets.* In August 2004, we acquiredall of the assets of TORC related to the design and manufactureof pellicle products used for our modulators. The purchase pricewas approximately $1.3 million, which we paid in cash andnotes.     *Acquisition of Quantum Composers Assets.* In June 2004, weacquired from Quantum Composers, Inc. all of the assets relatedto the design and manufacture of laser assembly products for ourrepair product line. The purchase price was approximately$3.0 million, which we paid in cash and notes, and assumedapproximately $156,000 in liabilities.     *Acquisition of Summit Imaging Assets.* In May 2003, weacquired substantially all of the assets of Summit Imaging,Inc., a privately held designer and manufacturer of cooledcameras for the capital equipment industry. The purchase pricewas approximately $1.5 million, which we paid in cash, andassumed approximately $15,000 in liabilities.     *Acquisition of RTP Assets.* In November 2002, we acquiredfrom Intevac, Inc. certain assets relating to rapid thermalprocessing technology (the “RTP Assets”). The purchaseprice was $20.0 million of cash.     We also continue to refine our strategic direction and, as aresult, no longer have a need for some acquired businesses andtechnologies. In fiscal 2003, we exited the printed circuitboard assembly inspection and cathode ray tube and high qualityglass inspection businesses. As a result, some or all of thetechnologies acquired in connection with some of our prioracquisitions, including Intelligent Reasoning Systems, Inc.,Image Processing Systems, Inc., and assets of Advanced ResearchTechnologies Inc., have been sold or abandoned.     In the fourth quarter of fiscal 2003, as a result of limitedopportunities in the inverter market and uncertainty with regardto flat panel manufacturers’ commitment to LTPS technology,we performed an impairment analysis of the goodwill and thepurchased intangible assets and certain other long-lived assetsassociated with the Akcron (a company we acquired in September2002) and RTP reporting units. As a result of this analysis, inthe fourth quarter of fiscal 2003, we recorded impairmentcharges of approximately $10.0 million related to goodwilland $3.5 million related to the unamortized portion of theacquired developed technology, core technology and patentintangible assets associated with these reporting units. Wewrote off the remaining $365,000 of goodwill and$2.1 million of acquired core technology and acquireddeveloped technology associated with these reporting units inthe three months ended December 31, 2003 as additionalimpairment charges. These additional impairment charges were aresult of the continuing deterioration in
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business conditions that included emergence of alternative andcompeting technologies, shrinkage of potential total marketopportunity due to one of the primary potential customer’sdecision to pursue an alternative technology and furthersoftness in this particular sector of the market sinceSeptember 30, 2003. We have not pursued new business forsystems, upgrades or enhancements. In the third quarter offiscal 2004, we sold all of our assets related to our TFT-LCDBacklight Inverter business and recorded a gain on thetransaction of $419,000 which is included in “Gain on saleof fixed assets” in the Consolidated Statements ofOperations. See Note 4 of our “Notes to ConsolidatedFinancial Statements” in Part II, Item 8.“Financial Statements and Supplementary Data” forfurther information.***Industry***     Continuous innovations in microelectronics and materials sciencehave enabled manufacturers, including our customers, to produceflat panel displays with sharper resolution, brighter pixels andfaster imaging in varying sizes for differing applications.Growth in the mobile electronic devices market, the desktopcomputer market and the television market have driven the demandfor flat panel displays, which offer reduced footprint, weight,power consumption and heat emission and better picture qualityas compared to cathode ray tube displays, the current standardtechnology for televisions.     Active matrix liquid crystal display (“AMLCD”) is themost prevalent and one of the highest performance flat paneldisplays available today. The manufacture of active matrixliquid crystal displays is an extremely complex process, whichhas been developed and refined for different substrate glasspanel sizes. Each progressive increase in initial substratepanel size is referred to by its “generation.”Manufacturing an active matrix liquid crystal display involves aseries of three principal phases — the Array Phase,the Cell Phase and the Module Assembly Phase. At various pointsin the manufacturing process, the flat panel displaymanufacturer uses test and inspection equipment to identifydefects to permit repair and to avoid wasting costly materialson continued manufacturing of a defective product. Our yieldmanagement products include our test and repair equipment thatare used primarily in the Array phase of production, and ourinspection equipment that is used primarily in the Cell andModule Assembly phases of production.     The flat panel display market growth during the first half ofcalendar 2004 was reflected in the 80% increase in flat paneldisplay capital equipment spending between 2003 and 2004. In thelast half of calendar year 2004, there was uncertainty in theflat panel display market as supply exceeded demand. Thisover-supply was driven primarily by decreasing demand due torecord high panel prices and increasing supply as a result ofnumerous generation 5 factories coming on line in Korea andTaiwan. This over-supply was moderated by longer factory ramptimes due to yield issues, and a shortage of key components suchas glass substrates and color filters. Current market indicatorsshow that demand has risen again in the latter half of calendaryear 2005 as a result of significantly reduced panel prices.     Growth in the AMLCD television market is expected to continue tofuel the overall growth in the flat panel display market. WhileAMLCD television demand lagged during the first half of calendaryear 2004, it picked up momentum during the second half of theyear and into calendar year 2005. AMLCD television demand isessentially on track due to successful generation 6 factories atSharp and LG Philips LCD and the resultant pricing efficienciesoffered from these factories. This represents an encouragingindicator of the future as generation 6 and 7 factories arecoming on line during calendar 2005. However, there are manyfactors that will dictate how successful AMLCD manufacturers arein penetrating the television market, including displayperformance, price reduction and the ability to maintainprofitability.     Demand for our Generation 5 and 6 test and repair equipmentremains high and our Generation 7 test system installation andacceptance is underway. In addition, we continue to see agrowing interest in our automated cell and module inspectionsystems.     We believe continued growth in demand for AMLCD products willfuel investments in Generation 6 and 7 factories to keep paceand that inspection, test and repair systems will continue torepresent a significant percentage of our customers’capital spending, driving increased demand for our products andservices.
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***Backlog***     Our backlog, consisting of unshipped system orders, unearnedrevenue and systems in deferred gross margin, as ofSeptember 30, 2005, was approximately $100.9 million,a majority of which we expect to ship, or to recognize forrevenue, within the next six to twelve months. We receivedorders valued at $44.2 million in the three months endedSeptember 30, 2005. Our backlog as of September 30,2004 was approximately $82.5 million.**Critical Accounting Policies and Estimates**     Our discussion and analysis of our financial condition andresults of operations are based upon our consolidated financialstatements, which have been prepared in accordance withU.S. generally accepted accounting principles. Thepreparation of our financial statements and the relateddisclosures requires our management to make judgments,assumptions and estimates that affect the reported amounts ofassets, liabilities, revenue and expenses, and relateddisclosure of contingent assets and liabilities. Note 1 ofthe “Notes to Consolidated Financial Statements”included under Part II, Item 8. “FinancialStatements and Supplementary Data,” describes significantaccounting policies used in the preparation of our consolidatedfinancial statements. Some of these significant accountingpolicies are considered to be critical accounting policies.     A critical accounting policy is defined as one that is bothmaterial to the presentation of our financial statements andrequires management to make difficult, subjective or complexjudgments that could have a material effect on our financialcondition and results of operations.     Estimates and assumptions about future events and their effectscannot be determined with certainty. We base our estimates onhistorical experience and on various other assumptions that arebelieved to be applicable and reasonable under thecircumstances. These estimates may change as new events occur,as additional information is obtained and as our operatingenvironment changes. In addition, management is periodicallyfaced with uncertainties, the outcomes of which are not withinits 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 ourmore significant judgments and estimates used in the preparationof our consolidated financial statements.***Revenue Recognition***     Note 1 of our “Notes to Consolidated FinancialStatements” included under Part II, Item 8.“Financial Statements and Supplementary Data,”provides a description of our revenue recognition policy. Foreach arrangement, we recognize revenue when persuasive evidenceof an arrangement exists, delivery has occurred or the serviceshave been rendered, the selling price is fixed or determinableand collectibility is reasonably assured, the latter of which issubject to judgment. If we determine that any of these criteriaare not met, we defer revenue recognition until such time as wedetermine that all of the criteria are met.     In addition, for arrangements with multiple deliverables, wemake additional judgments as to whether each item has value tothe customer on a stand-alone basis, the amounts of revenue foreach element that are not subject to refund, all definedcustomer acceptance experience levels have been met and the fairvalues of any undelivered items have been reliably determined.     We have a policy to record a provision for estimated salesreturns in the same period as the related revenue is recorded,which is netted against revenue. These estimates are based onhistorical sales returns and other known factors which have notvaried widely in the past and we do not reasonably expect thesefactors to significantly change in the foreseeable future. Ifthe historical data we use to calculate these estimates does notproperly reflect future returns, additional provisions may berequired. Historically, we have not experienced the return ofany of our flat panel display systems and do not expect this tochange in the foreseeable future. However, due to the relativelyhigh prices of our systems, the return of one of these systemswould have a material adverse effect on our results ofoperations.
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***Allowance for Doubtful Accounts***     Our trade receivables are derived from sales to flat paneldisplay manufacturers located in Korea, Taiwan, Japan and China.In order to monitor potential credit losses, we perform periodicevaluations of our customer’s financial condition. Wemaintain an allowance for doubtful accounts for the potentialinability of our customers to make required payments based uponour assessment of the expected collectibility of all accountsreceivable. In estimating the provision, we consider(i) historical experience, (ii) the length of time thereceivables are past due, (iii) any circumstances of whichwe are aware regarding a customer’s inability to meet itsfinancial obligations, and (iv) other known factors. Wereview this provision periodically to assess the adequacy of theprovision.     Our allowance for doubtful accounts was approximately $153,000and $497,000 at September 30, 2005 and 2004, respectively.These balances each represent less than 1% of each year’saccounts receivable balance. Our reserve at September 30,2005 decreased from the September 30, 2004 balance due tothe collection of certain receivable balances that werepreviously reserved and lower overall total accounts receivable.Historically, losses due to customer bad debts in our flat paneldisplay business have been immaterial, and we expect that thiswill not change in the foreseeable future. However, if a singlecustomer was unable to make payments, additional allowances maybe required. Accordingly, the inability of a single customer tomake required payments could have a material adverse effect onour results of operations.***Inventories***     The valuation of inventory requires us to estimate obsolete orexcess inventory and inventory that is not saleable. Thedetermination of obsolete or excess inventory requires us toestimate the future demand for our products within specific timehorizons, generally twelve months or less. If our demandforecast for specific products is greater than actual demand andwe fail to reduce manufacturing output accordingly, we could berequired to record additional inventory write-offs, which wouldhave a negative impact on our gross margin.     We review the adequacy of our inventory valuation on a quarterlybasis. For production inventory, our methodology involvesmatching our on-hand inventory with our demand forecast over thenext twelve months on a part-by-part basis. We then evaluate theparts found to be in excess of the twelve-month demand and takeappropriate write-downs and write-offs to reflect the risk ofobsolescence. This methodology is significantly affected by thedemand forecast assumption. Using a longer time period ofestimated demand could result in reduced inventory adjustmentrequirements. Based on our past experience, we believe thetwelve-month time period to best reflect the reasonable andrelative obsolescence risks. If actual demand or usage were tobe substantially lower than estimated, additional inventoryadjustments for excess or obsolete inventory may be required.***Warranty***     Our warranty policy generally states that we will providewarranty coverage for a period of one year from finalacceptance. We record the estimated cost of warranty coverage,primarily material and labor to repair and service the equipmentwhen the related revenue is recognized. Our warranty obligationis affected by product failure rates, consumption of fieldservice parts and the efficiency by which the product failure iscorrected. We estimate our warranty cost based on historicaldata related to these factors.     Our liability for warranty coverage was approximately$5.3 million and $6.2 million at September 30,2005 and 2004, respectively with the decrease in dollars fromfiscal 2004 being attributable to fewer systems shipped in thecurrent year and lower projected average costs per system.Should actual product failure rates, material usage or laborefficiencies differ from our estimates, revisions to theestimated warranty liability and related provision would berequired.***Goodwill and Intangible Assets***     We have accounted for goodwill and other intangible assetsresulting from our acquisitions in accordance with FAS 142,which prohibits the amortization of goodwill and intangibleassets with indefinite useful lives
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and requires that these assets be reviewed for impairment atleast annually and more frequently if there are indicators ofimpairment. The process for evaluating the potential impairmentof goodwill is highly subjective and requires significantjudgment at many points during the analysis. Should actualresults differ from our estimates, revisions to the recordedamount of goodwill could be reported.     We amortize intangible assets with finite lives and otherlong-lived assets over their estimated useful lives and alsosubject them to evaluation for impairment. We review long-livedassets including intangible assets with finite lives forimpairment whenever events or changes in business circumstancesindicate that the carrying amount of the assets may not be fullyrecoverable, such as a significant industry downturn,significant decline in the market value of the company, orsignificant reductions in projected future cash flows. We wouldrecognize an impairment loss when estimated undiscounted futurecash flows expected to result from the use of the asset and itseventual disposition is less than its carrying amount. Wedetermine impairment, if any, using discounted cash flows. Inassessing the recoverability of long-lived assets, includingintangible assets, we must make assumptions regarding estimatedfuture cash flows and other factors to determine the fair valueof the respective assets. If these estimates or their relatedassumptions change in the future, we may be required to recordadditional impairment charges for these assets.     As described in “Acquisitions and Dispositions” above,we recorded both goodwill and intangible asset impairmentcharges as part of our transition to a singular focus on ourcore business of developing yield management solutions for theflat panel display industry. In the fourth quarter of fiscal2003, 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 reportingunits. During fiscal quarter ended December 31, 2003, werecorded a goodwill impairment charge of approximately $365,000and an intangible asset impairment charge of $2.1 millionassociated with our Akcron reporting unit and the remainingintangible assets associated with our RTP and Akcron reportingunits. These charges were reflected in our results of operationsfor the three months ended December 31, 2003. In October2003, we settled $1.7 million of the $2.0 millionescrow related to the purchase of certain assets relating to theRTP Assets in our favor, and $300,000 was settled in favor ofIntevac, resulting in an additional goodwill impairment chargeof $300,000 in the three months ended December 31, 2003.     Goodwill as of September 30, 2005, was approximately$153,000, related entirely to our purchase of assets from SummitImaging. Intangible assets, net of accumulated amortization, asof September 30, 2005 were approximately $3.2 million,related to patents and acquired core technology resulting fromour purchase of assets from Summit Imaging, the assignment andlicense agreement signed with IHI, the purchase of QuantumComposers and the purchase of Tucson Optical ResearchCorporation.***Contingencies and Litigation***     We make an assessment of the probability of an adverse judgmentresulting from current and threatened litigation. We accrue thecost of an adverse judgment if, in our estimation and based onthe advice of legal counsel, the adverse settlement is probableand we can reasonably estimate the ultimate cost of such ajudgment. We are engaged in one significant litigation matter asof September 30, 2005 — Amtower v. PhotonDynamics, Inc. — in which the plaintiffs are seekingdamages in excess of $8 million, plus unspecified emotionaldistress and punitive damages. We settled our lawsuit withSanmina SCI in the second quarter of fiscal 2005. These mattersare as described in “Item 3 — LegalProceedings.” We have made our requisite assessments andaccruals, as warranted, as of September 30, 2005, whichconsisted of ongoing legal expenses for work being done by ourattorneys on our behalf. We believe that an adverse judgment inthe Amtower litigation could have a material adverse effect onour financial condition, results of operations and cash flows.
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**Results of Operations*****Fiscal Years Ended September 30, 2005, 2004 and    2003***     The following table sets forth, for the periods indicated, thepercentage of revenue of certain items in our ConsolidatedStatements of Operations.                 **Year Ended**  **September 30,**     **2005** **2004** **2003**           Revenue  100.0%  100.0%  100.0%    Cost of revenue  65.8   59.2   65.6               Gross margin  34.2   40.8   34.4     Operating expenses:                 Research and development  28.8   20.9   33.9      Selling, general and administrative  19.6   12.5   20.5      Restructuring charge  1.0   —   —      Goodwill impairment charge  —   0.5   14.9      Impairment of purchased intangibles  —   1.5   5.3      Impairment of fixed assets  0.5   0.2   —      Gain on sale of fixed assets  (0.1)  (0.3)  —      Acquired in-process research and development  —   0.1   3.7      Amortization of intangible assets  1.2   0.6   1.8                 Total operating expenses  51.0   36.0   80.1               Income (loss) from operations  (16.8)  4.8   (45.7)    Interest income and other, net  1.8   3.4   4.4               Income (loss) from continuing operations before income taxes and    discontinued operations  (15.0)  8.2   (41.3)    Provision for income taxes  0.5   0.4   0.1               Income (loss) from continuing operations before discontinued    operations  (15.5)  7.8   (41.4)    Income (loss) from discontinued operations  0.2   (1.0)  (66.3)              Net income (loss)  (15.3)%  6.8%  (107.7)%          ***Revenue***                           **Fiscal Year Ended** **Fiscal Year Ended**  **September 30,** **September 30,**       **2005** **Change** **2004** **2004** **Change** **2003**               **(Dollars in thousands)**    Revenue $125,813   (11.3)% $141,870  $141,870   111% $67,196      The decrease in revenue in fiscal 2005 from fiscal 2004 was dueto reduced capital expenditures by our customers due to theimpact of investments made by customers in 2004 which created anover-supply environment, primarily in the first quarter offiscal 2005. Despite the temporary excess inventory, flat paneldisplay manufacturers continue to increase capacity to meetprojected computer notebook, monitor and television demand. Theincrease in revenue in fiscal 2004 from fiscal 2003 wasprimarily due to the continued customer expansion ofmanufacturing capacity.     We generate revenue from the sales of ourArrayCheckertmandArraySavertmtest and repair equipment, ourPanelMastertminspection equipment, and the sales of spare parts.
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*ArrayChecker*tm    and    ArraySavertm    Product Revenue     *Fiscal 2005 v 2004:* OurArrayCheckertmandArraySavertmtest and repair equipment operate in the Array phase of AMLCDproduction and are built to handle the different generationsizes of substrate glass. Total revenue from our Generation 5and earlier generation test and repair systems representedapproximately 34% and 53% of revenue in fiscal 2005 and 2004,respectively. The decrease in Generation 5 and earlier productsas a percentage of revenues was due primarily to the increase inrevenue from our Generation 6 products as flat paneldisplay manufacturers move to a larger size glass substrate inthe manufacturing process and, to some extent, lower overallrevenues. Revenue from our Generation 6 products representedapproximately 50% and 42% of revenue in fiscal 2005 and 2004,respectively. Our products in each new generation contain newperformance and control features designed specifically toenhance yield improvement and process control. As a result,historically we generally have experienced increases in ouraverage selling prices of between 20% and 50% in each newgeneration product. As with prior generation products, ourGeneration 6ArrayCheckertmproducts have greater average selling prices than previousgenerations. However, the average selling prices of ourGeneration 6ArraySavertmproducts were relatively flat as compared to the priorgenerations due primarily to a more competitive environment inthe array repair market. There is no assurance that we will besuccessful at achieving or sustaining average selling priceincreases on our Generation 6 and future generation products.     Revenue from ourArrayCheckertmproducts represented approximately 60% and 75% of our totalrevenue for fiscal 2005 and 2004, respectively. Revenue from ourtest products decreased in absolute dollars primarily due to thereduced level of capital expenditures of our customers due tothe absorption during 2005 of manufacturing capacity broughtonline in 2004. Revenue from our test products decreased as apercentage of revenue due to the increase in revenue from ourrepair products.     Revenue from ourArraySavertmproducts represented approximately 24% and 19% of our totalrevenue for fiscal 2005 and 2004, respectively. Revenue from ourrepair products has increased in both absolute dollars and as apercentage of total revenue partly in response to the largerglass size processed in Generation 6 factories and due tothe expansion of customer manufacturing facilities. The cost ofyield loss associated with larger panels is driving flat paneldisplay manufacturers to increase the number of repair systemsused in the manufacturing process in an effort to maximizeyields.     Revenue from ourArrayCheckertmandArraySavertmproducts includes revenue recognized upon final customeracceptance. Our sales terms are typically 80% or 90% of thesales price due upon shipment with the remaining amount dueafter installation and upon final customer acceptance. Revenuefor fiscal 2005 includes a slightly lower absolute dollar valueof revenue related to the receipt of final customer acceptancesfollowing completed installation of our products compared withthe prior fiscal year. However, as a percentage of totalrevenues, revenues related to receipt of final customeracceptance is slightly higher.     *Fiscal 2004 v 2003:* Total revenue from our Generation 5and earlier generation products represented approximately 53%and 85% of revenue in fiscal 2004 and 2003, respectively. Thedecrease in fiscal 2004 was due primarily to revenue from ournew Generation 6 products. Revenue from our Generation 6products represented approximately 41% of revenue in fiscal2004, with no corresponding revenue in fiscal 2003.     The increase in fiscal 2004 revenue as compared to fiscal 2003was due to increased shipments of both ourArrayCheckertmandArraySavertmproducts. Revenue from ourArrayCheckertmproducts represented approximately 75% and 81% of our totalrevenue for fiscal 2004 and 2003, respectively. Revenue from ourtest products increased in absolute dollars primarily due to thecontinued customer expansion of manufacturing capacity. Revenuefrom our test products decreased as a percentage of revenue dueprimarily to the increase in revenue from our repair products.Revenue from ourArraySavertmproducts represented approximately 19% and 4% of our totalrevenue for fiscal 2004 and 2003, respectively. Revenue from ourrepair products have increased in both absolute dollars and as apercentage of total revenue partly in response to the largerglass size of Generation 6 and to expansion of customermanufacturing facilities. The cost of yield loss associated withlarge monitor or television panels is driving flat panel displaymanufacturers to increase the number of repair systems used inthe manufacturing process in an effort to maximize yields. Oursales terms are typically 80% or 90% of the sales price due uponshipment with the remaining amount due after installation andupon final
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customer acceptance. During fiscal 2004, we placed greateremphasis on obtaining final customer acceptances. As a result,fiscal 2004 revenue includes a higher percentage of revenuerelated to the receipt of final customer acceptances followingcompleted installation of our products compared with our priorfiscal year.*PanelMaster*tm    Product Revenue     OurPanelMastertminspection equipment operates in the Cell and Module Assemblyphases of AMLCD production, inspecting glass that has been cutdown to the size of the needed application. As such, ourPanelMastertmproduct is not dependent on the initial glass substrate size andcan function on either Generation 6 or Generation 7 fabricationlines. Consequently, we do not classify this product line bygenerations.     Revenue from ourPanelMastertmproducts represented approximately 6% in fiscal 2005 with nocorresponding revenue in the prior fiscal years. Our inspectionequipment was introduced in fiscal 2004 and the first productionunits were shipped in our fourth quarter of fiscal 2004. Inaccordance with our revenue recognition policy, because this wasa new product line, we deferred 100% of the revenue until wereceived customer final acceptance, which demonstrates that theproduct meets the customers’ specifications at thecustomers’ factory site. The revenue recognized in fiscal2005 represents certain systems at one customer from whom wereceived final acceptance in our fourth quarter of fiscal 2005.AdditionalPanelMastertmrevenue from 2004 shipments remains deferred atSeptember 30, 2005.*Spare Parts Revenue*     Revenue from spare part sales of approximately$13.6 million and $7.2 million representedapproximately 10% and 5% of our total revenue for fiscal 2005and 2004, respectively. The increase in absolute dollars is duein part to the increased installed base of tools at ourcustomers’ facilities.     Spare part sales of approximately $7.2 million and$5.8 million, represented approximately 5% and 9% of ourtotal revenue for fiscal 2004 and 2003, respectively. Thischange from prior year represents an increase in absolutedollars due primarily to the increase in total machines in thefield in 2004; however, it represents a decrease as a percentageof revenue due to the increase in test and repair machines sold.*Rapid Thermal Processing*     Revenue from our rapid thermal processing products, which arebased on the technology we acquired in November 2002,represented approximately 0%, 0.5% and 6% of our revenue forfiscal 2005, 2004 and 2003, respectively. The revenue reportedin 2004 reflected sales of upgrades to an existing product. Wehave discontinued supporting systems in the field and are notpursuing new business for this product offering. We do notexpect sales, if any, of this product line to be a significantportion of revenue in the foreseeable future.*International Revenue*     Revenue by region for the periods indicated were as follows:                           **Fiscal Year Ended** **Fiscal Year Ended**  **September 30,** **September 30,**       **2005** **Change** **2004** **2004** **Change** **2003**               **(Dollars in millions)**    Korea $41.5   (39)% $68.5  $68.5   46% $47.0     Taiwan  53.2   (13)%  60.8   60.8   218%  19.1     Japan  17.0   55%  11.0   11.0   952%  1.1     China  14.1   778%  1.6   1.6   —   —                      $125.8   (11)% $141.9  $141.9   111% $67.2                    
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     The changes in revenue from fiscal 2005 to 2004 and from fiscal2004 to 2003 are a result of the investment patterns of flatpanel display manufacturers, which in turn depends on thecurrent and anticipated market demand for products utilizingflat panel displays.     In fiscal 2005, 2004 and 2003, we invoiced revenue ofapproximately $19.3 million, $10.4 million and$300,000, respectively, in currencies other thanU.S. dollars, primarily Japanese yen. The increase inrevenue in Japanese yen is due to an overall increase in revenuefrom Japan and to the termination of our agreement with ourvalue-added reseller in the second quarter of fiscal 2004, whichwas previously invoiced in US dollars. Our direct sales to ourcustomers in Japan are denominated in yen.*Revenue Outlook*     We expect revenue for the first quarter of fiscal 2006 to bebetween $37 and $43 million. As stated above, forwardlooking statements such as these and the ones below regardingour expected financial results for fiscal 2006 are subject torisks and uncertainties. Please see “Factors AffectingOperating Results” below for factors that could cause theseforward looking statements not to come true.***Gross Margin***                           **Fiscal Year Ended** **Fiscal Year Ended**  **September 30,** **September 30,**       **2005** **Change** **2004** **2004** **Change** **2003**                 Gross Margin  34%   (16)%   41%   41%   19%   34%      The decrease of gross margin in fiscal 2005 as compared tofiscal 2004 reflects: •     Higher percentage sales of lower margin products, including our    Repair and new PanelMaster products;  •     High warranty costs, higher rework costs and expedite fees    incurred as a result of the execution issues surrounding the    production ramp up in our Generation 7 and PanelMaster products;  •     The under-utilization of our San Jose facilities; and  •     Increased manufacturing and support headcount and travel costs    to support installed product base.     The improvement of gross margin in fiscal 2004 as compared tofiscal 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 fiscal 2004 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    systems and our Generation 6    ArraySavertm    systems; and  •     The temporary loss of capacity early in our second quarter    caused by the move to our new facility.
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     Key factors that may impact our future gross margins include: •     Our revenue mix between higher margin    ArrayCheckertm    systems and lower margin    ArraySavertm    systems;  •     Our ability to cost effectively support our    PanelMastertm    products as new customers adopt this technology;  •     The costs of increasing customer service staff to support    potential increased demands of our customers;  •     The additional costs in connection with inefficiencies of    manufacturing newly introduced products;  •     Competitive pricing pressures, particularly in the array repair    market;  •     Reduced production levels as a consequence of either industry    slowdown, order cancellations or rescheduled product shipments    requested by our customers; and  •     Fluctuations in the level of revenue due to the cyclical nature    of our customers’ capital expenditures.***Research and Development***                           **Fiscal Year Ended** **Fiscal Year Ended**  **September 30,** **September 30,**       **2005** **Change** **2004** **2004** **Change** **2003**               **(Dollars in thousands)**    Expense $36,275   22% $29,701  $29,701   30% $22,786     Percent of Revenue  29%      21%  21%      34%     Our research and development expenses consisted primarily ofsalaries, related personnel costs, depreciation, prototypematerials and fees paid to consultants and outside serviceproviders, all of which relate to the design, development,testing, pre-manufacturing and improvement of our products.     We increased our overall research and development spending infiscal 2005 as compared to fiscal 2004 due to more engineeringprograms in process to support simultaneous development ofGeneration 6 and 7 test and repair products, and our inspectionproducts. The increased costs related primarily to higherspending on prototype materials and engineering headcount.     We increased our overall research and development spending infiscal 2004 as compared to fiscal 2003 due to additional timingdemands placed on both theArrayCheckertmandArraySavertmGeneration 6 and 7 product development programs, as well as ourcell/module inspection systems program. In our fourth quarter offiscal 2004, we incurred significant costs for redesign workperformed during the quarter on our Generation 6 repairproducts.     For fiscal 2006, we expect our research and development expensesto be relatively flat in absolute dollars as compared to fiscal2005. While we are able to reduce spending in some areas througheither completion of new product introductions or improvedefficiency, we will continue to invest in our research anddevelopment efforts to address several areas: •     Ramp up of our    PanelMastertm    program to address mass production requirements;  •     Continue our efforts on Generation 7 and 7.5 products and launch    programs for Generation 8 products;  •     Continue our reliability and cost reduction initiatives; and  •     Expansion of our repair product offering.     However, we believe the cost of these investments will bemitigated somewhat by operational efficiencies we implemented infiscal 2005, including elimination of excess space, discontinuedoperations, and more efficient management of our activities. Wewill continue to invest in research and development to maintaintechnology leadership in our products. Our customers mustcontinually improve their display quality performance andproduction costs in order to be successful in the displaymarket. To meet our customers’
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needs, we must improve our product performance in defectdetection, repair success, cost of ownership, ease of use andthroughput for each of our product generations.***Selling, General and Administrative***                           **Fiscal Year Ended** **Fiscal Year Ended**  **September 30,** **September 30,**       **2005** **Change** **2004** **2004** **Change** **2003**               **(Dollars in thousands)**    Expense $24,678   39% $17,780  $17,780   29% $13,763     Percent of Revenue  20%      13%  13%      21%     Our selling, general and administrative expenses consistedprimarily of salaries and related expenses for marketing, sales,finance, administration and human resources personnel, as wellas costs for auditing, commissions, insurance, legal and othercorporate expenses. Selling, general and administrative expenseswere higher in fiscal 2005 compared to fiscal 2004 in bothabsolute dollars and as a percentage of revenue due primarily to: •     Amounts spent on an internal investigation by our audit    committee and resulting restatement of our financial statements    for fiscal 2004 and the first quarter of fiscal 2005, resulting    in the filing of an amendment to our Annual Report on    Form 10-K for fiscal 2004 and our Quarterly Report on    Form 10-Q for the three month period ended    December 31, 2004. Expenses incurred were approximately    $1.6 million;  •     Amounts spent on preparation work for compliance with    Section 404 of the Sarbanes-Oxley Act of 2002; and  •     Additional investments in marketing.     The increase in selling, general and administrative expenses infiscal 2004 compared to fiscal 2003 was primarily attributed toincreases in expenses related to corporate governancerequirements, severance expenses, legal costs and increasedheadcount.     We expect these expenses in our first quarter of fiscal 2006 toremain relatively unchanged as compared to selling, general andadministrative expenses of approximately $6.5 million inour fourth quarter of fiscal 2005. For fiscal 2006, we expectour selling, general and administrative expenses to be slightlylower in absolute dollars as compared to fiscal 2005 due toreduced expenses for consulting, elimination of one time costsrelated to our audit committee investigation and financialstatement restatements, and reduced spending on Sarbanes-Oxleycompliance work.***Restructuring Charges***     In April, 2005, we recorded an initial restructuring charge ofapproximately $676,000 associated with a reduction in workforceand consolidation and closing of our facilities at our Markham,Canada location. The charge was comprised of approximately$430,000 for employee severance and related benefits as a resultof planned terminations of up to 32 employees and approximately$246,000 for contract termination costs associated with excessfacilities. The charge for excess facilities relates to rentobligations under a long-term operating lease agreement forfacilities we vacated in June 2005. This lease extends throughOctober 2007 and the charge is net of a sublease agreement weentered into in April 2005.     Under the restructuring plan, certain employees were offeredadditional severance amounts and retention bonuses to staythrough September 2005 and March 2006. We are accruing chargesfor these benefits ratably over the related service periods. Werecorded additional restructuring charges of approximately$521,000 through September 30, 2005 related to theseseverance and retention amounts. We expect to incur additionalseverance charges of approximately $140,000 in each of our firstand second quarters of fiscal 2006. We expect to settle allemployee severance and related benefits by the end of our thirdquarter of fiscal 2006.
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     Under the restructuring plan, we expect annual savings in salaryand benefits costs, amortization and rent expense ofapproximately $1.6 million to $2.0 million per fiscalyear primarily in research and development. Expected salary andbenefit savings will be partially offset by the expectedreplacement of approximately four of the eliminated positions,and we expect rent savings will be partially offset throughMarch of 2006 by costs to sublease a smaller location inMarkham, Ontario, Canada for the employees who have been offeredretention benefits to complete specific projects and assist inthe transition of technology.***Impairment of Goodwill, Purchased Intangibles and Fixed    Assets***     In the second, third and fourth quarters of fiscal 2005, weincurred impairment charges totaling approximately $637,000,consisting primarily of test beds that had no future use.     In the first fiscal quarter of 2004, as a result of suspendingoperations of the LTPS and inverter products, we determined thatall of our goodwill and long-lived assets related to LTPS andinverter products we had manufactured had been impaired,resulting in goodwill, intangible and fixed asset impairmentcharges of approximately $665,000, $2.1 million and$234,000, respectively.     In the fourth quarter of fiscal 2003, as a result of limitedopportunities in the inverter market and uncertainty with regardto 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 acquisitionsof Akcron and the RTP Assets, respectively. The valuations weredone as of July 1, 2003, using established valuationtechniques, specifically, the income and market approaches. As aresult of these analyses, we recorded goodwill impairmentcharges of $2.7 million and $7.3 million associatedwith the Akcron and RTP asset goodwill, respectively.     In the fourth quarter of fiscal 2003, we also performed animpairment analysis of purchased intangible assets associatedwith 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 developedtechnologies of the Akcron and RTP Assets, respectively.***Gain on Sale of Fixed Assets***     In fiscal 2005, we recorded a net gain on sale of fixed assetsof approximately $93,000 primarily due to the sale of ademonstration tool.     In fiscal 2004, we recorded a net gain on sale of fixed assetsof approximately $427,000. In May 2004, we sold all of ourassets in Korea related to our TFT-LCD Backlight Inverterbusiness for approximately $481,000. The assets includedinventory and production equipment, intellectual property andsome of the employees related to the inverter business. In thethree months ended June 30, 2004, we recorded a gain on thetransaction of approximately $419,000.***Acquired In-Process Research and Development***                           **Fiscal Year Ended** **Fiscal Year Ended**  **September 30,** **September 30,**       **2005** **Change** **2004** **2004** **Change** **2003**               **(Dollars in thousands)**    Expense $0   (100)% $210  $210   (92)% $2,474     Percent of Revenue  0%      0.1%  0.1%      4%     We had no acquired in-process research and development chargesin fiscal 2005. In fiscal 2004, we acquired from QuantumComposers all of the assets of Quantum Composers related to thedesign and manufacture of laser assembly products for flat paneldisplay LCD manufacturing and repair. In fiscal 2003, weacquired all of the assets of Summit Imaging related to thedesign and manufacture of “cooled” camerasspecifically tailored to our product offerings and we completedour acquisition of certain assets from Intevac, Inc. related toIntevac’s rapid thermal processing technology. The purchaseprices of these acquisitions were allocated in accordance withFAS 141, “Business Combinations,” includingin-process research and develop-
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ment charges that were expensed on the acquisition date as theyrepresented ongoing research and development projects that hadnot yet reached technological feasibility and had no alternativefuture uses.     Acquired in-process research and development was identified andvalued through interviews with executives of the companies fromwhich the assets were acquired, analysis of data concerningdevelopmental products and their stage of development, the timeand resources needed to complete the projects, their expectedincome 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-processresearch and development. We discounted projected incrementalcash flows back to their present value using discount rates of30%, 25% and 50% for the Quantum Composers, Intevac technologyand Summit Imaging asset purchases, respectively, which wasdetermined after consideration of our weighted average cost ofcapital and the weighted average return on assets.     In-process research and development related to Quantum Composersinvolves the design of the next generation lasercutting/ablation systems for our LCD panel repair products. Atthe time of acquisition, the project was approximately 75%complete, and was substantially completed by the end of fiscal2004, with additional incurred costs of approximately $25,000 tocomplete this development.     In-process research and development projects related to Intevacincluded a new transport system for more efficient handling oflarger glass, redesign of the lamphouse for selective heating ofthe film and enhancement of low oxygen technology. Theseprojects were substantially complete as of June 30, 2003.     In-process research and development related to Summit Imaginginvolved the design of the next generation cooled cameras forourArrayCheckertmtools. This project was substantially complete as ofSeptember 30, 2003.     Risks associated with our acquired in-process research anddevelopment include the inherent difficulties and uncertaintiesin completing each project and thereby achieving technologicalfeasibility, anticipated levels of market acceptance andpenetration, market growth rates and risks related to the impactof potential changes in future target markets. The nature of theefforts required to develop the acquired in-process research anddevelopment into commercially viable products principally relateto the completion of all planning, designing, prototyping,verification and testing activities that are necessary toestablish that the products can be produced to meet their designspecifications, including functions, features and technicalperformance requirements. As such, the timing of completion andultimate commercial application are affected by the successfulcompletion of these activities and ultimately, market acceptance.***Amortization of Intangible Assets***                           **Fiscal Year Ended** **Fiscal Year Ended**  **September 30,** **September 30,**       **2005** **Change** **2004** **2004** **Change** **2003**                   **(Dollars in thousands)**      Expense $1,548   96% $789  $789   (36)% $1,236     Percent of Revenue  1.2%      0.6%  0.6%      1.8%     The increase in amortization expense in fiscal 2005 compared tofiscal 2004 is due primarily to the additional amortizationassociated with the intangible assets related to both thepurchase of assets from TORC and from Quantum Composers, both ofwhich were purchased in the fourth quarter of fiscal 2004.     The decrease in amortization in fiscal 2004 compared to fiscal2003 was due to the write off of all intangible assetsassociated with the RTP Assets and Akcron acquisitions inDecember 2003 as discussed under “Impairment of Goodwill,Purchased Intangibles and Fixed Assets,” above.     Based on intangible assets recorded at September 30, 2005,and assuming no subsequent additions to, or impairment of theunderlying assets, we expect our quarterly amortization to beapproximately $370,000 through fiscal 2006.
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***Interest Income and Other, Net***                           **Fiscal Year Ended** **Fiscal Year Ended**  **September 30,** **September 30,**       **2005** **Change** **2004** **2004** **Change** **2003**               **(Dollars in thousands)**    Interest income and other, net $2,218   54% $4,802  $4,802   62% $2,968     Percent of Revenue  1.8%      3.4%  3.4%      4.4%     Interest income and other, net consisted primarily of interestincome, foreign currency exchange gains and losses and othermiscellaneous income and expense. In fiscal 2003, the amountalso included changes in the fair value of derivative financialinstruments. Interest income and other, net, in fiscal 2004 washigher than comparative amounts in both fiscal 2005 and fiscal2003, primarily due to the receipt of a technology license feeresulting from a litigation settlement in the first quarter offiscal 2004.***Provision for Income Taxes***     The fiscal 2005, 2004 and 2003 effective tax rates were (3.3)%,4.9%, and 0%, respectively. The negative rate for fiscal 2005primarily relates to foreign tax expense incurred regardless ofour net operating losses and does not denote a tax benefit. Theeffective tax rate for fiscal 2005 is lower than the beneficialstatutory rate primarily due to operating losses not benefitedand to foreign taxes. The effective tax rates for fiscal 2004included a foreign withholding tax related to a technologylicense fee resulting from a litigation settlement in the firstquarter of fiscal 2004. The effective tax rate in fiscal 2004 islower than the statutory rate due primarily to tax benefitsarising from net operating losses, offset by alternative minimumtaxes. The effective tax rate in fiscal 2003 is lower than thestatutory rate due to tax net operating losses not beingrecognized.     As of September 30, 2005, we have federal and state netoperating loss carryforwards of approximately $79.8 millionand $11.0 million, respectively. We expect that oureffective tax rate will be less than the statutory tax rate infiscal 2006.     We record a valuation allowance against our net deferred taxassets. Realization of our deferred tax assets depends on ourgenerating sufficient taxable income in future years inappropriate tax jurisdictions to obtain benefit from thereversal of temporary differences and from net operating lossand credit carryforwards. In fiscal 2005, we determined therewill be sufficient future taxable income in Japan to release thevaluation allowance related to temporary differences generatedby the Japanese subsidiary in the amount of $85,000. Due to theuncertainty of the timing and the amount of such realization inthe other tax jurisdictions, management concluded that a fullvaluation allowance was required for the net deferred tax assetsgenerated in the other tax jurisdictions as ofSeptember 30, 2005.     Our future effective income tax rate depends on various factors,such as tax legislation, the geographic composition of ourpre-tax income, amount of and access to tax loss carryforwards,expenses incurred in connection with acquisitions that are notdeductible for tax purposes, amounts of tax-exempt interestincome and research and development credits as a percentage ofaggregate pre-tax income, and the effectiveness of our taxplanning strategies.**Discontinued Operations**     Through January 14, 2003, we conducted business in threeoperating segments: flat panel display products, cathode raytube display and high quality glass inspection products andprinted circuit board assembly inspection products. In January2003, we implemented a plan to exit the printed circuit boardassembly inspection business. In June 2003, we implemented aplan to exit the cathode ray tube display and high quality glassinspection business. Accordingly, the operating results of theseformer business segments have been presented as discontinuedoperations for all periods presented.
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***Printed Circuit Board Assembly Inspection Business***               **Fiscal Year Ended**  **September 30,**     **2005** **2004** **2003**         **(In thousands)**    Net Loss $(56) $(1,562) $(38,586)     The loss from discontinued operations for the year endedSeptember 30, 2005, included approximately $113,000 ofadditional accruals for legal expenses related to the Amtowervs. Photon Dynamics, Inc lawsuit and approximately $75,000 ofother expenses, primarily legal and administrative, offset inpart by approximately a $132,000 benefit for the reversal of aliability related to the settlement of vendor obligations.     The loss from discontinued operations for the year endedSeptember 30, 2004, included approximately$1.5 million in litigation costs for settlement of priorinventory purchase commitments and for settlement of a lawsuitbrought by a former employee.     The loss from discontinued operations for the year endedSeptember 30, 2003, includes a write-off of inventory ofapproximately $7.6 million, a write-off of accountsreceivable of approximately $2.0 million, and a write-offof licensed technology of approximately $1.9 million. Thefiscal 2003 loss also includes impairment charges ofapproximately $15.1 million of goodwill, $2.9 millionof purchase intangibles and $2.5 million of long-livedassets recorded during the three months ended December 31,2002, as a result of our assessment of indicators of impairmentthat existed prior to our formal decision to discontinue theoperations of this segment.***Cathode Ray Tube Display and High Quality    Glass Inspection Business***               **Fiscal Year Ended**  **September 30,**     **2005** **2004** **2003**         **(In thousands)**    Net Income (Loss) $312  $171  $(6,006)     The income from discontinued operations for the year endedSeptember 30, 2005, includes approximately $288,000 for thereduction in certain accruals related to warranty and leaseobligations settled at amounts less than originally estimated.     The income from discontinued operations for the year endedSeptember 30, 2004, includes a gain on the sale of certainassets related to the former glass inspection business.     The loss from discontinued operations for the year endedSeptember 30, 2003, includes a write-off of inventory ofapproximately $1.8 million, a write-off of accountsreceivable of approximately $152,000, and a write-off of fixedassets of approximately $490,000. The fiscal 2003 loss alsoincludes approximately $460,000 in lease-related chargesassociated with excess facilities, and approximately $979,000 inemployee severance and related benefit charges.     We do not expect losses from these businesses to be material inthe foreseeable future; however, an adverse judgment in theAmtower v Photon Dynamics, Inc. lawsuit could have a materialadverse effect on the results of operations from discontinuedoperations. These matters are as described in“Item 3 — Legal Proceedings.”**Liquidity and Capital Resources**     We have financed our growth primarily by a combination of cashflows from operations and public stock offerings. Workingcapital was $116.5 million as of September 30, 2005,compared to $132.3 million as of September 30, 2004. Amajor component of working capital is $93.0 million ofcash, cash equivalents and short-term investments as ofSeptember 30, 2005, compared to $84.2 million as ofSeptember 30, 2004.
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     *Operating Activities of Continuing Operations.* Cashprovided by operating activities from continuing operations was$13.7 million in fiscal 2005, while cash used in operatingactivities from continuing operations was $24.4 million and$6.7 million in fiscal 2004 and fiscal 2003, respectively.In fiscal 2005, cash was provided despite our net loss of$19.6 million primarily by collections of accountsreceivables of $31.3 million due to our higher revenues of$52.8 million in the fourth quarter of fiscal 2004, and$38.5 million in the third quarter of fiscal 2004, comparedto $36.6 million, in the first quarter of fiscal 2005.These working capital sources were partially offset by adecrease in accounts payable of $5.5 million.     The increase in cash used in operating activities of$24.4 million in fiscal 2004 compared to $6.7 millionin fiscal 2003, despite net income of $11.1 million infiscal 2004 compared to a net loss of $27.8 million infiscal 2003, was due primarily to working capital uses of cash,primarily from an increase in accounts receivable of$48.1 million, and an increase in inventories of$22.7 million due to our increased revenue levels, of$24.4 million, $26.2 million, $38.5 million and$52.8 million in our first, second, third and fourthquarters of fiscal 2004, respectively, and the timing of ourfourth quarter revenues. These uses were partially offset by anincrease in our payables of $14.4 million, deferred grossmargin of $8.8 million, and accrued and other expenses of$4.8 million, respectively.     *Investing Activities of Continuing Operations.* Cash usedin investing activities from continuing operations was$18.8 million in fiscal 2005, while cash provided byinvesting activities from continuing operations was$26.7 million and $21.9 million in fiscal 2004 and2003, respectively. Cash used by investing activities in fiscal2005 was primarily the result of approximately$14.2 million in net purchases of short-term investmentsand $4.9 million in capital expenditures. Cash provided byinvesting activities in fiscal 2004 was primarily the result ofapproximately $39.1 million of net redemptions ofshort-term investments. This was partially offset by theacquisition of the Quantum and TORC Assets for approximately$1.0 million and $625,000, respectively, and byapproximately $9.8 million in capital expenditures, ofwhich approximately $6.1 million was related toexpenditures on leasehold improvements associated with our newfacility in San Jose, California. Cash provided byinvesting activities in fiscal 2003 was primarily the result ofapproximately $46.2 million of net redemptions ofshort-term investments. This was partially offset by theacquisition of the RTP assets of Intevac for $20.0 million,the acquisition of assets from Summit Imaging for$1.7 million and by approximately $2.5 million incapital expenditures.     *Financing Activities of Continuing Operations.* Cashprovided by financing activities was $718,000 in fiscal 2005resulting from sales of our common stock under our employeeequity compensation plans of $1.9 million, and partiallyoffset by net payments of short term obligations of$1.2 million. Cash provided by financing activities was$6.2 million in fiscal 2004, resulting solely from sales ofour common stock under our employee equity compensation plans.Cash used in financing activities was $9.8 million infiscal 2003, as sales of our common stock under our employeeequity compensation plans of $7.9 million was more thanoffset by the $17.7 million of repurchases of our commonstock during fiscal 2003.     The timing of and amounts received from employee stock optionexercises are dependent upon the decisions of the respectiveoption holders, and are not controlled by us. Therefore, fundsraised from the issuance of common stock upon the exercise ofemployee stock options should not be considered an indication ofadditional funds to be received in future periods.     In March 2000, we entered into a bank line of credit (“lineof credit”) which had an initial term of one year. We haverenegotiated the line of credit on an annual basis and currentlyhave a $4.0 million borrowing capacity on the line ofcredit with an interest rate of floating prime, with an originalexpiration in October 2005. On December 1, 2005, werenegotiated the line of credit with terms substantially thesame as the original line of credit and extended it throughOctober 16, 2006. The line of credit is secured bysubstantially all of our assets and contains certain financialand other covenants. At September 30, 2005, no amounts wereoutstanding under the line of credit.     *Operating, Investing and Financing Activities of DiscontinuedOperations.* In January 2003, we implemented a plan to exitthe printed circuit board assembly inspection business and inJune 2003 we implemented a plan to exit the cathode ray tubedisplay and high quality glass inspection business.
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Accordingly, the operating results of these business segmentshave been reclassified as discontinued operations. Net cash usedby discontinued operations during fiscal 2005, 2004, and 2003 isas follows:                 **Fiscal Year Ended**     **2005** **2004** **2003**         **(In thousands)**    Cash flows from operating activities:                  Printed circuit board business $(543) $(1,387) $(10,777)      Cathode ray tube display and high quality glass inspection    business  (97)  (47)  (1,858)               Net cash used in operating activities from discontinued    operations  (640)  (1,434)  (12,635)              Cash flows from investing activities:                  Printed circuit board business  —   —   (92)      Cathode ray tube display and high quality glass inspection    business  —   —   —                Net cash used in investing activities from discontinued    operations  —   —   (92)              Cash flows from financing activities:                  Printed circuit board business  —   —   —       Cathode ray tube display and high quality glass inspection    business  (313)  —   —                Net cash used in financing activities from discontinued    operations  (313)  —   —               Net decrease in cash and cash equivalents from discontinued    operations:                  Printed circuit board business  (543)  (1,387)  (10,869)      Cathode ray tube display and high quality glass inspection    business  (410)  (47)  (1,858)               Net decrease in cash and cash equivalents from discontinued    operations $(953) $(1,434) $(12,727)               Cash used in discontinued operations in fiscal 2005 consistedprimarily of changes in working capital balances, payments forsettlement of prior inventory purchase commitments, and thesettlement of a lawsuit.**     *****Contractual Obligations***     The following table summarizes the approximate contractualobligations that we have at September 30, 2005. Theseobligations include both non-cancelable obligations and otherobligations that are generally non-cancelable except undercertain limited conditions.                                **Payments Due by Fiscal Year**     **Total** **2006** **2007** **2008** **2009** **2010** **Thereafter**                 **(In thousands)**    Notes payable $1,500  $500  $1,000  $—  $—  $—  $—     Operating lease obligations  15,361   3,610   3,066   2,664   2,623   2,714   684     Purchase obligations  33,759   28,581   4,434   744   —   —   —                            Total $50,620  $32,691  $8500  $3,408  $2,623  $2,714  $684                            In August 2003, we signed a lease agreement for a128,520 square-foot building in San Jose, Californiainto which we consolidated our former San Jose facilities,effective January 5, 2004. The lease on our priorSan Jose location terminated concurrently with theinception date of the new lease. The new facility is leasedunder a non-cancelable operating lease that expires in 2010,with two renewal options at fair market value for additionalfive year periods and is reflected in the “operating leaseobligations” in the table above.     We maintain certain open inventory purchase commitments with oursuppliers to ensure a smooth and continuous supply chain for keycomponents. Our liability under these purchase arrangements isgenerally restricted to purchase commitments over a forecastedtime horizon as mutually agreed upon between the
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parties and is reflected in “purchase obligations” inthe table above. The majority of these purchase commitments arecovered by confirmed customer orders.     Notes payable primarily relate to notes issued in the Quantumand TORC acquisitions. For additional information related tothese notes, See Note 14 of “Notes ToConsolidated Financial Statements” in this Annual Report onForm 10-K.***Working Capital***     We believe that cash generated from operations, together withthe liquidity provided by existing cash balances and borrowingcapability, will be sufficient to meet our operating and capitalrequirements and obligations for at least the next twelvemonths. However, this forward-looking statement is based uponour current plans and assumptions, which may change, and ourcapital requirements may increase in future periods. Inaddition, we believe that success in our industry requiressubstantial capital in order to maintain the flexibility to takeadvantage of opportunities as they may arise. We may, from timeto time, invest in or acquire complementary businesses, productsor technologies and may seek additional equity or debt financingto fund such activities. There can be no assurance that suchfunding will be available to us on commercially reasonableterms, if at all, and if we were to proceed with acquisitionswithout this funding or with limited funding it would decreaseour capital resources. The sale of additional equity orconvertible debt securities could result in dilution to ourexisting shareholders.***Off-Balance Sheet Arrangements***     As of September 30, 2005, we did not have any off-balancesheet arrangements, as defined in Item 303(a)(4)(ii) of SECRegulation S-K.***Transactions with Related Parties***     During fiscal 2005, 2004, and 2003, we paid $108,000, $138,000,and $18,000, respectively, to Dr. Malcolm Thompson, ourExecutive Chairman of the Board, for consulting servicesrendered to us. During fiscal 2005 and 2004, we recordedapproximately $52,000 and $206,000, respectively, in stockownership expense related to options granted toDr. Thompson in connection with his services to us.**Impact of Accounting Pronouncements**     In March 2005, the FASB published FASB InterpretationNo. 47, “Accounting for Conditional Asset RetirementObligations,” which clarifies that the term, conditionalasset retirement obligations, as used in SFAS No. 143,“Accounting for Asset Retirement Obligations,” refersto a legal obligation to perform an asset retirement activity inwhich the timing and (or) method of settlement areconditional on a future event that may or may not be within thecontrol of the entity. The uncertainty about the timing and(or) method of settlement of a conditional asset retirementobligation should be factored into the measurement of theliability when sufficient information exists. The interpretationalso clarifies when an entity would have sufficient informationto reasonably estimate the fair value of an asset retirementobligation. This interpretation is effective no later than theend of our fiscal 2006. The adoption of this Interpretation isnot expected to have a material effect on our consolidatedfinancial position or results of operations.     In November 2004, the FASB issued SFAS No. 151,“Inventory Costs, an amendment of ARB No. 43,Chapter 4” (SFAS No. 151). SFAS No. 151clarifies that abnormal inventory costs such as costs of idlefacilities, excess freight and handling costs, and wastedmaterials (spoilage) are required to be recognized ascurrent period charges. The provisions of SFAS No. 151are effective for fiscal periods beginning after June 15,2005. We have not yet determined the impact the adoption ofSFAS No. 151 would have on our consolidated results ofoperations, financial position or cash flows.     In December 2004, the FASB issued SFAS No. 153,“Exchanges of Nonmonetary Assets, an amendment of APBOpinion No. 29” (SFAS No. 153).SFAS No. 153 addresses the measurement of exchanges ofnonmonetary assets and redefines the scope of transactions thatshould be measured based on the fair value of the assetsexchanged. SFAS No. 153 is effective for us fornonmonetary asset exchanges
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beginning in the first quarter of fiscal 2006. We do not expectthe adoption of SFAS No. 153 to have a material effecton our consolidated financial position, results of operations,and cash flows.     In December 2004, the FASB issued FASB Staff PositionNo. FAS 109-2, “Accounting and DisclosureGuidance for the Foreign Earnings Repatriation Provision withinthe American Jobs Creation Act of 2004” (FSPFAS 109-2). The American Jobs Creation Act introduces aspecial one-time dividends received deduction on therepatriation of certain foreign earnings to a U.S. taxpayer(repatriation provision), provided certain criteria are met. FSPFAS 109-2 provides accounting and disclosure guidance forthe repatriation provision. We have analyzed this provision andhave concluded that it is not beneficial to pursue therepatriation under this Act as of September 30, 2005.     In December 2004, the FASB issued SFAS 123 (revised 2004),“Share-Based Payment” (SFAS No. 123R). SFASNo. 123R requires measurement of all employee stock-basedcompensation awards using a fair value method and the recordingof such expense in the consolidated financial statements. Inaddition, the adoption of SFAS No. 123R will requireadditional accounting related to the income tax effects andadditional disclosure regarding the cash flow effects resultingfrom share-based payment arrangements. SFAS No. 123R iseffective beginning in our first quarter of fiscal 2006. We haveselected the Black-Scholes option-pricing model as the mostappropriate fair-value method for our awards and plan to adoptusing the modified prospective method. The adoption of SFASNo. 123R will have a material impact on our consolidatedresults of operations, financial position and statement of cashflows. However, uncertainties, including our future stock-basedcompensation strategy, stock price volatility, estimatedforfeitures and employee stock option exercise behavior, make itdifficult to determine whether the stock-based compensationexpense that we will incur in future periods will be similar tothe SFAS 123 pro forma expense disclosed in Note 1, ofthe Consolidated Financial Statements in this Annual Report onForm 10-K. In addition, the amount of stock-basedcompensation expense to be incurred in future periods will bereduced by our acceleration of certain unvested and“out-of-the-money” stock options in fiscal 2005 asdisclosed in Note 1, of the Consolidated FinancialStatements in this Annual Report on Form 10K.     In June 2005, the FASB issued SFAS No. 154,“Accounting Changes and Error Corrections” (“SFASNo. 154”). SFAS No. 154 replaces APBO No. 20(“APBO 20”) and SFAS No. 3, “ReportingAccounting Changes in Interim Financial Statements,” andapplies to all voluntary changes in accounting principle, andchanges the requirements for accounting for and reporting of achange in accounting principle. APBO 20 previously required thatmost voluntary changes in accounting principle be recognized byincluding in net income of the period of change a cumulativeeffect of changing to the new accounting principle whereas SFASNo. 154 requires retrospective application to priorperiods’ financial statements of a voluntary change inaccounting principle, unless it is impracticable. SFASNo. 154 enhances the consistency of financial informationbetween periods. SFAS No. 154 will be effective beginningwith our first quarter of fiscal year 2006. We do not expectthat the adoption of SFAS No. 154 will have a materialimpact on our results of operations, financial position or cashflows.**Factors Affecting Operating Results*****We have sustained losses and we may sustain losses in the    future.***     We reported a net loss for the fiscal year endedSeptember 30, 2005, as well as net losses for each of thefiscal years ended September 30, 2003 and 2002. In thefuture our revenue may decline, remain flat or grow at a rateslower than expected. Our ability to maintain profitability isdependent in part on the success of our efforts to increaserevenues and to reduce operating expenses as a percentage ofrevenue through our ongoing cost-cutting measures and our grossmargin improvement programs. However, we have increased ourmanufacturing capacity to meet greater demand for our products,and this has caused us to experience increased operatingexpenses. If the increase in demand for our products is notsustained, or if we are not able to increase our manufacturingcapacity in a cost-efficient manner, this would impair ourability to again achieve profitability. For all of thesereasons, there is no assurance that we will be successful inachieving or maintaining increased revenue, reduced operatingexpenses, positive cash flows or profitability.
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***Our operating results are difficult to predict and may    vary from investors’ expectations, which could cause our    stock price to fall.***     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 financialresults. A substantial percentage of our revenue is derived fromthe sale of a small number of yield management systems rangingin price from $300,000 to $2.8 million. Therefore, thetiming of the sale of a single system could have a significantimpact on our quarterly results. After we ship our products,customers may reject or delay acceptance, which would adverselyimpact our revenues. Moreover, customers may cancel orreschedule shipments, and production difficulties could delayshipments. For example, in the fourth quarter of 2004, weincurred additional costs such as expedite fees, premiums anddelivery penalties in an effort to meet customer deliveryschedules and quality related costs such as rework and higherwarranty.     Other factors which may influence our operating results in aparticular 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;  •     changing international economic conditions;  •     the outcome of our litigation with a former executive officer;  •     worldwide political instability;  •     our ability to design, manufacture and introduce new products on    a cost-effective and timely basis;  •     the delay between expenses to further develop marketing and    service capabilities and the realization of benefits from those    improved capabilities; and  •     the introduction of new products by our competitors.     Our operating results also could be affected by sudden changesin customer requirements, currency exchange rate fluctuationsand other economic conditions affecting customer demand and thecost of operations in the global markets in which we dobusiness. As a result of these or other factors, our operatingresults could be significantly and adversely affected and ourstock price could decline. In addition, it is possible that insome future quarter our operating results may be below theexpectations of public market analysts and investors, whichcould 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 inpart on our ability to satisfy the performance, reliability andquality standards required by our customers. Particularly ascustomers seek increased yields, greater throughput and higherquality end products, we must continually redesign our productsto meet the needs of our customers. As with the introduction ofany new product, our customers may experience yield loss. Forexample, with ourArraySavertm650,ArrayCheckertm3628 andArrayCheckertm3500, certain customers experienced yield loss higher thanexpected when the products were first introduced. If ourproducts have performance, reliability or quality problems, thenwe may experience: •     delays in collecting accounts receivable;  •     reduced orders;
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 •     additional service expenses; and  •     higher manufacturing costs.     If we are unable to meet the requirements of our customers, ourrevenue may decrease and our business could be harmed.     In addition, we typically provide a limited warranty on ourproducts for a period of one year from final acceptance bycustomers. Warranty claim experience may, at times, exceed theestimated cost of warranty coverage we record in our warrantyprovision. For example, in our fourth quarter of fiscal 2004, weincurred higher warranty costs and recorded incremental warrantyprovisions to cover certain identified quality problems. In thefuture, we may incur substantial warranty claim expenses on ourproducts and actual warranty claims may exceed recordedprovisions, 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 bymanufacturers of flat panel display products, which in turndepends on the current and anticipated market demand for the endproducts in that industry. The market for flat panel displayproducts is highly cyclical and has experienced periods ofoversupply resulting in significantly reduced demand for capitalequipment. In fiscal 2004, we saw AMLCD product supply exceeddemand. Though this oversupply has been moderated given thepanel price decreases, it has resulted in a slowdown in capacityincreases in fiscal 2005, with flat panel display manufacturerspressing forward with carefully considered new capacityinvestments.     If the flat panel display markets in which we sell our productsexperience further slowdowns in the future, it could cause ourrevenue to decrease significantly. We do not control the timingor volume of orders placed by our customers. Whether and to whatextent our customers place orders for any specific products, aswell as the mix and quantities of products included in thoseorders, are factors beyond our control. Insufficient orders willresult in under-utilization of our manufacturing facilities andinfrastructure and will negatively affect our operating resultsand financial condition. In addition, the need to invest in theengineering, research and development, and marketing required topenetrate targeted foreign markets and maintain extensiveservice and support capabilities limits our ability to reduceexpenses 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 asmall number of manufacturers producing the majority of theworld’s flat panel displays. If one or more of our majorcustomers ceased or significantly curtailed their purchases, ourrevenue could drop significantly. We may be unable to replacesales to these customers. Sales to our greater than 10%customers in the last three fiscal years is as follows: our topfive customers accounted for 67% of our revenue in fiscal 2005;our top four customers accounted for 72% of our revenue infiscal 2004; and our top three customers accounted for 79% ofour revenue in fiscal 2003.***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 ofproducts for the flat panel display industry. As a result, weare solely reliant on the flat panel display industry. Anydecline in demand for, or failure to achieve continued marketacceptance of, our primary products or any new version of theseproducts could harm our business. Continued market acceptance ofour array test, array repair and cell inspection products iscritical to our success.
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***We may not be able to develop and introduce new products    that respond to evolving industry requirements in a timely    manner, which could reduce our ability to compete    effectively.***     The markets for our products are characterized by rapidlychanging technologies and frequent new product introductions.The failure to develop new products and introduce themsuccessfully and in a timely manner could harm our competitiveposition and results of operations. We believe that our futuresuccess will depend in part upon our ability to continue toenhance our existing products and to develop and manufacture newproducts. For example, the size of glass plates for flat paneldisplays and the resolution of flat panel displays have changedfrequently and may continue to change, requiring us to redesignor reconfigure our flat panel display products.     We expect to continue to incur significant research anddevelopment costs. There can be no assurance that we will besuccessful in the introduction, marketing and cost effectivemanufacture of any of our new products, that we will be able totimely develop and introduce new products and enhance ourexisting products and processes to satisfy customer needs orachieve market acceptance, or that the new markets for which weare developing new products or expect to sell current productswill develop sufficiently. For example, in the third quarter offiscal 2004, shipments of the Generation 7ArrayCheckertm,Generation 7ArraySavertmandPanelMastertmsystems were shipped later than the customers requested deliverydates.     In addition, we depend on close relationships with our customersand the willingness of those customers to share information withus, and the failure to maintain these relationships could harmour product development efforts.***If we are not able to obtain critical components from our    single or limited source suppliers, we may experience    significant delays in producing our products, which could    decrease our revenue for an extended period of time.***     We obtain some equipment for our systems from a single source ora limited group of suppliers. For example, we currently obtainmaterials handling platforms from a single source supplier.Although we seek to reduce dependence on our sole and limitedsource suppliers, alternative sources of supply for thisequipment may not be available or may be available onunfavorable terms. The partial or complete loss of our sole andlimited source suppliers could significantly delay our shipmentsor otherwise harm our results of operations and damage customerrelationships. Further, a significant increase in the price ofone or more of these pieces of equipment could harm our resultsof 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 torepresent 100% of our revenue in the foreseeable future. Anumber of factors may adversely affect our international salesand 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;  •     decreases in productivity, temporary plant shutdowns or    infrastructure service disruptions resulting from widespread    health alerts including SARS and warnings of an Avian Flu    pandemic;
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 •     changes in tariffs; and  •     difficulties in staffing and managing international operations.     If any of these factors occur, our operating results and revenuecould be materially and adversely affected.***Compliance with new reporting requirements may strain our    resources and we may be unable to implement in a timely manner    additional finance and accounting systems, procedures and    controls in the future to satisfy new reporting requirements,    which could cause our stock price to fall.***     Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002,we are required, beginning with this Annual Report onForm 10-K for our fiscal year 2005, to perform anevaluation of our internal control over financial reporting andhave our independent registered public accounting firm publiclyattest to such evaluation. During fiscal 2005, we executed aninternal plan of action for compliance, which included atimeline and scheduled activities. As discussed under“Item 9A. Controls and Procedures” in thisreport, we have one material weakness in our internal controlover financial reporting, and we are working to remediate thismaterial weakness. However, there is no guarantee that once weremediate our material weakness, our internal control overfinancial reporting will continue to be adequate to providereasonable assurance regarding the reliability of our financialreporting and the preparation of our financial statements inaccordance with generally accepted accounting standards, or thatour independent registered public accounting firm will concurwith our assessments in the future. Preparation for andcompliance with these requirements has been, and we expect itwill continue to be, expensive and time-consuming. This isespecially true because we have had a number of materialweaknesses in the past that we have remediated, which wasexpensive and time consuming to do. In the future, if we areunable to complete the required assessment as to the adequacy ofour internal control over financial reporting or if ourindependent registered public accounting firm is unable toprovide us with an unqualified report as to the effectiveness ofour internal control over financial reporting, we could besubject to further regulatory scrutiny and a further loss ofpublic confidence in our internal control over financialreporting. In addition, any failure to implement required new orimproved controls, or difficulties encountered in theirimplementation, could harm our operating results or cause us tofail to meet our reporting obligation and potentially result ina decline of our stock price.     We have previously disclosed material weaknesses in our internalcontrol over financial close process and sales order fulfillmentand revenue recognition process as discussed in Item 9A ofour Annual Report on Form 10-K/ A, Amendment No. 3 forthe fiscal year 2004, filed with the SEC, and additionally,restated our quarterly results of operations and financialcondition for both the first and the third quarters of fiscal2005. Although we committed significant resources to remediatethese weaknesses, we encountered an additional material weaknessin the fourth quarter of fiscal 2005 and there can be noassurances that material weaknesses will not occur in thefuture. Accordingly, to the extent these material weaknesses mayoccur in the future or new material weaknesses may be found toexist, these material weaknesses may have a material effect onour company, or our results of operations, or result in afailure to meet our reporting obligations.***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 frominternal sources, we also may seek to acquire new technologiesfrom external sources. For example, in August 2004, we acquiredall of the assets relating to the design and manufacture ofpellicle products used in our modulators from Tucson OpticalResearch Corporation. In June 2004, we acquired from QuantumComposers, Inc. all of the assets related to the design andmanufacture of laser assembly products for our repair systems.In May 2003, we acquired all of the assets of Summit Imagingrelated to the design and manufacture of “cooled”cameras. All three of these acquisitions were to purchasetechnology that we use in our products so that we are notdependent on independent suppliers to provide the technology andrelated components. In the future, we may make additionalacquisitions of, or significant investments in, businesses withcomplementary products, services and/or technologies.Integrating businesses can be a complex, time-consuming andexpensive process. If we are not able to do so effectively, wewill not be able to realize the benefits that we expect toreceive from either our
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past or future acquisitions. For each acquisition, we mustintegrate separate technologies, product lines, businesscultures and practices, employees and systems. Acquisitions aresubject 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 orresult in impairment of purchased assets, which could harm ourfinancial performance.     In addition, we may also elect to change our strategic directionand may no longer have need for the acquired businesses ortechnologies. For example, in 2004 we determined not to pursuenew business for RTP Systems acquired from IntevacCorporation in November 2002. In 2003, we exited the printedcircuit board assembly inspection and high quality glassinspection businesses. As a result, some or all of thetechnologies acquired in connection with certain of our prioracquisitions have been abandoned. In the third quarter of fiscal2004, we sold all of our assets related to our TFT-LCD backlightinverter business. Future acquisitions may also result inpotentially dilutive issuances of equity securities, incurrenceof debt and contingent liabilities and amortization expensesrelated to acquired intangible assets, which could harm ourprofitability.***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 ourproducts, including custom electronic and mechanical components,and we use numerous suppliers to supply these materials. If anythird party that we use to manufacture our products is unable tosatisfy our quality requirements or provide us with the productsand services in a timely manner, our shipments of these productsmay be delayed, our customer relationships may be harmed and ourresults of operations may be adversely impacted. There can be noassurance that our relationship with any third party that we useto manufacture our products will result in a reduction of ourexpenses or enable us to satisfy our customers’ qualityrequirements or to deliver our products to our customers in atimely 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 paneldisplay industry are highly competitive. We face substantialcompetition from established competitors that have greaterfinancial, engineering and manufacturing resources than us andhave larger service organizations and long-standing customerrelationships. Our competitors can be expected to continue toimprove the design and performance of their products and tointroduce new products with competitive price and performancecharacteristics. Competitive pressures may force pricereductions that could harm our results of operations. Ourcustomers may also develop technology and equipment that mayreduce or eliminate their need to purchase our products.Although we believe we have certain technological and otheradvantages over our competitors, maintaining and capitalizing onthese advantages will require us to continue a high level ofinvestment in engineering, research and development, marketingand customer service support. There can be no assurance that wewill have sufficient
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resources to continue to make these investments or that we willbe able to make the technological advances necessary to maintainour 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 displaytechnologies, our experience has been focused on applicationsfor active matrix liquid crystal displays, the most prevalentand one of the highest performance flat panel displays availabletoday. We derive 100% of our revenue from flat panel displayproducts, substantially all of which were based on the activematrix liquid crystal display technology. An industry shift awayfrom active matrix liquid crystal display technology to existingor new competing technologies could reduce the demand for ourexisting products and require significant expenditures todevelop new products, each of which could harm our business. Asan example, if the emerging AMLCD Television market has asignificant shift to plasma technology, LCD manufacturers’fab planning and Photon Dynamics business would be negativelyimpacted.***Our business could be harmed if we fail to properly    protect our intellectual property.***     Our success depends largely on our ability to protect ourintellectual property. While we attempt to protect ourintellectual property through patents, copyrights and tradesecrets in the United States and other countries, there can beno assurance that we will successfully protect our technology orthat competitors will not be able to develop similar technologyindependently. We cannot assure you that the claims allowed onany patents held by us will be sufficiently broad to protect ourtechnology against competition from third parties with similartechnologies or products. In addition, we cannot assure you thatany patents issued to us will not be challenged, invalidated orcircumvented or that the rights granted there-under will providecompetitive advantages to us. Moreover, the laws of some foreigncountries do not protect intellectual property rights to thesame extent as the laws of the United States, and we couldexperience various obstacles and high costs in protecting ourintellectual property rights in foreign countries. If we areunable to obtain or maintain these protections, we may not beable to prevent third parties from using our intellectualproperty.     We also rely on trade secrets, proprietary know-how andcontinuing technological innovation to remain competitive. Wehave taken measures to protect our trade secrets and know-how,including the use of confidentiality agreements with ouremployees. It is possible that these agreements may be breachedand that the available remedies for any breach will not besufficient 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 patentsand other intellectual property rights, to protect our tradesecrets or to determine the validity and scope of theproprietary rights of others. Any litigation, regardless of theoutcome, could be costly and require significant time andattention of key members of our management and technicalpersonnel.     Our domestic and international competitors, many of which havesubstantially greater resources and have made substantialinvestments in competing technologies, may have patents thatwill prevent, limit or interfere with our ability to manufactureand sell our products. We have not conducted a comprehensiveindependent review of patents issued to third parties. Thirdparties may assert infringement claims, successful or otherwise,against us, and litigation may be necessary to defend againstclaims of infringement or invalidity. An adverse outcome in thedefense of a patent suit could subject us to significantliabilities to third parties, require disputed rights to belicensed from third parties or require us to cease selling ourproducts. Even successful defenses of patent suits can be costlyand time-consuming.
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***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 keypersonnel, particularly senior management and engineers. We alsoneed to attract additional skilled personnel in significantareas of our business to grow. There can be no assurance that wewill be able to retain our existing personnel or attractadditional qualified employees in the future. We generally donot have employment contracts with our employees and do notmaintain 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 inwhich we do business increases the uncertainty in our marketsand may delay any recovery in the general economy, which couldthreaten our business.     Increased international political instability, particularlyresulting from the threat of terrorist attacks, and furtherenhanced security measures as a result of the threat ofterrorist attacks may hinder our ability to do business and mayincrease our costs of operations. Such continuing instabilitycould cause us to incur increased costs in transportation, makesuch transportation unreliable, increase our insurance costs andcause international markets to fluctuate. This instability couldhave the same effects on our suppliers and their ability totimely deliver their products to us. If this internationalpolitical instability continues or increases, our business andresults of operations could be harmed.***Our manufacturing facilities may be subject to disruption    from natural disasters.***     Operations at our manufacturing facilities are subject todisruption for a variety of reasons, including work stoppages,acts of war, terrorism, fire, earthquake, energy shortages,flooding or other natural disasters. Our corporate andmanufacturing facilities in California are located near majorearthquake faults, which have experienced earthquakes in thepast. Such disruption could cause delays in shipments ofproducts to our customers. We cannot ensure that alternateproduction capacity would be available if a major disruptionwere to occur or that, if it were available, it could beobtained on favorable terms. Such disruption could result incancellation of orders or loss of customers and could seriouslyharm our business. It could also significantly delay ourresearch and engineering efforts for the development of newproducts, most of which is conducted at our Californiafacilities.     In addition, some of our customers in Asia are located nearfault lines. A major earthquake in Asia could disrupt ouroperations or the operations of our customers, which couldreduce demand for our products.***Our stock price may fluctuate significantly.***     The market price of our common stock could fluctuatesignificantly in response to variations in quarterly operatingresults 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 experiencedsignificant price fluctuations. These fluctuations often havebeen unrelated to the operating performance of the specificcompanies whose stock is traded. Broad market fluctuations,general economic condition and specific conditions in the flatpanel display industry may adversely affect the market price ofour common stock.
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***Some anti-takeover provisions may affect the price of our    common stock.***     Our Amended and Restated Articles of Incorporation authorize ourboard of directors to issue up to 5,000,000 shares ofpreferred stock. The board also has the authority to determinethe price, rights, preferences and privileges, including votingrights, of those shares without any further vote or action bythe shareholders. The rights of our shareholders will be subjectto, and may be impaired by, the rights of the holders of anypreferred stock that may be issued in the future. These andother provisions contained in our charter documents andapplicable provisions of California law could serve to depressour stock price or discourage a hostile bid in whichshareholders could receive a premium for their shares. Inaddition, these provisions could make it more difficult for athird party to acquire a majority of our outstanding votingstock 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 capitalstock and do not anticipate paying cash dividends in theforeseeable future. We have also agreed not to pay cashdividends under our current bank line of credit. Instead, weintend to apply any earnings to the expansion and development ofour business.***New regulations related to equity compensation will    negatively impact our financial statements and could adversely    affect our ability to attract and retain key personnel.***     Since our inception, we have used stock options and otherlong-term equity incentives as a fundamental component of ouremployee compensation packages. We believe that stock optionsand other long-term equity incentives directly motivate ouremployees to maximize long-term stockholder value and, throughthe use of vesting, encourage employees to remain with PhotonDynamics. The Financial Accounting Standards Board(FASB) has announced changes to U.S. generallyaccepted accounting principles that will require us to recordcharges to earnings for employee stock option grants. Theserules become effective for us in our first quarter of fiscal2006. We believe this accounting standard will have a materialimpact on our consolidated financial statements as reportedunder generally accepted accounting principles. In addition,regulations implemented by The NASDAQ National Market requiringshareholder approval for all stock option plans, as well asregulations implemented by the New York Stock Exchangeprohibiting NYSE member organizations from giving a proxy tovote on equity-compensation plans unless the beneficial owner ofthe shares has given voting instructions, could make it moredifficult for us to grant options to employees in the future. InSeptember 2005, in order to attempt to mitigate the impact ofthese changes on our financial statements going forward, weaccelerated vesting of all employee options granted at a priceof $25 per share or more.     To the extent that new regulations make it more difficult orexpensive to grant stock options to employees, we may incurincreased compensation costs, change our equity compensationstrategy or find it difficult to attract, retain and motivateemployees, each of which could materially and adversely affectour business.**Item 7A.*****Quantitative and Qualitative Disclosures about Market    Risk*****Foreign Currency Exchange Rate Risk**     We are exposed to changes in foreign currency exchange ratesprimarily related to the operating results of our foreignaffiliates. Actual changes in foreign exchange rates couldadversely affect our operating results or financial condition.The potential impact depends upon the magnitude of the ratechange. We believe our exposure to changes in foreign currencyexchange rates for our cash, accounts receivable and accountspayable is limited as the majority of our cash, accountsreceivable and accounts payable are denominated inU.S. dollars. In fiscal 2005, 2004 and 2003, approximately$19.3 million, $10.4 million and $276,000,respectively, were invoiced in currencies other thanU.S. dollars, primarily Japanese Yen. As ofSeptember 30, 2005, we had approximately $243,000 inaccounts receivables denominated in foreign currencies,primarily Japanese yen which results in nominal risk exposure.     We did not have any outstanding forward sales contracts atSeptember 30, 2005 or 2004.
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**Interest Rate Risk**     The primary objective of our investment activities is topreserve principal while maximizing the income we receive fromour investments without significantly increasing risk. Some ofthe securities that we may invest in may be subject to marketrisk. To minimize this risk, we maintain our portfolio of cashequivalents and short-term investments in a variety ofsecurities, including commercial paper, money market funds,government and non-government debt securities and certificatesof deposit.     Our exposure to market risk relates primarily to interest ratefluctuations in connection with our cash and cash equivalentsand short-term investment portfolios. We enter into financialinstruments for non-trading purposes and do not have derivativefinancial instruments in our portfolio. The following tablepresents principal amounts and related weighted average interestrates by year of maturity for our short-term investmentportfolio, substantially all of which is held inU.S. dollars:                             **September 30, 2005** **2006** **2007** **2008** **2009** **2010** **Total** **Fair Value**                   Cash equivalents (variable rate) $20,288   —   —   —   —  $20,288  $20,288     Average interest rate  1.30%                            Short-term investments (variable rate) $30,075   —   —   —   —  $30,075  $30,071     Average interest rate  3.71%                            Short-term investments (fixed rate) $40,503  $2,484   —   —   —  $42,987  $42,667     Average interest rate  2.56%  3.46%                                                 **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%                         The fixed rate securities, as with all fixed income instruments,are subject to interest rate risk and will fall in value ifmarket interest rates increase.
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**Item 8.*****Financial Statements and Supplementary Data*****Index to Consolidated Financial Statements**     **Description** **Page**        Reports of Independent Registered Public    Accounting Firm  46      Consolidated Balance Sheets  49      Consolidated Statements of Operations  50      Consolidated Statements of    Shareholders’ Equity  51      Consolidated Statements of Cash Flows  52      Notes to Consolidated Financial    Statements  53 
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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**The Board of Directors and ShareholdersPhoton Dynamics, Inc.     We have audited the accompanying consolidated balance sheets ofPhoton Dynamics, Inc. as of September 30, 2005 and 2004,and the related consolidated statements of operations,shareholders’ equity, and cash flows for each of the threeyears in the period ended September 30, 2005. Our auditsalso included the financial statement schedule listed in theindex at Item 15(a)(2). These financial statements andschedule are the responsibility of the management of PhotonDynamics, Inc. Our responsibility is to express an opinion onthese financial statements and schedule based on our audits.     We conducted our audits in accordance with the standards of thePublic Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements arefree of material misstatement. An audit includes examining, on atest basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing theaccounting principles used and significant estimates made bymanagement, as well as evaluating the overall financialstatement presentation. We believe that our audits provide areasonable basis for our opinion.     In our opinion, the financial statements referred to abovepresent fairly, in all material respects, the consolidatedfinancial position of Photon Dynamics, Inc. as ofSeptember 30, 2005 and 2004, and the consolidated resultsof its operations and its cash flows for each of the three yearsin the period ended September 30, 2005, in conformity withU.S. generally accepted accounting principles. Also, in ouropinion, the related financial statement schedule, whenconsidered in relation to the basic financial statements takenas a whole, presents fairly in all material respects theinformation set forth therein.     We have also audited, in accordance with the standards of thePublic Company Accounting Oversight Board (United States), theeffectiveness of Photon Dynamics, Inc.’s internal controlover financial reporting as of September 30, 2005, based oncriteria established in *Internal Control —Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission and our report, datedDecember 12, 2005 expressed an unqualified opinion onmanagement’s assessment of the effectiveness of internalcontrol over financial reporting and an adverse opinion on theeffectiveness of internal control over financial reporting.     /s/ ERNST & YOUNG LLPPalo Alto, CaliforniaDecember 12, 2005
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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**The Board of Directors and ShareholdersPhoton Dynamics, Inc.     We have audited management’s assessment, included in theaccompanying Report of Management on Internal Control overFinancial Reporting, that Photon Dynamics, Inc. did not maintaineffective internal control over financial reporting as ofSeptember 30, 2005, because of the effect of a materialweakness related to documentation, evaluation and communicationof complex and unusual transactions, based on criteriaestablished in *Internal Control — IntegratedFramework*issued by the Committee of SponsoringOrganizations of the Treadway Commission (the “COSOcriteria’). Photon Dynamics Inc.’s management isresponsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectivenessof internal control over financial reporting. Our responsibilityis to express an opinion on management’s assessment and anopinion on the effectiveness of the company’s internalcontrol over financial reporting based on our audit.     We conducted our audit in accordance with the standards of thePublic Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtainreasonable assurance about whether effective internal controlover financial reporting was maintained in all materialrespects. Our audit included obtaining an understanding ofinternal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the designand operating effectiveness of internal control, and performingsuch other procedures as we considered necessary in thecircumstances. We believe that our audit provides a reasonablebasis for our opinion.     A company’s internal control over financial reporting is aprocess designed to provide reasonable assurance regarding thereliability of financial reporting and the preparation offinancial statements for external purposes in accordance withgenerally accepted accounting principles. A company’sinternal control over financial reporting includes thosepolicies and procedures that (1) pertain to the maintenanceof records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of thecompany; (2) provide reasonable assurance that transactionsare recorded as necessary to permit preparation of financialstatements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the companyare being made only in accordance with authorizations ofmanagement and directors of the company; and (3) providereasonable assurance regarding prevention or timely detection ofunauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on thefinancial statements.     Because of its inherent limitations, internal control overfinancial reporting may not prevent or detect misstatements.Also, projections of any evaluation of effectiveness to futureperiods are subject to the risk that controls may becomeinadequate because of changes in conditions, or that the degreeof compliance with the policies or procedures may deteriorate.     A material weakness is a control deficiency, or combination ofcontrol deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interimfinancial statements will not be prevented or detected. Thefollowing material weakness has been identified and included inmanagement’s assessment as of September 30, 2005:          A material weakness in the Company’s financial reporting    process arising from not contemporaneously documenting and    evaluating complex and unusual transactions of a material nature    and communicating such evaluation to its Audit Committee on a    timely basis. This material weakness results in more than a    remote likelihood that a material misstatement to any of the    Company’s significant financial statement accounts will not    be prevented or detected in the annual or interim financial    statements and this material weakness resulted in the    restatement of the deferred margin and cost of revenue accounts    in the Company’s unaudited interim financial statements for    the third quarter of fiscal 2005.     This material weakness was considered in determining the nature,timing, and extent of audit tests applied in our audit of theCompany’s 2005 consolidated financial statements, and thisreport does not affect our report dated December 12, 2005on those financial statements.
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     In our opinion, management’s assessment that PhotonDynamics, Inc. did not maintain effective internal control overfinancial reporting as of September 30, 2005, is fairlystated, in all material respects, based on the COSO controlcriteria. Also, in our opinion, because of the effect of thematerial weakness described above on the achievement of theobjectives of the control criteria, Photon Dynamics, Inc. hasnot maintained effective internal control over financialreporting as of September 30, 2005, based on the COSOcontrol criteria.     We also have audited, in accordance with the standards of thePublic Company Accounting Oversight Board (United States), theconsolidated balance sheets of Photon Dynamics, Inc. as ofSeptember 30, 2005 and 2004, and the related consolidatedstatements of operations, shareholders’ equity, and cashflows for each of the three years in the period endedSeptember 30, 2005 and our report dated December 12,2005 expressed an unqualified opinion thereon.     /s/ ERNST & YOUNG LLPPalo Alto, CaliforniaDecember 12, 2005
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**PHOTON DYNAMICS, INC.****CONSOLIDATED BALANCE SHEETS**             **September 30,**     **2005** **2004**       **(In thousands except**  **share data)****ASSETS**    Current assets:             Cash and cash equivalents $20,288  $25,483      Short-term investments  72,738   58,672      Accounts receivable, net of allowance for doubtful accounts of    $153 and $497, respectively  27,067   58,341      Inventories  32,545   31,716      Other current assets  3,932   4,536              Total current assets  156,570   178,748     Land, property and equipment, net  19,366   20,337     Other assets  4,390   3,909     Intangible assets, net  3,205   4,753     Goodwill  153   153              Total assets $183,684  $207,900         **LIABILITIES AND SHAREHOLDERS’ EQUITY**    Current liabilities:             Accounts payable $13,005  $18,485      Warranty  5,346   6,194      Employee notes payable  490   667      Other current liabilities  8,128   9,564      Deferred gross margin  13,113   11,503              Total current liabilities  40,082   46,413     Other non-current liabilities  1,008   1,528     Commitments and contingencies            Shareholders’ equity:             Preferred stock, no par value, 5,000,000 shares authorized,    none outstanding, as of September 30, 2005 and 2004,    respectively  —   —      Common stock, no par value, 30,000,000 shares authorized,    16,989,940 and 16,859,084 shares issued and outstanding, as    of September 30, 2005 and 2004, respectively  287,765   285,790      Accumulated deficit  (145,489)  (126,178)     Accumulated other comprehensive income  318   347              Total shareholders’ equity  142,594   159,959              Total liabilities and shareholders’ equity $183,684  $207,900        See accompanying notes to consolidated financial statements.
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**PHOTON DYNAMICS, INC.****CONSOLIDATED STATEMENTS OF OPERATIONS**                 **Year Ended September 30,**     **2005** **2004** **2003**         **(In thousands, except per share data)**    Revenue $125,813  $141,870  $67,196     Cost of revenue  82,732   83,969   44,071               Gross margin  43,081   57,901   23,125     Operating expenses:                 Research and development  36,275   29,701   22,786      Selling, general and administrative  24,678   17,780   13,763      Restructuring charge  1,197   —   —      Goodwill impairment charge  —   665   10,010      Impairment of purchased intangibles  —   2,089   3,548      Impairment of fixed assets  637   234   —      Gain on sale of fixed assets  (93)  (427)  —      Acquired in-process research and development  —   210   2,474      Amortization of intangible assets  1,548   789   1,236                 Total operating expenses  64,242   51,041   53,817     Income (loss) from operations  (21,161)  6,860   (30,692)    Interest income and other, net  2,218   4,802   2,968               Income (loss) from continuing operations before income taxes and    discontinued operations  (18,943)  11,662   (27,724)    Provision for income taxes  624   577   56               Income (loss) from continuing operations before discontinued    operations  (19,567)  11,085   (27,780)    Income (loss) from discontinued operations  256   (1,391)  (44,592)                Net income (loss) $(19,311) $9,694  $(72,372)              Income (loss) per share from continuing operations:                 Basic $(1.16) $0.67  $(1.73)               Diluted $(1.16) $0.65  $(1.73)              Income (loss) per share from discontinued operations:                 Basic $0.02  $(0.08) $(2.77)               Diluted $0.02  $(0.08) $(2.77)              Net income (loss) per share:                 Basic $(1.14) $0.58  $(4.50)               Diluted $(1.14) $0.57  $(4.50)              Weighted average number of shares:                 Basic  16,890   16,631   16,089      Diluted  16,890   17,087   16,089 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, 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 income:                         Net income  —   —   9,694   —   9,694      Change in unrealized gain on investments  —   —   —   (377)  (377)     Currency translation adjustments  —   —   —   126   126                       Total comprehensive income                  9,443                      Net issuance of common stock  469   6,167   —   —   6,167      Stock ownership expense  —   206   —   —   206                     Balances at September 30, 2004  16,859   285,790   (126,178)  347   159,959     Components of comprehensive loss:                         Net loss  —   —   (19,311)  —   (19,311)     Change in unrealized gain on investments  —   —   —   (138)  (138)     Currency translation adjustments  —   —   —   109   109                       Total comprehensive loss                  (19,340)                     Net issuance of common stock  131   1,797   —   —   1,797      Tax benefits of stock option transactions  —   126   —   —   126      Stock ownership expense  —   52   —   —   52                     Balances at September 30, 2005  16,990  $287,765  $(145,489) $318  $142,594                 See accompanying notes to consolidated financial statements.
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**PHOTON DYNAMICS, INC.****CONSOLIDATED STATEMENTS OF CASH FLOWS**                   **Year Ended September 30,**     **2005** **2004** **2003**         **(In thousands)**    Cash flows from operating activities:                 Net income (loss) from continuing operations $(19,567) $11,085  $(27,780)     Adjustments to reconcile net income (loss) from continuing    operations to net cash used in operating activities from    continuing operations:                  Depreciation  5,037   2,898   3,119       Amortization of intangible assets  1,548   789   1,793       Acquired in process research and development  —   210   2,474       Impairment of goodwill  —   665   10,010       Impairment of purchased intangibles  —   2,089   3,548       Impairment of fixed assets  637   234   —       Loss on disposal of equipment  —   —   211       Stock ownership expense  52   206   364       Restructuring expense  171   —   —       Gain on sale of fixed assets  (93)  (427)  —       Accretion of non-interest bearing notes payable  64   17   —       Changes in assets and liabilities:                   Accounts receivable  31,274   (48,074)  (4)       Inventories  (829)  (22,720)  993        Other current assets  (130)  1,553   1,498        Related party receivable  —   250   —        Other assets  536   (1,157)  (166)       Accounts payable  (5,475)  14,448   (4,167)       Other current liabilities  (999)  4,808   (647)       Deferred gross margin  1,610   8,764   2,717        Other liabilities  (91)  (49)  (684)                  Net cash provided by (used in) operating activities from    continuing operations  13,745   (24,411)  (6,721)        Net cash used in operating activities from discontinued    operations  (640)  (1,434)  (12,635)                  Net cash provided by (used in) operating activities  13,105   (25,845)  (19,356)              Cash flows from investing activities:                 Purchase of property and equipment  (4,880)  (9,803)  (2,547)     Proceeds from sale of fixed assets  270   481   —      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  (56,380)  (420,296)  (569,566)     Maturities and sales of short-term investments  42,175   459,411   615,759                   Net cash provided by (used in) investing activities from    continuing operations  (18,815)  26,730   21,970         Net cash used in investing activities from discontinued    operations  —   —   (92)                  Net cash provided by (used in) investing activities  (18,815)  26,730   21,878               Cash flows from financing activities:                 Issuance of common stock, net  1,923   6,167   7,898      Repurchase of common stock  —   —   (17,678)     Repayment of short-term notes  (1,205)  —   —      Capital lease repayments  —   —   (11)                  Net cash provided by (used in) financing activities from    continuing operations  718   6,167   (9,791)                  Net cash used in financing activities from discontinued    operations  (313)  —   —                   Net cash provided by (used in) financing activities  405   6,167   (9,791)              Effect of exchange rate changes on cash and cash equivalents  110   126   (6)              Net increase (decrease) in cash and cash equivalents from    continuing operations  (4,242)  8,612   5,452     Net decrease in cash and cash equivalents from discontinued    operations  (953)  (1,434)  (12,727)              Net increase (decrease) in cash and cash equivalents  (5,195)  7,178   (7,275)    Cash and cash equivalents at beginning of year  25,483   18,305   25,580               Cash and cash equivalents at end of year $20,288  $25,483  $18,305               Supplemental cash flow disclosures:                 Income taxes paid $498  $59  $69      Interest paid  1   6   21     Supplemental non-cash financing and investing activities    disclosure:                 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 issued in acquisition of Quantum Composers, Inc.    assets  —   2,000   —      Note payable issued in acquisition of TORC assets  —   625   — See accompanying notes to consolidated financial statements.
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIAL STATEMENTS****Note 1 —****Summary of Significant Accounting Policies**     *Description of Operations and Principles ofConsolidation.* Photon Dynamics, Inc. (“PhotonDynamics” or the “Company”) is a supplier ofintegrated yield management solutions for the flat panel displayindustry. The consolidated financial statements include theaccounts of the Company and its wholly owned subsidiaries.Intercompany accounts and transactions have been eliminated.     Through January 14, 2003, the Company conducted business inthree operating segments: flat panel display products, cathoderay tube display and high quality glass inspection products andprinted circuit board assembly inspection products. In January2003, the Company implemented a plan to exit the printed circuitboard assembly inspection business. In June 2003, the Companyimplemented a plan to exit the cathode ray tube display and highquality glass inspection business. Accordingly, the operatingresults of these former business segments have been presented asdiscontinued operations in accordance with the provisions ofStatement of Financial Accounting Standards No. 144,“Accounting for the Impairment or Disposal of Long-livedAssets,” (“FAS 144”). Accordingly, in theconsolidated statements of operations, the operating results ofthese former businesses have been classified as “Income(loss) from discontinued operations” for all periodspresented. The cash flows from these businesses have beenpresented as “Net cash flows from discontinuedoperations” in the operating, investing and financingsections of the consolidated statements of cash flows.     *Management Estimates.* The preparation of financialstatements in conformity with U.S. generally acceptedaccounting principles requires management to make estimates andassumptions that affect the reported amounts of assets andliabilities at the date of the financial statements and thereported amounts of revenues and expenses during the reportingperiods. Actual results could differ from those estimates.Significant estimates made by management include revenuerecognition, the calculation of the allowance for doubtfulaccounts, inventory write-downs and write-offs, warrantyliabilities, impairment of goodwill and other acquiredintangible assets, restructuring expenses and litigation andcontingency assessments.     *Fair Value of Financial Instruments.* The Companyevaluates the estimated fair value of financial instrumentsusing available market information and valuation methodologies.The use of different market assumptions and/or estimationmethodologies could have a negative effect on the estimated fairvalue amounts. The fair value of the Company’s cash, cashequivalents, accounts receivable, accounts payable, employeenotes payable and other current liabilities approximates thecarrying amount due to the relatively short maturity of theseitems (see Note 7).     *Cash Equivalents and Short-Term Investments.* Cashequivalents consist of highly liquid investments withinsignificant interest rate risk and have original maturitydates of three months or less from the date of acquisition.Short-term investments consist of highly liquid investments withremaining maturities greater than three months from the date ofacquisition. The Company classifies all securities asavailable-for-sale in accordance with the provisions of theStatement of Financial Accounting Standards No. 115,“Accounting for Certain Investments in Debt and EquitySecurities” (“SFAS No. 115”). The cost andfair market value of short-term investments are based on thespecific identification method. Securities classified asavailable-for-sale are reported at fair market value with therelated unrealized gains or losses, net of tax, presented as aseparate component of shareholders’ equity under thecaption “Accumulated other comprehensive income.” Allrealized gains and losses and unrealized losses and declines infair value that are other than temporary are recorded inearnings in the period of occurrence.     *Inventories.* Inventories, consisting of raw materials,work in process and finished goods, are stated at the lower ofcost (first-in, first-out) or market. Inventory which isobsolete (defined as inventory that will no longer be used inthe manufacturing process) or in excess of the forecasted usageis written down to its estimated market value based on projecteddemand, historical usage and other known factors. Photon
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**Dynamics reviews the appropriate valuation of its inventories ona quarterly basis. If actual demand were to decline below theCompany’s forecasts, the Company may need to takeadditional inventory write-downs.     *Land, Property and Equipment.* Property and equipment arerecorded at cost. Depreciation of property and equipment isbased on the straight-line method over the estimated usefullives of the assets which are thirty years for buildings, andthree to five years for equipment and office furniture andfixtures. Leasehold improvements are amortized over the shorterof the life of the lease or the useful life of the relatedasset. Land is recorded at cost, and is not depreciated.     *Goodwill and Intangible Assets.* The Company accounts forgoodwill and other intangible assets resulting from itsacquisitions in accordance with Statement of FinancialAccounting Standards No. 142 “Goodwill and OtherIntangible Assets” (“SFAS No. 142”). SFASNo. 142 prohibits the amortization of goodwill andintangible assets with indefinite useful lives and requires thatthese assets be reviewed for impairment at least annually. Theprocess for evaluating the potential impairment of goodwill ishighly subjective and requires significant judgment at manypoints during the analysis. In estimating the fair value of theoperating unit with recognized goodwill for the purposes of ourfinancial statements, the Company made estimates and judgmentsabout the future cash flows of that operating unit. TheCompany’s cash flow forecasts were based on assumptionsthat were consistent with the plans and estimates it was usingto manage the underlying business. The Company also considersits market capitalization (adjusted for unallocated monetaryassets such as cash, marketable debt securities and debt) indetermining the fair value of the respective businesses.     Intangible assets with finite lives and other long-lived assetsare amortized over their estimated useful lives and subject toevaluation for impairment.     *Impairment of Long-Lived Assets.* The Company reviewslong-lived assets including intangible assets with finite livesfor impairment whenever events or changes in businesscircumstances indicate that the carrying amount of the assetsmay not be fully recoverable, such as a significant industrydownturn, significant decline in the market value of thecompany, or significant reductions in projected future cashflows. An impairment loss would be recognized when estimatedundiscounted future cash flows expected to result from the useof the asset and its eventual disposition is less than itscarrying amount. Impairment, if any, is assessed usingdiscounted cash flows. In assessing the recoverability oflong-lived assets, including intangible assets, the Company mustmake assumptions regarding estimated future cash flows and otherfactors to determine the fair value of the respective assets. Infiscal 2005, the Company incurred impairment charges totalingapproximately $637,000, consisting primarily of test beds thathad no future use, of which $382,000 related to theCompany’s LTPS technology.     *Accumulated other comprehensive Income.* Statement ofFinancial Accounting Standards No. 130 “ReportingComprehensive Income” (“FAS 130”) requiresthat all items required to be recognized under accountingstandards as components of comprehensive income, includingunrealized gains and losses on available-for-sale securities andforeign currency translation adjustments, be reported in theconsolidated financial statements. As a result, the Company hasreported comprehensive income (loss) within the accompanyingConsolidated Statements of Shareholders’ Equity.     *Concentration of Credit and Other Risk.* Financialinstruments which potentially subject the Company toconcentrations of credit risk consist principally of availablefor sale securities, trade accounts receivable and, during theyear ending September 30, 2003, derivative financialinstruments, primarily foreign currency forward exchangecontracts used to mitigate the effect of exchange rate changes.     The Company invests excess cash not required for use inoperations in securities that the Company believes bear minimalrisk of loss. These investments are of a short-term nature andinclude investments in auction rate preferred securities,commercial paper and government and corporate debt securities.The Company has not experienced any losses due to institutionalfailure or bankruptcy.
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     The Company’s customers are located in Korea, Taiwan, Japanand China. Therefore, the Company’s sales to thesecustomers may be adversely affected by the overall health ofthese economies, including the effects of currency exchange ratefluctuations. The Company generally does not require collateralfor its trade accounts receivable. The Company maintains aprovision for potential credit losses based upon expectedcollectibility of all accounts receivable. For sales to some ofits customers in certain geographic regions, the Companyrequires letters of credit. The majority of the Company’srevenue is invoiced in U.S. dollars although approximately$19.3 million, $10.4 million and $276,000 of revenuethat was recognized in fiscal 2005, 2004 and 2003, respectively,were invoiced in currencies other than the U.S. dollar,primarily Japanese Yen. The Company believes its creditevaluation prior to shipment and subsequent monitoring ofcustomer status mitigates its credit risk.     Although the Company had no foreign currency exchange contractsoutstanding as of September 30, 2005, these instrumentshave been used in the past to mitigate the impact of currencyfluctuations on the Company’s income. The Company isexposed to credit loss in the event of non-performance bycounterparties on the foreign exchange contracts used tomitigate the effect of exchange rate changes. Thesecounterparties are large international financial institutionsand to date, no such counterparty has failed to meet itsfinancial obligations to the Company. Photon Dynamics does notanticipate nonperformance by these counterparties.     The Company’s products include certain components that arecurrently single-sourced. The Company believes that othervendors would be able to provide similar components; however,the qualification of such vendors may require start-up time. Inorder to mitigate any adverse impacts from a disruption ofsupply, the Company attempts to maintain an adequate supply ofcritical single-sourced components.     *Foreign Currency.* The functional currencies of theCompany’s foreign subsidiaries are their respective localcurrencies. Accordingly, all assets and liabilities of theforeign operations are translated to U.S. dollars atcurrent period end exchange rates, and revenues and expenses aretranslated to U.S. dollars using weighted average exchangerates in effect during the period. The gains and losses from thetranslation of these subsidiaries’ financial statementsinto the U.S. dollar are recorded directly into a separatecomponent of shareholders’ equity under the caption“Accumulated other comprehensive income” inshareholders’ equity. Currency transaction gains and lossesare included in the Company’s results of operations.     *Derivative Financial Instruments.* The Company may useforward exchange contracts to mitigate the effect of exchangerate changes on a portion of, but not all, existing andanticipated foreign currency denominated transactions expectedto occur within the following 18 months. The purpose ofPhoton Dynamics’ foreign currency program is to manage theeffect of exchange rate fluctuations on certain foreign currencydenominated revenues, cost and eventual cash flows. The Companybelieves these financial instruments do not subject it tospeculative risk that would otherwise result from changes incurrency exchange rates. The Company does not use derivativefinancial instruments for speculative or trading purposes.     The Company’s derivative instruments are recorded at fairvalue based on quoted market prices for comparable instruments.Gains and losses are recorded immediately in earnings.     During fiscal year 2005 and 2004, the Company did not purchaseany new foreign currency exchange contracts and had nooutstanding foreign currency forward exchange contracts atSeptember 30, 2005 or 2004. At September 30, 2003, theCompany had foreign currency forward exchange contracts maturingthroughout fiscal 2004 to sell $2.8 million in Japaneseyen. See Note 7 for further information related toderivatives.     *Warranty.* The Company’s warranty policy generallystates that it will provide warranty coverage for a period ofone year from final acceptance. The Company records theestimated cost of warranty coverage, primarily material andlabor to repair and service the equipment upon product shipment,when the related revenue is recognized. The Company’swarranty obligation is affected by product failure rates,material usage rates and the efficiency by which the productfailure is corrected.
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     *Revenue Recognition.* Photon Dynamics derives revenueprimarily from the sale and installation of equipment and sparepart sales. The Company recognizes revenue when persuasiveevidence of an arrangement exists, delivery has occurred orservices have been rendered, the selling price is fixed ordeterminable and collectibility is reasonably assured.Persuasive evidence of an arrangement exists when a salesquotation outlining the terms and conditions of the arrangementhas been issued to the customer and a purchase order has beenreceived from the customer accepting the terms of the salesquotation and stating, at a minimum, the number of systemsordered and the value of the overall arrangement. For newproducts that have not been demonstrated to meet productspecifications, 100% of revenue is deferred until customeracceptance.     The Company accounts for certain of its product sales, asarrangements with multiple deliverables in accordance withEmerging Issues Task Force Issue 00-21 “RevenueArrangements with Multiple Deliverables.” For arrangementswith multiple deliverables, the Company recognizes revenue forthe delivered items if the delivered items have value to thecustomer on a standalone basis, the amount of revenue fordelivered elements is not subject to refund, and delivery orperformance of the undelivered items is considered probable andsubstantially in the control of the Company, the Company has metdefined customer acceptance experience levels for the delivereditems, and the fair value of undelivered items, such asinstallation and system upgrade rights, can be reliablydetermined. The Company allocates revenue to the delivered itemsbased on the lesser of the amount due and billable upon shipmentand the difference between the total amount due at time ofshipment and the allocated fair value of the undeliveredelements, with the remaining amount recognized afterinstallation and acceptance when the final amount becomes due.Installation and other services are not essential to thefunctionality of the products as these services do not alter theproduct capabilities, do not require specialized skills or toolsand can be performed by other vendors. For new products thathave not been demonstrated to meet product specifications, 100%of revenue is deferred until customer acceptance. The Companyrecognizes revenue from the sale of spare parts generally uponshipment.     Through the second quarter of fiscal 2004, the Company sold itsproducts in Japan through a value-added reseller. Terms andconditions of the Company’s sale of products to itsvalue-added reseller were generally consistent with terms andconditions offered to other customers and title typicallytransferred to the value-added reseller upon shipment. TheCompany did not grant any rights of return, stock rotation orprice protection for its product sales to its value-addedreseller. Accordingly, sales transactions with the value-addedreseller, consisting of $0, $6.0 million and $978,000 ofrevenue in fiscal 2005, 2004 and 2003, respectively, arerecorded in accordance with the policy stated above.     The Company has a policy to record a provision as necessarybased on historical rates for estimated sales returns in thesame period as the related revenue is recorded, which is nettedagainst revenue.     *Shipping Costs.* The Company’s shipping and handlingcosts are included under cost of sales for all periodspresented. In those instances where the Company does bill forshipping and handling, the amounts billed are classified asrevenue.     *Advertising.* Advertising costs are expensed as incurred.Advertising expense was $56,000, $109,000 and $173,000 forfiscal 2005, 2004 and 2003, respectively.     *Research and Development Cost.* Costs to develop theCompany’s products, which include both hardware andsoftware components are expensed as incurred. Softwareincorporated in the Company’s products is an integral partof the overall product design process and costs to developsoftware, which is deemed to be incidental, are not trackedseparately. The Company does not currently sell or market anysoftware product on a standalone basis.     *Income Taxes.* The Company accounts for income taxes inaccordance with the liability method in accounting for incometaxes. Under the liability method, deferred tax assets andliabilities are measured based
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**on differences between the financial reporting and tax bases ofassets and liabilities using enacted tax rates and laws thatwill be in effect when differences are expected to reverse (seeNote 8).     *Earnings Per Share.* Basic net income (loss) per share iscalculated using the weighted average number of shares of commonstock outstanding. Diluted earnings per share is computed in thesame manner and also gives effect to all dilutive commonequivalent shares outstanding during the period. Commonequivalent shares consist of stock options issued to employeesunder employee stock option plans and warrants (seeNote 10).     *Stock-Based Compensation Plans.* The Company accounts forits stock-based employee compensation plans using the intrinsicvalue method in accordance with the provisions of AccountingPrinciples Board (“APB”) Opinion No. 25,“Accounting For Stock Issued to Employees”(“APB 25”) and related interpretations. TheCompany expenses option grants to consultants in accordance withEmerging Issue Task Force 96-18 “Accounting for EquityInstruments That Are Issued to Other Than Employees forAcquiring, or in Conjunction with Selling, Goods orService” using the Black-Scholes valuation model.     Pro forma information regarding net income and earnings pershare is required by Statement of Financial Accounting StandardsNo. 123, “Accounting for Stock-BasedCompensation” (“FAS 123”) and has beendetermined as if the Company had accounted for its employeestock purchase plan and employee stock options granted under thefair value method of FAS 123. The fair value of each optiongrant is estimated on the date of grant using the Black-Scholesoption pricing model for the multiple option approach with thefollowing weighted-average assumptions:                **2005** **2004** **2003**           Stock option plan:                 Expected stock price volatility  0.69   0.83   0.93      Risk free interest rate  3.4%  2.33%  2.05%     Expected life of options (years)  5   6   5     Stock purchase plan:                 Expected stock price volatility  0.80   0.96   0.90      Risk free interest rate  1.70%  2.13%  2.19%     Expected life of plan (years)  1.6   2.0   0.9      For purposes of pro forma disclosures required by FAS 123,the estimated fair value of the options is amortized to expenseover the options’ vesting periods using the straight-linemethod. The Company’s pro forma information for the yearsended September 30, 2005, 2004 and 2003 is as follows:                **Year Ended September 30,**     **2005** **2004** **2003**         **(In thousands, except per share data)**    Net income (loss) — as reported $(19,311) $9,694  $(72,372)     Plus: stock based employee compensation expense included in    reported net income  —   —   364      Less: total stock-based employee compensation expense determined    under fair value based method for all awards  (9,534)  (7,532)  (6,619)              Net income (loss) — pro forma $(28,845) $2,162  $(78,627)              Basic net income (loss) per share — as reported $(1.14) $0.58  $(4.50)    Diluted net income (loss) per share — as reported $(1.14) $0.57  $(4.50)    Basic net income (loss) per share — pro forma $(1.71) $0.13  $(4.89)    Diluted net income (loss) per share — pro forma $(1.71) $0.13  $(4.89)
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     On September 1, 2005, the Company’s Board of Directorsapproved the accelerated and full vesting of all unvestedoutstanding stock options to purchase shares of common stock ofPhoton Dynamics, Inc. that were held by current employees,including executive officers, but excluding non-employee membersof the Company’s Board of Directors, that had an exerciseprice greater than $25.00 issued under the Company’sAmended and Restated 1995 Stock Option Plan and 2001 EquityIncentive Plan. Options to purchase 340,718 shareswere subject to this acceleration, which was effective as ofSeptember 1, 2005. The decision to accelerate the vestingof these options was made primarily to reduce future financialimpact to the Company’s results of operations, since afteranalysis it was determined that the retention value of theunderwater options was relatively small compared to the incomecharge to continue vesting these options following the adoptionof Financial Accounting Standards Board Statement No. 123“Share Based Payment (revised 2004),”(“SFAS123R”) by the Company on October 1, 2005.     Under the accounting guidance of APB 25, the acceleratedvesting did not result in any compensation to be recognized inthe Company’s Consolidated statement of operations as theseunvested stock options had no intrinsic value. The effect of thevesting acceleration was the recognition of incrementaladditional stock-based employee compensation of approximately$3.6 million in the quarter ended September 30, 2005,which is reflected in the Company’s fiscal 2005 pro-formadisclosure, above. This stock-based employee compensationexpense amount would otherwise in part have been recognized inthe Company’s consolidated statement of operations infuture periods after the adoption of SFAS123R in the firstquarter of fiscal 2006.     *Reclassifications.* Certain prior year and prior quarterbalances have been reclassified to conform to current financialstatement presentation. These reclassifications had no impact onpreviously reported results of operations or shareholders’equity.     *Recent Accounting Pronouncements.* In March 2005, the FASBpublished FASB Interpretation No. 47, “Accounting forConditional Asset Retirement Obligations,” which clarifiesthat the term, conditional asset retirement obligations, as usedin SFAS No. 143, “Accounting for Asset RetirementObligations,” refers to a legal obligation to perform anasset retirement activity in which the timing and(or) method of settlement are conditional on a future eventthat may or may not be within the control of the entity. Theuncertainty about the timing and (or) method of settlementof a conditional asset retirement obligation should be factoredinto the measurement of the liability when sufficientinformation exists. The interpretation also clarifies when anentity would have sufficient information to reasonably estimatethe fair value of an asset retirement obligation. Thisinterpretation is effective no later than the end of theCompany’s fiscal 2006. The adoption of this Interpretationis not expected to have a material effect on the Company’sconsolidated financial position or results of operations.     In November 2004, the FASB issued SFAS No. 151,“Inventory Costs, an amendment of ARB No. 43,Chapter 4” (“SFAS No. 151”). SFASNo. 151 clarifies that abnormal inventory costs such ascosts of idle facilities, excess freight and handling costs, andwasted materials (spoilage) are required to be recognizedas current period charges. The provisions ofSFAS No. 151 are effective for fiscal years beginningafter June 15, 2005. The Company has not yet determined theimpact the adoption of SFAS No. 151 would have on theCompany’s consolidated results of operations, financialposition or cash flows.     In December 2004, the FASB issued SFAS No. 153,“Exchanges of Nonmonetary Assets, an amendment of APBOpinion No. 29” (“SFAS No. 153”).SFAS No. 153 addresses the measurement of exchanges ofnonmonetary assets and redefines the scope of transactions thatshould be measured based on the fair value of the assetsexchanged. SFAS No. 153 is effective for the Companyfor nonmonetary asset exchanges beginning in the first quarterof fiscal 2006. The adoption of SFAS No. 153 is notexpected to have a material effect on the Company’sconsolidated financial position, results of operations and cashflows.     In December 2004, the FASB issued FASB Staff PositionNo. FAS 109-2, “Accounting and DisclosureGuidance for the Foreign Earnings Repatriation Provision withinthe American Jobs Creation Act of 2004”
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**(FSP FAS 109-2”). The American Jobs Creation Actintroduces a special one-time dividends received deduction onthe repatriation of certain foreign earnings to aU.S. taxpayer (repatriation provision), provided certaincriteria are met. FSP FAS 109-2 provides accounting anddisclosure guidance for the repatriation provision. The Companyhas analyzed this provision and has concluded that it is notbeneficial to pursue the repatriation under this Act as ofSeptember 30, 2005.     In December 2004, the FASB issued SFAS No. 123 (revised2004), “Share-Based Payment” (“SFASNo. 123R”) SFAS No. 123R requires measurement ofall employee stock-based compensation awards using a fair valuemethod and the recording of such expense in the consolidatedfinancial statements. In addition, the adoption of SFASNo. 123R will require additional accounting related to theincome tax effects and additional disclosure regarding the cashflow effects resulting from share-based payment arrangements.SFAS No. 123R is effective beginning in our first quarterof fiscal 2006. The Company has selected the Black-Scholesoption-pricing model as the most appropriate fair-value methodfor its awards and plans to adopt using the modified prospectivemethod. The adoption of SFAS No. 123R will have a materialimpact on the Company’s consolidated results of operations,financial position and statement of cash flows. However,uncertainties, including the Company’s future stock-basedcompensation strategy, stock price volatility, estimatedforfeitures and employee stock option exercise behavior, make itdifficult to determine whether the stock-based compensationexpense that the Company will incur in future periods will besimilar to the SFAS 123 pro forma expense disclosed inNote 1, above. In addition, the amount of stock-basedcompensation expense to be incurred in future periods will bereduced by the Company’s acceleration of certain unvestedand “out-of-the-money” stock options in fiscal 2005 asdisclosed in Note 1, above.     In June 2005, the FASB issued SFAS No. 154,“Accounting Changes and Error Corrections” (“SFASNo. 154”). SFAS No. 154 replaces APB No. 20(“APB 20”) and SFAS No. 3,“Reporting Accounting Changes in Interim FinancialStatements,” and applies to all voluntary changes inaccounting principle, and changes the requirements foraccounting for and reporting of a change in accountingprinciple. APB 20 previously required that most voluntarychanges in accounting principle be recognized by including innet income of the period of change a cumulative effect ofchanging to the new accounting principle whereas SFASNo. 154 requires retrospective application to priorperiods’ financial statements of a voluntary change inaccounting principle, unless it is impracticable. SFASNo. 154 enhances the consistency of financial informationbetween periods. SFAS No. 154 will be effective beginningwith the Company’s first quarter of fiscal year 2006. TheCompany does not expect that the adoption of SFAS No. 154will have a material impact on its results of operations,financial position or cash flows.
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)****Note 2 —****Financial Statement Components**              **September 30,**     **2005** **2004**       **(In thousands)****Balance Sheet**             Inventories:              Raw materials $12,476  $15,529       Work-in-process  19,327   15,046       Finished goods  742   1,141               Total $32,545  $31,716             Land, property and equipment:              Land and building $7,056  $7,299       Equipment  17,380   17,647       Office furniture and fixtures  3,102   3,057       Leasehold improvements  8,401   8,934           35,939   36,937       Less: accumulated depreciation and amortization  (16,573)  (16,600)              Total(1) $19,366  $20,337             Other current liabilities:              Compensation $3,838  $3,984       Commissions  295   197       Obligation to a manufacturing subcontractor in connection with    inventory purchases  —   623       Accrued closing costs associated with discontinued operations  40   449       Notes Payable (Note 14)  —   519       Other accrued expenses  3,955   3,792               Total $8,128  $9,564             Deferred gross margin:              Deferred system sales $25,481  $16,536       Deferred cost of revenue related to system sales  (12,368)  (5,033)              Total $13,113  $11,503             Other non-current liabilities:              Long-term portion of notes payable $966  $1,407       Other non-current liabilities  42   121               Total $1,008  $1,528             Accumulated other comprehensive income              Foreign currency translation adjustments $643  $533       Unrealized losses on available for sale securities  (325)  (186)              Total $318  $347        
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**                  **Year Ended September 30,**     **2005** **2004** **2003**         **(In thousands)****Statements of Operations**                 Interest income and other, net                  Interest income $2,187  $1,508  $2,548       Interest expense  (74)  (25)  (11)      Foreign exchange gain (loss)  356   (90)  (425)      Other(2)  (251)  3,409   856                  Total $2,218  $4,802  $2,968            (1)     In fiscal 2005, the Company disposed of certain fully    depreciated assets. (2)     In fiscal 2004, the Company recorded a technology license fee    resulting from a litigation settlement in the first quarter of    fiscal 2004.**Note 3 —****Discontinued Operations*****Printed Circuit Board Assembly Inspection Business***     The Company’s printed circuit board assembly inspectionproducts enabled printed circuit board assembly inspectionmanufacturers to detect and identify defects, thereby increasingyields and quality and reducing costs. The Company previouslysold its products for the printed circuit board assemblyindustry primarily through sales representatives anddistributors. The Company generally recognized revenue from thesale of its printed circuit board assembly inspection productsupon shipment as such product sales were not subject to customeracceptance provisions. In January 2003, the Company implementeda plan to exit the printed circuit board assembly inspectionbusiness. Accordingly, the operating results of this formerbusiness segment have been reclassified as a discontinuedoperation for all periods presented.     The following table summarizes the results of discontinuing theprinted circuit board assembly inspection products reportingsegment:                 **Year Ended September 30,**     **2005** **2004** **2003**         **(In thousands)**    Revenue $—  $83  $4,320     Cost of revenue  (126)  —   11,661               Gross margin  126   83   (7,341)              Operating expenses:                 Research and development  —   21   3,695      Selling, general and administrative  182   1,624   6,827      Goodwill impairment charge  —   —   15,083      Impairment of purchased intangibles and fixed assets  —   —   5,445      Amortization of intangible assets  —   —   195                 Total operating expenses  182   1,645   31,245               Loss from discontinued operations $(56) $(1,562) $(38,586)          
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     The loss from discontinued operations for the year endedSeptember 30, 2005, includes approximately $132,000 for thereversal of a liability related to the settlement of vendorobligations, approximately $113,000 of accruals for legalexpenses related to the Amtower v Photon Dynamics Inc. lawsuit(See Note 11), and approximately $75,000 in other expenses,primarily legal and administrative expenditures.     The loss from discontinued operations for the year endedSeptember 30, 2004, includes litigation costs ofapproximately $1.5 million for settlement of priorinventory purchase commitments, the settlement of theThomason v. Photon Dynamics lawsuit and the legal expensesincurred as part of the settlement.     The loss from discontinued operations for the year endedSeptember 30, 2003, includes a write-off of inventory ofapproximately $7.6 million, a write-off of accountsreceivable of approximately $2.0 million, and a write-offof licensed technology of approximately $1.9 million. Thefiscal 2003 loss also includes impairment charges ofapproximately $15.1 million of goodwill, $2.9 millionof purchase intangibles and $2.5 million of long-livedassets recorded during the three months ended December 31,2002, as a result of management’s assessment of indicatorsof impairment that existed prior to the Company’s formaldecision to discontinue the operations of this segment. Suchimpairment charges were recorded in accordance with theprovisions of FAS 142 and FAS 144.     The Company determined the fair values of the assets impairedbased on the estimated net realizable values of the assets,taking into account independent appraisals of those netrealizable values.     The following summarizes the assets and liabilities of theprinted circuit board assembly inspection products discontinuedoperations:             **September 30,**     **2005** **2004**       **(In thousands)****ASSETS**    Current assets:             Other current assets $175  $175             Total current assets  175   175     Other assets             Other non-current assets  1,016   733              Total assets $1,191  $908         **LIABILITIES**    Current liabilities:             Accounts payable $—  $5      Other current liabilities  579   707              Total current liabilities  579   712     Other liabilities  42   113              Total liabilities $621  $825             At September 30, 2005 assets include a receivable ofapproximately $1.0 million against shares that are beingheld in escrow related to the IRSI acquisition and $175,000 insecurity deposits on various leases. An aggregate of57,195 shares of Photon Dynamics, Inc. common stock, issuedin July 2001 as part of a share purchase agreement withIntelligent Reasoning Systems, Inc. (“IRSI”), continueto be held in an escrow account pending resolution of theCompany’s claim against the escrow related to the Austinfacility lease. The
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**Company is obligated to make lease payments on this facilitythrough December 2006, and under the acquisition agreement canbe indemnified for a portion of such payments.     At September 30, 2005 liabilities include approximately$79,000 related to current operating lease obligations,approximately $300,000 related to accrued legal costs for theAmtower v Photon Dynamics Inc. lawsuit (See Note 11) andapproximately $200,000 related to potential vendor obligations.Other liabilities of approximately $42,000 relate entirely tonon-current operating lease obligations. Lease obligations areto be paid out through December 2006.     In the second quarter of fiscal 2003, in accordance withStatement of Financial Accounting Standards No. 146,“Accounting for Costs Associated with Exit or DisposalActivities” (“FAS 146”), the Companyrecorded a liability of approximately $2.0 million forcosts associated with the discontinuation of the business,including termination benefits of approximately $700,000 andapproximately $1.3 million of purchase obligations tosuppliers. The following summarizes the liability sinceinception:                **One-Time**      **Termination** **Other**    **Benefits** **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, 2004  —   537   537     Cash expenditures  —   (205)  (205)    Adjustments to the liability  —   (132)  (132)               Balance at September 30, 2005 $—  $200  $200                In March of 2005, the Company settled certain vendor obligationsfor $205,000 and reversed $132,000 of remaining accrual relatedto those obligations. The balance of $200,000 remaining atSeptember 30, 2005, consists primarily of potential vendorobligations 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 qualityglass inspection products allowed cathode ray tube displaymanufacturers to locate and characterize defects and glassmanufacturers to detect and identify defects such as scratches,pits, bubbles, stones, inclusions and distortions, therebyincreasing yields and quality and reducing costs. The Companypreviously sold its products for the cathode ray tube displayand high quality glass inspection industry primarily throughsales representatives and distributors. The Company generallyrecognized revenue from product sales upon customer acceptance.In June 2003, the Company implemented a plan to exit the cathoderay tube display and high quality glass inspection business.Accordingly, the operating results of this former businesssegment have been reclassified as a discontinued operation forall periods presented and the Company now conducts business inone segment.
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     The following table summarizes the results of discontinuing thecathode ray tube display and high quality glass inspectionproducts reporting segment:                 **Year Ended September 30,**     **2005** **2004** **2003**         **(In thousands)**    Revenue $—  $—  $2,412     Cost of revenue  (150)  —   4,393               Gross margin  150   —   (1,981)              Operating expenses:                 Research and development  —   —   701      Selling, general and administrative  (162)  38   2,533      Impairment of purchased intangibles and fixed assets  —   —   791      Gain on sale of fixed assets  —   (209)  —                 Total operating expenses  (162)  (171)  4,025               Income (loss) from discontinued operations $312  $171  $(6,006)               The income from discontinued operations for the year endedSeptember 30, 2005, includes approximately $288,000 for thereduction in certain reserves, including $143,000 related towarranty provisions and approximately $145,000 related to leaseobligations settled at amounts less than originally estimated.     The income from discontinued operations for the year endedSeptember 30, 2004, includes a gain on the sale of certainassets related to the former glass inspection business.     The loss from discontinued operations for the year endedSeptember 30, 2003, includes a write-off of inventory ofapproximately $1.8 million, a write-off of accountsreceivable of approximately $152,000, and a write-off of fixedassets of approximately $490,000. The fiscal 2003 loss alsoincludes approximately $460,000 in lease-related chargesassociated with excess facilities, and approximately $979,000 inemployee severance and related benefit charges accounted for inaccordance with FAS 146. The Company has paid outsubstantially all of the severance and related benefit amountsas of September 30, 2003.     The following summarizes the assets and liabilities of thecathode ray tube display and high quality glass inspectiondiscontinued operations:           **September 30,**     **2005** **2004**       **(In thousands)**    Other current liabilities $74  $797             At September 30, 2005 other current liabilities includeapproximately $35,000 related to warranty obligations andapproximately $40,000 related to operating lease obligations.Lease obligations are to be paid out through October of 2007.
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     In the third quarter of fiscal 2003, in accordance withFAS 146, the Company recorded a liability of approximately$1.9 million for costs associated with the discontinuationof the business. The following summarizes the liability sinceinception:                    **One-Time** **Contract**      **Termination** **Termination** **Other**    **Benefits** **Costs** **Costs** **Total**             **(In thousands)**      Inception of liability $1,116  $771  $11  $1,898     Cash expenditures  (1,116)  (322)  (61)  (1,499)    Adjustments to the liability  —   —   50   50                   Balance of liability at September 30, 2004  —   449   —   449     Cash expenditures  —   (71)  —   (71)    Adjustments to the liability  —   (304)  —   (304)                  Balance of liability at September 30, 2005 $—  $74  $—  $74                   In April of 2005, the Company entered into a sublease agreementin connection with the closing of its facilities in Canada, and,as a result, reduced its liability by approximately $145,000 forthe difference in the estimate of sublease income. In September2005, the Company adjusted the warranty liability byapproximately $143,000 to reflect expected remaining estimatedwarranty amounts. The remaining warranty will be amortized overthe remaining warranty period. Future minimum lease payments netof sublease income, due by fiscal year are approximately:$16,000, $16,000 and $8,000 in fiscal 2006, 2007 and 2008,respectively.**Note 4 —****Acquisitions and Dispositions*****Year ended September 30, 2004 dispositions***     In May 2004, the Company sold all of its assets in Korea relatedto its TFT-LCD Backlight Inverter business to WOOYOUNG CO. LTDfor approximately $481,000. The assets included inventory andproduction equipment for which the Company had previouslyrecorded impairment charges, intellectual property and certainemployees related to the inverter business. For the year endedSeptember 30, 2004, the Company recorded a gain on thetransaction of approximately $419,000, which is included in“Operating income” in the Consolidated Statements ofOperations.***Year ended September 30, 2004 acquisitions***     In June 2004, the Company acquired all of the assets of QuantumComposers, Inc., related to the design and manufacture of laserassembly products for flat panel display LCD manufacturing andrepair (the “Quantum Assets”). Quantum Composersdesigned and sold pulse generator and laser diagnostic systemsand provided contract engineering and system design services tothe laser industry. The purchase price was approximately$3.0 million, of which the Company paid $1.0 millionup front and issued $2.0 million of non- interest bearingnotes payable, due through June of 2007. In addition, theCompany assumed approximately $156,000 of liabilities andincurred approximately $56,000 in acquisition-related expenses,consisting primarily of consulting, legal and accounting fees.The identifiable tangible assets acquired consisted primarily ofinventory.     In August 2004, the Company acquired all of the assets of TucsonOptical Research Corporation (“TORC”) related to thedesign and manufacture of pellicle products which are used inthe Company’s modulators (the “TORC Assets”). Thepurchase price was approximately $1.3 million, of which theCompany paid $625,000 up front and issued $625,000 ofnon-interest bearing notes payable, due through August of 2005.In addition, the Company incurred approximately $25,000 inacquisition-related expenses,
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**consisting primarily of consulting, legal and accounting fees.The identifiable tangible assets acquired consisted primarily ofinventory.***Year Ended September 30, 2003 Purchase    Acquisitions***     In May 2003, the Company acquired all of the assets of SummitImaging, Inc. related to the design and manufacture of“cooled” cameras specifically tailored to theCompany’s product offerings (the “SummitAssets”). 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 andincurred approximately $130,000 in acquisition-related expenses,consisting primarily of consulting, legal and accounting fees.The identifiable tangible assets acquired consisted primarily ofinventory.     In November 2002, the Company acquired rapid thermal processingtechnology assets (the “RTP Assets”) from Intevac,Inc. (“Intevac”). The purchase price was$20.0 million of cash, of which $18.0 million was paidto Intevac at closing and an additional $2.0 million wasplaced into escrow to be released either to the Company or toIntevac depending on the occurrence of certain future eventsduring the escrow period as follows: $1.2 million relatedto the attainment of a certain level of sales by the Company ofequipment included in the RTP Assets acquired from Intevac;$500,000 related to the re-issuance of a former rapid thermalprocessing patent in Japan for certain acquired technology; and$300,000 for indemnification and reimbursement should Intevacbreach any representations and warranties under the acquisitionagreement.     In September 2003, the Company filed a claim against the escrowfor the full $2.0 million. In October 2003, the Companyreceived $1.7 million on its claim against the$2.0 million escrow related to the purchase of the RTPAssets from Intevac. The claim for the remaining $300,000 wasresolved in favor of Intevac and, accordingly, the Companyrecorded an additional goodwill impairment charge in the threemonths ended December 31, 2003.***Purchase Price Allocation and Pro Forma Information***     The acquisitions of TORC Assets, Quantum Assets, Summit Assets,and RTP Assets were accounted for under the purchase method ofaccounting. The purchase prices were allocated by management tothe assets acquired and liabilities assumed taking into accountan third-party appraisal of their respective fair values. Todetermine the value of the developed and core technologies, theexpected future cash flows attributed to all existing technologywere discounted, taking into account risks related to thecharacteristics and application of the technology, existing andfuture markets and assessments of the life cycle stage of thetechnology. The value of the non-compete agreements was valuedat the cash paid up front and the present value of thenon-interest payments on the notes issued. The value attributedto the RTP backlog was related to purchase orders that had beenreceived prior to the close of the acquisition, determined asthe expected discounted cash flow resulting from the revenuerelated to the shipment of such orders, less normal profitmargins.     The value of in-process research and development was determinedbased on the expected cash flow attributed to the in-processprojects, taking into account revenue that was attributable topreviously developed technology, the level of effort to date inthe in-process research and development, the percentage ofcompletion of the project and the level of risk associated withthe in-process technology. The projects identified as in-processwere those that were underway as of the acquisition date andthat will, after the applicable closing date, require additionaleffort in order to establish technological feasibility and haveno alternative future uses. These projects have identifiabletechnological risk factors that indicate that even thoughsuccessful completion is expected, it is not assured. The valueof in-process research and development has been included in theCompany’s results of operations.
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     The Company applied discount factors to the projected cash flowsof the acquired technology in order to determine the presentvalue, based on discount rates with inherent risk and expectedgrowth of the developed, core and in-process technologies. Thediscount rates used for the developed, core and in-processtechnologies for each acquisition were as follows:                   **TORC** **Quantum** **Summit** **RTP**  **Assets** **Assets** **Assets** **Assets**             Developed technology  —   25%   —   15%     Core technology  25%  25%   50%  20%     In-process technology  —   30%   60%  25%      A summary of the allocation of the purchase prices is as follows:                    **TORC** **Quantum** **Summit** **RTP**  **Assets** **Assets** **Assets** **Assets**           **(In thousands)**    Acquired core technology $1,144  $699  $565  $3,764     Acquired developed technology  —   1,006   —   2,673     Backlog  —   —   —   557     Acquired in-process research and development  —   210   625   1,849     Non-compete agreement  —   769   199   —     Goodwill  —   —   106   7,386     Net fair value of acquired tangible assets and assumed    liabilities  114   397   163   2,621                   Total $1,258  $3,081  $1,658  $18,850                   The acquired core technology associated with the TORC Assets isbeing amortized over four years. The acquired core technologyand acquired developed technology associated with the QuantumAssets are being amortized over four years. The acquired coretechnology associated with the Summit Assets is being amortizedover four years. The non-compete agreements from the SummitAssets and Quantum Assets are being amortized over two and threeyears, respectively. The RTP backlog was amortized to cost ofsales at the time revenue was recognized for the relatedcustomer orders.     The purchase price for the Summit Assets and RTP Assets resultedin the recognition of goodwill. The primary factor contributingto the recognition of goodwill for Summit Assets was the abilityto integrate a workforce with technical expertise. The primaryfactors contributing to the recognition of goodwill for the RTPAssets included 1) an increase in speed to market throughacquisition of the business and associated products andtechnology, 2) the integration of a workforce with thetechnical expertise, and 3) a deeper penetration of theCompany’s current customer base with a broader portfolio ofproducts. The Company expects that the goodwill for both theSummit Assets and RTP Assets will be deductible for tax purposesin the United States.     The purchase price of the TORC Assets and Quantum Assetsresulted in the fair value of the identifiable assets acquiredexceeding the cost of the acquired business by approximately$2.2 million and $676,000, respectively. In accordance withStatement of Financial Accounting Standards No. 141“Business Combinations,” the values of the non-currentassets acquired were reduced by a proportionate part of theexcess to determine the assigned values.     The acquired core technology and acquired developed technologyassociated with the RTP Assets were partially written off andthe goodwill associated with the RTP Assets was entirely writtenoff as part of the impairment of intangibles and goodwillimpairment charges taken in the fourth quarter of fiscal 2003.The
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**remaining acquired core technology and acquired developedtechnology amounts were written off in the three months endedDecember 31, 2003 as additional impairment charges. Theseadditional impairment charges were a result of the continuingdeterioration in business conditions that included emergence ofalternative and competing technologies, shrinkage of thepotential total market opportunity due to one of the primarypotential customer’s decision to pursue an alternativetechnology and further softness in this particular sector of themarket since September 30, 2003. Accordingly, the Companyperformed an impairment analysis for the remaining acquiredintangible assets as required by Statement of FinancialAccounting Standards No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets”(“FAS 144”).     The following pro forma information presents the results ofcontinuing operations of the Company for the fiscal years endedSeptember 30, 2004 and 2003 as if TORC Assets, QuantumAssets, Summit Assets and RTP Assets had been acquired as of thebeginning of the fiscal year of acquisition and the immediatelypreceding period. The Company’s results of operations forthe fiscal year ended September 30, 2005 includes thepost-acquisition results of all purchased Assets. The pro formainformation does not purport to be indicative of what would haveoccurred had the acquisition been made as of these dates or ofresults that may occur in the future.     The pro forma results exclude nonrecurring charges, such as thewrite-off of purchased in-process research and development,which resulted directly from these transactions. The unauditedpro forma information is as follows:            **Year Ended**  **September 30,**     **2004** **2003**       **(Unaudited)**  **(In thousands, except**  **per share data)**    Total revenue $146,412  $71,734     Income (loss) from operations  8,095   (26,922)     Net income (loss) from continuing operations  12,320   (24,010)    Pro forma income (loss) per share from operations:             Basic $0.49  $(1.67)     Diluted $0.47  $(1.67)    Pro forma income (loss) per share from continuing operations:             Basic $0.74  $(1.49)     Diluted $0.72  $(1.49)**Note 5 —****Goodwill and Other Purchased Intangible Assets*****Goodwill***     Changes in the carrying amount of goodwill for the years endedSeptember 30, 2005 and 2004 are as follows:        **Total**     **(In thousands)**    Balance as of September 30, 2003 $518      Adjustments to goodwill, net  300      Goodwill impairment charge  (665)        Balance as of September 30, 2004  153      Adjustments to goodwill, net  —      Goodwill impairment charge  —         Balance as of September 30, 2005 $153     
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     In November 2002, as part of the acquisition of the RTP Assets,$2.0 million was placed into escrow to be released eitherto the Company or to Intevac depending on the occurrence ofcertain future events during the escrow period. In September2003, 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 millionescrow related to the RTP Asset purchase from Intevac. The claimfor the remaining $300,000 was resolved in favor of Intevac.Because the Company had written off all goodwill resulting fromthe acquisition of the RTP Assets, the $300,000 resolved infavor of Intevac resulted in an adjustment to record additionalgoodwill, which was deemed to be impaired due to continuingdeterioration in business conditions during the three monthperiod ended December 31, 2003.     During the three months ended December 31, 2003, theCompany recorded a goodwill impairment charge of approximately$365,000 under the provisions of Statement of FinancialAccounting Standards No. 142, “Goodwill and OtherIntangible Assets” (“FAS 142”), representingthe remaining goodwill associated with its Akcron reportingunit. This impairment charge was a result of the continuingsoftness in the inverter market since September 30, 2003.Accordingly the Company performed an impairment analysis for theremaining acquired intangible assets as required by FAS 144.     In accordance with FAS 142 and FAS 144, these fiscal2004 impairment charges established new cost bases for theremaining goodwill assets.     Goodwill as of September 30, 2005 relates entirely to theCompany’s purchase of assets from Summit Imaging.***Intangible Assets***     Information regarding the Company’s intangible assets is asfollows:                       **Developed** **Core** **License** **Non Compete**    **Technology** **Technology** **Agreement** **Contract** **Total**             **(In thousands)**    Balance as of September 30, 2003 $655  $2,082  $—  $157  $2,894     Acquired during the period  987   1,843   1,138   770   4,738     Amortization during the period included in continuing operations  (221)  (219)  (190)  (160)  (790)    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     Amortization during the period included in continuing operations  (152)  (700)  (378)  (318)  (1,548)                    Balance as of September 30, 2005 $680  $1,506  $570  $449  $3,205                      During the three months ended March 31, 2004, the Companysigned a Termination and Assignment Agreement (the“Agreement”) with Ishikawajima-Harima Heavy Industries(“IHI”), the Company’s value-added reseller ofits flat panel display products in Japan. Under the terms of theAgreement, all prior existing agreements between IHI and theCompany were terminated, including IHI’s rights to sell andsupport the Company’s flat panel display products on anexclusive basis in Japan. As part of this termination agreement,IHI assigned to the Company the right to use all intellectualproperty rights associated with the Company’s products heldby IHI, including any patents and patent applications associatedwith the intellectual property rights. Additionally, as part ofthis termination agreement, IHI retained rights to purchasesystems from the Company for resale to one particular customerin Japan for purchase orders issued from the customer to IHIprior to April 1, 2005. The Company paid to IHI$1.5 million, consisting of $339,000 for IHI’sremaining field
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**spares inventory and $1.1 million for the aforementionedintellectual property rights and other intangible assets. Theseintangible assets are being amortized over three years,beginning in April 2004.     During the three months ended December 31, 2003, theCompany recorded impairment charges of approximately$2.1 million related to the remaining portion of theacquired developed technology and core technology related to theAkcron and RTP reporting units. These impairment charges were aresult of the continuing softness in the inverter market andincreasing uncertainty surrounding LTPS technology sinceSeptember 30, 2003. These charges have been reflected inthe results of operations in the quarter ended December 31,2003.     In accordance with FAS 142 and FAS 144, these fiscal2004 impairment charges established new cost basis for theremaining intangible assets.     Future estimated amortization expense relating to intangibleassets at September 30, 2005 is approximately$1.5 million, $1.2 million and $558,000 in fiscal 2006through 2008, respectively.     In assessing the recoverability of its intangible assets, theCompany must make assumptions regarding estimated future cashflows and other factors to determine the fair value of therespective assets. It is reasonably possible that theseestimates, or their related assumptions, may change in thefuture, in which case the Company may be required to recordadditional impairment charges for these assets.**Note 6 —****Restructuring Charges**     During the third quarter of fiscal 2005, the Company implementeda restructuring plan to relocate all activities in its Markham,Canada location — consisting of research anddevelopment related to the Company’sPanelMastertminspection systems — to the Company’s Daejon,Korea and San Jose, California locations. The Companyrecorded this restructuring plan in accordance with Statement ofFinancial Accounting Standards No. 146 “Accounting forCosts Associated with Exit or Disposal Activities”(“SFAS 146”).     The restructuring plan included reducing its workforce andclosing its Markham, Canada location. Management approved andimplemented the plan and determined the benefits that would beoffered to the employees being terminated. Management determinedthat terminations affecting up to 32 employees would take placein three phases through March 31, 2006. Certain of theseemployees were offered permanent employment elsewhere in theCompany and those that accepted were provided with certainrelocation benefits in lieu of severance benefits. All 32 of theaffected employees were notified of their termination and thebenefits package was explained in sufficient detail such thateach affected employee was able to determine the type and amountof benefits they were entitled to receive.     The Company recorded an initial restructuring charge ofapproximately $676,000 in its third quarter, which was comprisedof approximately $430,000 for employee severance and relatedbenefits and approximately $246,000 related to contracttermination costs associated with excess facilities. Thesecharges are reflected in “Restructuring charges” inthe Company’s Consolidated Statements of Operations. Thecharge for excess facilities relates to rent obligations underlong term operating lease agreements which are to be paid incash through October 2007, net of a sublease agreement theCompany entered into in April 2005 and to costs associated withthe book value of leasehold improvements. The Company recordedan additional restructuring charge of approximately $521,000during its fourth quarter which represent the fourth quartershare of the ratable charges for future employee severance andrelated retention benefits to be paid in future periods.
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     The following table summarizes the liability since inception:                **One-Time** **Contract**    **Termination** **Termination**    **Benefits** **Costs** **Total**         **(In thousands)**    Inception of liability $430  $246  $676     Cash payments  (526)  (21)  (547)    Costs incurred and charged to expense  521   —   521     Adjustments to the liability  24   (166)  (142)               Balance at September 30, 2005 $449  $59  $508                As of September 30, 2005, the remaining liability ofapproximately $508,000 is reflected in “Other currentliabilities” in the Company’s Consolidated BalanceSheets. Adjustments to the liability represents the write-off ofleasehold improvements and currency translation effects on theliability.     Additional restructuring charges for employee severance andrelated benefits will be ratably expensed over the relatedservice periods through March of 2006; and, as such, the Companyexpects additional restructuring charges of approximately$140,000 in both its first and second fiscal quarters of fiscal2006. Management expects to settle all employee severance andbenefits by the end of the third quarter of fiscal 2006.**Note 7 —****Financial Instruments*****Cash Equivalents and Short Term Investments***     The Company’s cash equivalents at September 30, 2005consist of money market accounts.     The amortized costs and estimated fair value of securitiesavailable-for-sale, by type, as of September 30, 2005 and2004 are as follows:                       **Gross** **Gross**    **Amortized** **Unrealized** **Unrealized** **Estimated**  **Cost** **Gains** **Losses** **Fair Value**           **(In thousands)**    September 30, 2005                     Auction rate preferred securities $30,075  $—  $(4) $30,071      Mortgage-backed securities  21,769   —   (164)  21,605      Commercial paper and corporate debt securities  21,218   —   (156)  21,062                    Amounts included in short-term investments $73,062  $—  $(324) $72,738                  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                   Photon Dynamics’ investment portfolio consists of bothcorporate and government securities that have a maximum maturityof 4.25 years. The longer the duration of these securities,the more susceptible they are to changes in market interestrates and bond yields. As yields increase, those securities witha lower yield-at-cost show a mark-to market unrealized loss. Allunrealized losses are due to changes in interest rates and bondyields. The Company believes it has the ability to realize thefull value of all these investments upon maturity.
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**The following table summarizes the fair value and grossunrealized losses of the Company’s investments, aggregatedby investment instrument and unrealized loss position atSeptember 30, 2005:            **Total in a Loss**  **Position(1)**       **Gross**    **Unrealized**  **FMV** **Losses**       **(In thousands)**    U.S. government and agency securities $22,601  $(168)    Asset-backed securities  13,500   (106)    Municipal bonds  7,543   (50)            Total $43,644  $(324)        (1)     Of the total gross unrealized losses, approximately $177,000 of    gross unrealized losses relates primarily to governmental debt    and asset backed securities with a fair value of    $21.9 million that have been in a loss position for    12 months or more.     The contractual maturities of debt securities classified asavailable-for-sale as of September 30, 2005, regardless ofthe consolidated balance sheet classification, are as follows:              **Estimated**  **Cost** **Fair Value**       **(In thousands)**    Due within one year $65,077  $64,786     Due after one year through five years  7,985   7,952             Total cost and estimated fair values $73,062  $72,738             Actual maturities may differ from contractual maturities becauseborrowers may have the right to call or prepay obligations withor without call or prepayment penalties. Net realized gains andlosses for the years ended September 30, 2005, 2004 and2003 were not material to the Company’s financial positionor results of operations and have been included in“Interest income and other, net” in the ConsolidatedStatements of Operations in the respective period.***Derivative Financial Instruments***     Under its foreign currency risk management strategy, the Companymay, from time to time, utilize derivative instruments toprotect its interests from unanticipated fluctuations inearnings and cash flows caused by volatility in currencyexchange rates. This financial exposure is monitored and managedby the Company as an integral part of its overall riskmanagement program which focuses on the unpredictability offinancial markets and seeks to reduce the potentially adverseeffects that the volatility of these markets may have on itsoperating results.     The Company accounts for its derivatives instruments accordingto Statement of Financial Accounting Standards No. 133,“Accounting for Derivative Instruments and HedgingActivities” (“FAS 133”), which requires thatall derivatives be recorded on the balance sheet at fair value.Changes in the fair value of derivatives which do not qualify orare not effective as hedges must be recognized currently inearnings. The Company does not use derivative financialinstruments for speculative or trading purposes, nor does ithold or issue leveraged derivative financial instruments.
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     The Company’s international sales are primarily denominatedin U.S. dollars although approximately $19.3 million,$10.4 million and $276,000 of revenue that was recognizedin fiscal 2005, 2004 and 2003, respectively, were invoiced incurrencies other than the U.S. dollar, primarily JapaneseYen. For foreign currency denominated sales, however, thevolatility of the foreign currency markets represents risk tothe Company’s margins. The Company defines its exposure asthe risk of changes in the functional-currency-equivalent cashflows (generally U.S. dollars) attributable to changes inthe related foreign currency exchange rates. The Company recordsthe mark-to-market change in fair value of its derivativeinstruments within “Other current liabilities” in theCompany’s Consolidated Balance Sheet. The Company did nothave any foreign currency forward exchange sales contracts atSeptember 30, 2005 or 2004. At September 30, 2003, theCompany had foreign currency forward exchange contracts maturingthroughout fiscal 2004 to sell approximately $2.8 millionin foreign currencies, primarily Japanese Yen. The Company didnot qualify these forward sales contract as hedging instruments,as defined by FAS 133, and, as such, recorded the changesin the fair value of these derivatives immediately in“Interest income and other, net” in the ConsolidatedStatements of Operations. The Company recorded a net gain ofapproximately $208,000 from changes in fair values of theseforeign currency exchange contracts in fiscal year 2004, and anet loss of $208,000 in fiscal 2003. This net gain (loss) isincluded in “Interest income and other, net” in theConsolidated Statements of Operations.**Note 8 —****Income Taxes**     The provision for income taxes related to continuing operationsconsists of the following:                 **Year Ended**  **September 30,**     **2005** **2004** **2003**         **(In thousands)**    Current:                 Federal $23  $164  $—      State  8   3   —      Foreign  678   410   56     Deferred:                 Foreign  (85)  —   —                 Provision for income taxes $624  $577  $56                Income (loss) before income taxes related to continuingoperations consists of the following:               **Year Ended September 30,**     **2005** **2004** **2003**         **(In thousands)**    Domestic $(26,965) $17,490  $(17,848)    Foreign  8,053   (5,828)  (9,876)              Income (loss) before income taxes $(18,912) $11,662  $(27,724)          
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     The significant components of the Company’s deferred incometax assets are as follows:             **September 30,**     **2005** **2004**       **(In thousands)**    Deferred tax assets:             Net operating loss carryforwards $31,954  $32,385      Research credit carryforwards  9,528   9,805      Canadian research and development expenditures  9,242   3,722      Purchased intangibles  3,083   696      Inventory write-downs  4,229   3,244      Depreciation  2,591   1,572      Allowance for doubtful accounts  58   202      Expenses not currently deductible  4,327   5,374      Deferred revenue  7,210   7,173              Total deferred tax assets  72,222   64,173     Valuation allowance  (72,137)  (64,173)           Net deferred tax assets  85   —     Deferred tax liabilities  —   —              Total net deferred tax assets $85  $—             Deferred tax assets reflect net operating loss and creditcarryforwards and the net tax effects of temporary differencesbetween the carrying amounts of assets and liabilities forfinancial reporting purposes and the amounts used for income taxpurposes.     The valuation allowance increased by approximately$8.0 million in fiscal 2005 and increased by approximately$0.4 million in fiscal 2004. As of September 30, 2005,approximately $14 million of the valuation allowance isrelated to the benefits attributable to stock option deductionswhich will be credited to paid-in capital when realized.     As of September 30, 2005, the Company has federal and statenet operating loss carryforwards of approximately$79.8 million and $11.0 million, respectively. Thefederal net operating loss carryforwards will begin expiring infiscal year 2021 if not utilized. The state net operating losscarryforwards will expire at various times beginning in fiscalyear 2012 if not utilized. The Company also has federal andstate research and development tax credit carryforwards of$6 million and $3.2 million, respectively. The federalcredits will begin expiring in fiscal year 2006 and willcontinue to expire on an annual basis through fiscal year 2025if not utilized. The state credits have an indefinitecarryforward period.     The Company has cumulative foreign loss carryforwards forCanadian income tax purposes of approximately $4.3 million.These foreign loss carryforwards will begin expiring in fiscalyear 2006 and will continue to expire through 2012 if notutilized.     The Company has cumulative Canadian scientific research anddevelopment expenditures (“SR&D”) available fordeduction in future years of approximately of $14 million.These deductible SR&D can be carried forward to reducefuture Canadian taxable income indefinitely. The Company alsohas SR&D credit carryforwards of $3.6 million, whichwill begin expiring in fiscal year 2006 and will continue toexpire on an annual basis through fiscal year 2015.
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     Under certain provisions of the Internal Revenue Code of 1986,as amended, the availability of the Company’s domestic netoperating loss and tax credit carryforwards may be subject tolimitation if it should be determined that there has been achange in ownership of more than 50% of the value of theCompany’s stock. Such determination could limit theutilization of net operating loss and tax credit carryforwards.     The American Jobs Creation Act of 2004 provides for a specialone time benefit relating to the repatriation of certain foreignearnings. The Company has analyzed this provision and hasconcluded that it is not beneficial to pursue the repatriationunder this Act as of September 30, 2005.     The reconciliation of the U.S. federal statutory income taxrate to the Company’s effective income tax rate is asfollows:                **Year Ended September 30,**     **2005** **2004** **2003**         **(In thousands)**    Expected provision (benefit) at federal statutory rate $(6,540) $3,594  $(9,723)    Foreign income taxes  593   410   56     Losses (benefited)/not benefited — discontinued    operations  —   —   (18,171)    Losses (benefited)/not benefited  6,555   (3,428)  26,993     Other individually immaterial items  16   1   901                Provision for income taxes $624  $577  $56           **Note 9 —****Shareholders’ Equity and Employee Benefits**     *Common Stock.* In August 2002, the Company’s Board ofDirectors approved a stock repurchase program authorizing theCompany to repurchase up to an aggregate of $25.0 millionof the Company’s common stock. The repurchase program wasterminated on January 15, 2003. The repurchases were madefrom time to time on the open market at prevailing prices, innegotiated transactions off the market or pursuant to a 10b5-1plan adopted by the Company. The 10b5-1 plan allowed the Companyto repurchase its shares during a period in which the Companywas in possession of material non-public information, providedthat the Company communicated share repurchase instructions tothe broker at a time when it was not in possession of suchmaterial non-public information. As of September 30, 2002the Company had repurchased 350,900 shares for an aggregaterepurchase price of approximately $6.9 million. During theperiod October 1, 2002 through January 15, 2003, theCompany repurchased 903,032 shares for an aggregaterepurchase price of approximately $17.7 million. TheCompany repurchased a total of 1,253,932 shares for anaggregate repurchase price of approximately $24.6 millionunder this program.     *Stock Option Plans.* Under the Company’s stock optionplans approved in 2005, 1995 and 2001 the Board of Directorsmay, at its discretion, grant incentive or non-qualified stockoptions to employees, officers, directors and consultants atprices no less than 100% of the fair market value of shares atthe date of grant. The plans also permit the grant of stockbonus awards to qualified individuals. Options generally vestover a period of 50 months commencing from the date ofgrant and expire ten years after the options are granted.     The Company’s 1995 Amended and Restated Stock Option Planexpired in November of 2005, while the 1995 Employee StockPurchase Plan expired in July 2005. On March 7, 2005, atthe Company’s Annual Meeting of Shareholders, theCompany’s shareholders approved the Company’s 2005Equity Incentive Plan, 2005 Employee Stock Purchase Plan and2005 Non-Employee Directors’ Stock Option Plan. The 2005Equity Incentive Plan is an amendment and restatement of PhotonDynamics’ 2001 Equity Incentive Plan and has a total of1,450,000 shares of Common stock reserved for issuance,including 650,000 shares of Common Stock that were reservedfor issuance under the 2001 Plan. The 2005 Employee StockPurchase Plan has a total of
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**1,000,000 shares of Common Stock reserved for issuance. The2005 Non-Employee Directors’ Stock Option Plan has a totalof 400,000 shares of Common Stock reserved for issuance.     The activity under the option plans, combined, is as follows:               **Available** **Options** **Weighted-Average**  **for Grant** **Outstanding** **Exercise Price**           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     Additional shares reserved  1,200,000   —   —     Options granted  (797,800)  797,800   19.37     Options canceled/expired  402,104   (399,144)  28.89     Options exercised  —   (84,591)  13.59               Balances at September 30, 2005  1,663,308   1,946,274  $24.64                The following table summarizes information about stock optionsoutstanding as of September 30, 2005:                       **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** **2005** **(In years)** **2005** **Exercisable** **2005**               $ 3.00 - $17.36  311,480   7.19  $15.11   178,166  $13.43      17.75 -  18.41  196,624   7.29   18.09   126,602   18.05      19.50 -  19.50  314,500   9.92   19.50   14,650   19.50      19.68 -  24.43  215,906   7.96   22.85   96,703   22.55      25.63 -  27.58  316,440   7.74   26.65   316,440   26.65      27.83 -  29.91  264,064   7.88   29.33   264,064   29.33      31.11 -  37.14  198,780   7.82   32.55   198,780   32.56      38.50 -  59.00  128,480   6.20   46.46   128,480   46.53                     $ 3.00 - $59.00  1,946,274   7.91  $24.64   1,323,885  $26.97                      The weighted average fair value of options granted in fiscal2005, 2004 and 2003 was $12.39, $21.63 and $15.14, respectively.Options exercisable were 1,323,885, 778,627 and 769,177 as ofSeptember 30, 2005, 2004 and 2003, respectively.     *Employee Purchase Plan.* The Company’s employee stockpurchase plan provides that eligible employees may contribute upto 10% of their base earnings, through accumulated payrolldeductions, toward the semi-annual purchase of theCompany’s common stock. Participants purchase shares on thelast day of each
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**offering period. The price at which shares are purchased isequal to 85% of the lower of the fair market value of a share ofcommon stock on the first day of the offering period or thepurchase date. In fiscal 2005, 2004 and 2003, employeespurchased 47,188, 84,785 and 96,601 shares, respectively.At September 30, 2005, 1,000,000 shares were reservedand available for issuance under the plan. The weighted-averagefair value of shares issued in fiscal 2005, 2004 and 2003 was$13.70, $15.80 and $11.41 respectively.     *Other Employee Benefits Plans.* The Company has aretirement savings plan that qualifies as a deferred salaryarrangement under Section 401(k) of the Internal RevenueCode. In fiscal 2005, 2004 and 2003, the Company matched 50% onthe first 7% up to $3,500 per year of an eligibleemployee’s contribution. The total charge to operationsunder the 401(k) program was approximately $469,000, $411,000and $282,000 in fiscal 2005, 2004 and 2003, respectively.     *Stock Ownership Expense.* During fiscal 2005 and 2004, theCompany recorded approximately $52,000 and $206,000 in stockownership expense related to options granted to a member of itsBoard of Directors for consulting services (see Note 13).The fair value of these options was computed using theBlack-Scholes option-pricing model. The Options are subject tovariable accounting and will be revalued until they are fullyvested and exercised.     During fiscal 2003, the Company recorded approximately $174,000in stock ownership expense related to the acceleration ofoptions for two former officers of the Company. The stockownership expense for this option acceleration was computedusing intrinsic value in accordance with APB 25. Duringfiscal 2003, the Company recorded approximately $190,000 instock ownership expense related to options granted to aconsultant who was subsequently hired by the Company. The fairvalue was computed using the Black-Scholes option-pricing model.     *Shares Reserved.* The Company has reserved shares ofcommon stock for future issuance as follows:        **September 30,**  **2005**       Stock options outstanding  1,946,274     Stock options, available for grant  1,663,308     Shares for employee stock purchase plan  1,000,000     Exchange shares for previous acquisitions  32,699          Total  4,642,281     **Note 10 —****Net Income (Loss) Per Share**     Basic earnings per share is calculated using the weightedaverage number of shares of common stock outstanding. Dilutedearnings per share is computed in the same manner and also giveseffect to all dilutive potential common shares outstandingduring the period. Common equivalent shares consist of stockoptions issued to employees under employee stock option plansand warrants.
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     The following table sets forth the computation of basic anddiluted net income (loss) per share:                 **Year Ended September 30,**     **2005** **2004** **2003**         **(In thousand, except per share data)**    Numerator:                 Net income (loss) from continuing operations before discontinued    operations $(19,567) $11,085  $(27,780)     Net income (loss) from discontinued operations  256   (1,391)  (44,592)               Net income (loss) $(19,311) $9,694  $(72,372)              Denominator:                 Weighted average shares for basic net income (loss) per share  16,890   16,631   16,089      Effect of dilutive securities: Employee stock options  —(1)  456   —(1)               Weighted average shares for diluted net income per share  16,890   17,087   16,089               Earnings per share:                 Basic net income (loss) per share:                  Net income (loss) from continuing operations $(1.16) $0.67  $(1.73)      Net income (loss) from discontinued operations  0.02   (0.08)  (2.77)                Net income (loss) per share $(1.14) $0.58  $(4.50)               Diluted net income (loss) per share:                  Net income (loss) from continuing operations $(1.16) $0.65  $(1.73)      Net income (loss) from discontinued operations  0.02   (0.08)(2)  (2.77)                Net income (loss) per share $(1.14) $0.57  $(4.50)           (1)     The effect of dilutive securities from employee stock options    and warrants to purchase 124,060 and 479,000 shares at    September 30, 2005 and 2003, respectively, 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 shares in its    calculation of 2004 diluted net loss from discontinued    operations.     At September 30, 2005, 2004 and 2003, options topurchase 1,203,202, 243,000 and 982,000 shares,respectively, were not included in the computation of dilutedearnings per share because the exercise price was greater thanthe average market price of common shares for the respectiveperiods and hence, their effect would have been anti-dilutive.**Note 11 —****Commitments and Contingencies*****Facilities***     In August 2003, the Company signed a lease agreement for a128,520 square-foot building in San Jose, Californiainto which it consolidated its San Jose facilities in thesecond quarter of fiscal 2004. The lease on the priorSan Jose location terminated concurrently with theinception date of the new lease. The new facility is leasedunder a non-cancelable operating lease that expires in 2010,with two renewal options at fair market value for additionalfive year periods. In fiscal 2002, the Company renewed the leaseon its Markham, Ontario (Canada) facilities under anon-cancelable operating lease that expires in fiscal 2007. Aspart of restructuring
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**plan to relocate all activities in its Markham, Canada location(See Note 6), the Company sublet the Markham facilitiesthrough the remaining lease term. Concurrently, the Companyleased a smaller research and development facility in Markhamthrough March 2006. The Company leases its Austin, Texasfacility under a non-cancelable operating lease that expires infiscal 2006. The Company also leases office facilities invarious foreign locations under non-cancelable operating leasesthat range in terms from one to two years. The Company alsoleases equipment under operating leases.     Total rent expense under all operating leases was approximately$2.9, million, $2.4 million and $1.8 million for theyears ended September 30, 2005, 2004 and 2003, respectively.     Future minimum lease commitments under operating leases atSeptember 30, 2005, net of expected sublease income, areapproximately $3.6 million, $3.1 million,$2.7 million, $2.6 million, and $2.7 million infiscal 2006 through 2010, respectively. Expected sublease incomeis approximately $141,000, $35,000 and $0 in fiscal 2006 through2008, 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 oneyear. The Company has renegotiated the line of credit on anannual basis and currently has a $4.0 million borrowingcapacity on the line of credit with an interest rate of floatingprime with an original expiration of October 2005. As ofDecember 1, 2005, the Company renewed its line of creditwith its bank, with terms substantially the same as the originaland extended through October 16, 2006. The line of creditis secured by substantially all of the Company’s assets andcontains certain financial and other covenants. AtSeptember 30, 2005 and 2004, no amounts were outstandingunder the line of credit.***Purchase Agreements***     The Company maintains certain open inventory purchasecommitments with its suppliers to ensure a smooth and continuoussupply chain for key components. The Company’s liability inthese purchase commitments is generally restricted to aforecasted time horizon as mutually agreed upon between theparties. The Company’s open purchase commitments were$33.8 million as of September 30, 2005, includingcancelable purchase commitments.***Retention Bonus***     The Company entered into an agreement with certain key employeesof Summit Imaging, Inc. whereby the Company will pay incentivebonuses to retain the identified employees. The agreementprovides for a total bonus payment of $1.5 million, to bepaid out in four annual installments beginning on April 1,2004. In August of 2004, the Company entered into separationagreements with these employees. The agreement containscontingent provisions for the original bonus to continue to bepaid. As of September 30, 2005 and 2004, the Company hadaccrued approximately $375,000 and $188,000, respectively,through charges to earnings which is included in “Othercurrent liabilities” in the financial statements.     The Company entered into an agreement with certain key employeesof Quantum Composers, Inc. whereby the Company will payincentive bonuses to retain the identified employees. Theagreement provides for a total bonus payment of $398,000, to bepaid out in equal quarterly installments beginning in September2004. As of September 30, 2005 and 2004, the Company hadaccrued approximately $0 and $71,000, respectively, throughcharges to earnings which is included in “Other currentliabilities” in the financial statements.     The Company entered into an agreement with certain key employeesof Tucson Optical Research Corporation whereby the Company willpay incentive bonuses to retain the identified employees. Theagreement provides for a total bonus payment of $200,000, to bepaid out in four equal quarterly installments
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**beginning in November 2004. As of September 30, 2005 and2004, the Company had accrued approximately $8,000 and $11,000,respectively, through charges to earnings which is included in“Other current liabilities” in the financialstatements.***Warranty Obligations***     The Company generally offers warranty coverage for a period ofone year from the date of final customer acceptance. Uponproduct shipment, the Company records the estimated cost ofwarranty coverage, primarily material and labor to repair andservice the equipment. Factors that affect the Company’swarranty liability include the number of installed units underwarranty, product failure rates, material usage rates and theefficiency by which the product failure is corrected. TheCompany periodically assesses the adequacy of its recordedwarranty liability and adjusts the amount as necessary.     Changes in the Company’s product liability during fiscal2005 and 2004 were as follows:            **Fiscal** **Fiscal**  **2005** **2004**       **(In thousands)**    Beginning balance $6,194  $2,363      Estimated warranty cost of new shipments during the period  4,770   6,744      Warranty charges during the period  (4,651)  (4,588)     Changes in liability for pre-existing warranties, including    expirations  (967)  1,675            Ending balance $5,346  $6,194        ***Legal Proceedings***     The Company and certain of its directors and officers have beennamed 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 ofSanta Clara. The plaintiff, who previously served as one ofthe Company’s officers, has asserted several causes ofaction arising out of alleged misrepresentations made toplaintiff regarding the existence and enforcement of theCompany’s insider trading policy. The plaintiff is seekingdamages in excess of $8 million for defendants’alleged refusal to allow plaintiff to sell shares of theCompany’s stock in May of 2000, plus unspecified emotionaldistress and punitive damages. On December 2, 2005, theCourt denied defendant’s motion for summary judgment. Thetrial of this case is scheduled to being on January 17,2006. The Company believes the plaintiff’s case is withoutmerit and it intends to defend this action vigorously. TheCompany cannot predict the outcome of this litigation and noprovision or liability has been recorded in the accompanyingcondensed consolidated financial statement should the outcome ofthis matter be adverse to the Company. The Company believes thatan adverse judgment in this litigation could be material andcould have an adverse effect on the Company’s financialcondition, results of operations and cash flows.     The Company was named as a defendant in a lawsuit captionedSanmina SCI Corporation v. Photon Dynamics, Inc.,No. CV 013715, filed on February 3, 2004 in theSuperior Court of the State of California, County ofSanta Clara. The plaintiff in this action, which previouslywas a third-party manufacturer of the Company, asserted severalcauses of action arising out of the alleged nonperformance bythe Company of the manufacturing outsourcing agreement betweenthe Company and the plaintiff, and sought approximately$3.1 million in compensatory damages and punitive damagesin an unknown amount. The Company responded to the complaint onMarch 19, 2004, by filing an answer and cross complaintseeking damages of at least $135,000. The Company amended itscross complaint on June 26, 2004. The parties settled thisdispute in March 2005, pursuant to which the Company paidSanmina SCI Corporation $1.4 million, and the courtdismissed the matter on April 1, 2005. The Company hadpreviously accrued a liability of approximately
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**$622,000, for managements’ estimates of the amount owedupon termination of its relationship with Sanmina SCI. Thedifference between the $778,000 additional liability arisingfrom the settlement and the value assigned to the inventoryreceived was recorded as a charge to Cost of revenue ofapproximately $278,000 and as a recovery of approximately$132,000 in discontinued operations.     Photon Dynamics is subject to certain other legal proceedingsand claims that have arisen from time to time in the ordinarycourse of business and have not been fully adjudicated.Additionally, the Company in the ordinary course of business maypotentially be subject to future legal proceedings that could,or in the aggregate, have a material adverse effect on itsfinancial condition, liquidity or results of operations.Litigation in general, and intellectual property and securitieslitigation in particular, can be expensive and disruptive tonormal business operations. Moreover, the results of complexlegal proceedings are difficult to predict. The Company believesthat it has defenses in each of the aforementioned matters andit is 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 RelatedInformation,” establishes standards for reportinginformation about operating segments. Operating segments aredefined as components of an enterprise about which separatefinancial information is available that is evaluated regularlyby the chief operating decision maker, or decision making group,in deciding how to allocate resources and in assessingperformance of the company. The Company’s chief operatingdecision maker is considered to be the Company’s ChiefExecutive Officer (“CEO”). The CEO reviews theCompany’s financial information presented on a consolidatedbasis substantially similar to the accompanying consolidatedfinancial statements. Therefore, the Company has concluded thatit operates in one segment, the manufacture and servicing offlat panel display products, and accordingly has provided onlythe required enterprise wide disclosures.     The Company sells its products for the flat panel displayindustry directly to customers in Korea, Taiwan, China andJapan. The Company also, on a limited basis, sold in Japanthrough a value-added distributor, Ishikawajima-Harima HeavyIndustries Co., Ltd. (“IHI”). For geographicalreporting, revenue is attributed to the geographic location towhich the product was shipped. Long-lived assets consistprimarily of property, plant and equipment, and are attributedto the geographic location in which they are located.     The following is a summary of revenue by geographic area basedon location where the product was shipped:                 **Year Ended**  **September 30,**     **2005** **2004** **2003**         **(In thousands)**    Revenue:                 Korea $41,474  $68,450  $47,024      Taiwan  53,159   60,793   19,125      Japan  17,044   11,017   1,047      China  14,136   1,610   —                 Total $125,813  $141,870  $67,196           
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**     The following is a summary of revenue by product line:                 **Year Ended September 30,**     **2005** **2004** **2003**         **(Percent of total revenue)**    Revenue:                 ArrayCheckertm  60%  75%  81%     ArraySavertm  24%  19%  4%     RTP systems  —   1%  6%     PanelMastertm  5%  —   —      Spares and other  11%  5%  9%                Total  100%  100%  100%               Sales to individual unaffiliated customers in excess of 10% oftotal revenue were as follows:               **Year Ended**  **September 30,**     **2005** **2004** **2003**         **(Percent of revenue)**    Customer A  22%  39%  43%    Customer B  10%  *   23%    Customer C  11%  *   *     Customer D  *   13%  *     Customer E  12%  *   *     Customer F  12%  *   *     Customer G  *   10%  *     Customer H  *   10%  *     Customer I  *   *   13% *     Customer accounted for less than 10% of total revenue for the    period.     Accounts receivable from individual unaffiliated customers inexcess of 10% of total gross accounts receivable were as follows:           **September 30,**     **2005** **2004**       **(Percent of**  **gross accounts**  **receivable)**    Customer A  29%  29%    Customer B  19%  *     Customer C  19%  16%    Customer D  *   13%    Customer E  10%  *     Customer F  *   12%
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)** *     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,**     **2005** **2004**       **(In thousands)**    United States $21,022  $22,889     Canada  519   1,947     Other  1,183   407             Total $22,724  $25,243        **Note 13 —****Related Party Transactions**     During fiscal 2005, 2004 and 2003, the Company paid $108,000,$138,000 and $18,000, respectively, to one board member forconsulting services rendered to the Company. During fiscal 2005and 2004 the Company recorded approximately $52,000 and$206,000, respectively, in stock ownership expense related tooptions 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). Theloan amount was advanced to Photon Dynamics Canada, Inc.(“PDC”) under a program for pre-commercializationassistance in the development of glass inspection technology.Under this agreement, PDC would repay the NRC based on apercentage of gross revenue earned, on a quarterly basis,beginning on October 1, 2002. The amount repayable to NRCwas capped at 150% of the contribution amount received by PDC.The loan was repaid in full in fiscal 2005.     In the third quarter of fiscal 2004, the Company issued$2.0 million in a series of six promissory notes inconnection with the acquisition of Quantum Composers, Inc. Thenotes are non-interest bearing and mature at various timesthrough June 25, 2007. The discount on the notes of$127,000 was calculated based on an imputed interest rate of 6%.The outstanding balance on the promissory notes, net ofunamortized discount, was approximately $1.4 million and$1.9 million at September 30, 2005 and 2004,respectively.     In the fourth quarter of fiscal 2004, the Company issued a$625,000 promissory note in connection with the acquisition ofTORC. The note was non-interest bearing and matured onAugust 6, 2005. The discount on the note of $17,000 wascalculated based on an imputed interest rate of 3%. Theoutstanding balance on the promissory note, net of unamortizeddiscount, was approximately $0 and $608,000 atSeptember 30, 2005 and 2004, respectively.     The following table summarizes the repayment of notes payable asof September 30, 2005.                               **Payments Due by Fiscal Year**     **Total** **2006** **2007** **2008** **2009** **2010** **Thereafter**                 **(In thousands)**    Notes payable $1,500  $500  $1,000  $—  $—  $—  $— 
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)****Note 15 —****Quarterly Consolidated Results of Operations (Unaudited)**     The following tables contain selected unaudited consolidatedstatements of operations data for each quarter of fiscal 2005and 2004:                     **Three Months Ended**     **December 31,** **March 31,** **June 30,** **September 30,**  **2004** **2005** **2005** **2005**           **(In thousands, except per share data)**    Revenue $36,639  $25,326  $39,096  $24,752     Cost of revenue  22,781   18,768   25,966   15,217                  Gross margin  13,858   6,558   13,130   9,535     Operating expenses:                     Research and development  9,470   9,818   8,618   8,369      Selling, general and administrative  4,684   6,107   7,352   6,535      Restructuring charges  —   —   951   246      Impairment of fixed assets  —   382   174   81      (Gain) loss on sale of property and equipment  —   —   (143)  50      Amortization of intangible assets  397   398   380   373                    Total operating expenses  14,551   16,705   17,332   15,654                  Loss from operations  (693)  (10,147)  (4,202)  (6,119)    Interest income and other, net  1,255   164   472   327                  Income (loss) before income taxes  562   (9,983)  (3,730)  (5,792)    Provision for income taxes  39   359   167   59                  Income (loss) from continuing operations  523   (10,342)  (3,897)  (5,851)     Income (loss) from discontinued operations  (6)  (4)  268   (2)                  Net income (loss) $517  $(10,346) $(3,629) $(5,853)                 Net income (loss) per share from continuing operations:                     Basic $0.03  $(0.61) $(0.23) $(0.35)                  Diluted $0.03  $(0.61) $(0.23) $(0.35)                 Net income (loss) per share from discontinued operations:                     Basic $0.00  $(0.00) $0.02  $(0.00)                  Diluted $0.00  $(0.00) $0.02  $(0.00)                 Net income (loss) per share:                     Basic $0.03  $(0.61) $(0.21) $(0.35)                  Diluted $0.03  $(0.61) $(0.21) $(0.35)                 Weighted average number of shares:                     Basic  16,872   16,948   16,984   16,931      Diluted  17,009   16,948   16,984   16,931 
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**PHOTON DYNAMICS, INC.****NOTES TO CONSOLIDATED FINANCIALSTATEMENTS — (Continued)**                      **Three Months Ended**     **December 31,** **March 31,** **June 30,** **September 30,**  **2003** **2004** **2004** **2004**           **(In thousands, except per share data)**    Revenue $24,375  $26,182  $38,522  $52,791     Cost of revenue  13,412   14,183   20,711   35,663                  Gross margin  10,963   11,999   17,811   17,128     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                  Income (loss) from operations  (2,624)  1,849   5,240   2,395     Interest income and other, net  3,771   334   389   308                  Income before income taxes  1,147   2,183   5,629   2,703     Provision for income taxes  362   64   134   17                  Income from continuing operations  785   2,119   5,495   2,686     Income (loss) from discontinued operations  47   (1,276)  (265)  103                  Net income $832  $843  $5,230  $2,789                  Net income per share from continuing operations:                     Basic $0.05  $0.13  $0.33  $0.16                   Diluted $0.05  $0.12  $0.32  $0.16                  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 $0.05  $0.05  $0.31  $0.17                   Diluted $0.05  $0.05  $0.31  $0.16                  Weighted average number of shares:                     Basic  16,461   16,572   16,663   16,826      Diluted  17,174   17,172   17,071   16,977 
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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 bereported under this Item 9.**Item 9A.*****Controls and Procedures******Evaluation of Disclosure Controls and Procedures***     Photon Dynamics maintains disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934, as amended (the “ExchangeAct”)) that are designed to ensure that informationrequired to be disclosed in the reports we file or submit underthe Exchange Act is recorded, processed, summarized, andreported within the time periods specified in the Securities andExchange Commission rules and forms, and that such informationis accumulated and communicated to management, including ourchief executive officer and chief financial officer, asappropriate to allow timely decisions regarding requireddisclosure.     Based on our management’s evaluation (with theparticipation of our chief executive officer and chief financialofficer), our chief executive officer and chief financialofficer have concluded that, as of September 30, 2005, ourdisclosure controls and procedures were not effective to providereasonable assurance that the information required to bedisclosed by us in reports that we file or submit under theExchange Act is recorded, processed, summarized and reportedwithin the time periods specified in Securities and ExchangeCommission rules and forms, and that such information isaccumulated and communicated to management, including our chiefexecutive officer and chief financial officer, as appropriate toallow timely decisions regarding required disclosure, due to thematerial weakness in our internal control over financialreporting described in “Management’s Report onInternal Control Over Financial Reporting” below.***Management’s Report on Internal Control Over    Financial Reporting***     Our management is responsible for establishing and maintainingadequate internal control over financial reporting, as definedin Rules 13a-15(f) and 15d-15(f) under the Securities andExchange Act of 1934. Internal control over financial reportingis a process designed to provide reasonable assurance regardingthe reliability of financial reporting and the preparation offinancial statements for external purposes in accordance withgenerally accepted accounting principles in the United States.     Under the supervision and with the participation of ourmanagement, including our chief executive officer and chieffinancial officer, we conducted an evaluation of the design andoperational effectiveness of our internal control over financialreporting as of September 30, 2005, the end of the fiscalyear covered by this report based on the framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission(“COSO”) in *Internal Control — IntegratedFramework.* Based on this evaluation, management concludedthat as of September 30, 2005, Photon Dynamics did notmaintain effective internal control over financial reporting inaccordance with the COSO criteria, because management determinedthat we had a material weakness in the design and operatingeffectiveness of our internal control over financial reportingat September 30, 2005.     A material weakness is a control deficiency or combination ofcontrol deficiencies that results in more than a remotelikelihood that a material misstatement of the annual or interimfinancial statements will not be prevented or detected. Inconnection with the evaluation and testing of internal controlover financial reporting, as required by Section 404 of theSarbanes-Oxley Act of 2002, we identified the following materialweakness that existed at September 30, 2005:          A material weakness in our financial reporting process arising    from not contemporaneously documenting and evaluating complex    and unusual transactions of a material nature and communicating    such evaluation to our Audit Committee on a timely basis. This    material weakness results in more than a remote likelihood that    a material misstatement to any of our significant financial    statement accounts will not be prevented or detected in the    annual or interim financial statements and this material    weakness resulted in the restatement of the deferred margin and    cost of revenue accounts in our unaudited interim financial    statements for the third quarter of fiscal 2005.
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     Management’s assessment of the effectiveness of ourinternal control over financial reporting as ofSeptember 30, 2005, was audited by Ernst & YoungLLP, our independent registered public accounting firm thataudited our financial statements included in this Annual Reporton Form 10-K. Ernst & Young LLP has issued anattestation report on management’s assessment of ourinternal control over financial reporting as ofSeptember 30, 2005, which report is included Item 8 ofthis Annual Report on Form 10-K and is incorporated here byreference.***Changes in Control Over Financial Reporting in the Fourth    Quarter of Fiscal 2005***     During the fourth fiscal quarter, we implemented the followingchanges in our internal control over financial reporting, thathave materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting: •     We continued training our key personnel worldwide in technical    revenue recognition concepts and our sales order fulfillment    process.  •     We strengthened and increased the level of review of our actual    versus forecasted results of operations.  •     We enhanced our cost of revenue review to include analyses of    actual versus forecasted gross margins on complex transactions.***Remediation of the Material Weakness That Existed as of    September 30, 2005***     Our management is taking very seriously the material weaknessidentified by management as of September 30, 2005 and isundertaking the following actions to remediate such materialweakness:          We are implementing a policy requiring the contemporaneous    documentation and evaluation of complex and unusual transactions    which are material either by the size or the nature of the    transaction. In conjunction with this policy, we are    implementing more rigorous controls for ensuring that those    transactions which involve a significant level of management    judgment or which by the nature of the transactions rise to the    level of communication are communicated to the Audit Committee    on a timely basis.***Inherent Limitations of Disclosure Controls and Procedures    and Internal Control Over Financial Reporting.***     Our management, including the chief executive officer and chieffinancial officer, does not expect that our disclosure controlsand procedures or internal control over financial reporting willprevent all error and all fraud. A control system no matter howwell designed and implemented, can provide only reasonable, notabsolute, assurance that the control system’s objectiveswill be met. Further, the design of a control system mustreflect the fact that there are resource constraints, and thebenefits of controls must be considered relative to their costs.Because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that allcontrol issues within a company are detected. The inherentlimitations include the realities that judgments indecision-making can be faulty, and that breakdowns can occurbecause of simple error or mistakes. Controls can also becircumvented by the individual acts of some persons, bycollusion of two or more people or by management override of thecontrols. Because of the inherent limitations in acost-effective control system, misstatements due to error orfraud may occur and not be detected.**Item 9B.*****Other Information***     On December 13, 2005, we entered into an agreement withJeffrey A. Hawthorne, our Chief Executive Officer, pursuantto which in the event of a termination ofMr. Hawthorne’s employment without cause orMr. Hawthorne’s resignation for good cause, in eachcase within 12 months after a change of control ofPhoton Dynamics, Mr. Hawthorne is entitled to receiveone year of his then-existing base salary and on-target bonuses.In addition, all stock options granted to him by Photon Dynamicswill become fully vested and exercisable as of the date of thechange of control.
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**PART III**     Certain information required by Part III is omitted fromthis Annual Report on Form 10-K since we intend to file ourdefinitive Proxy Statement for our 2006 Annual Meeting ofShareholders, pursuant to Regulation 14A of the SecuritiesExchange Act of 1934, as amended (the “ProxyStatement”), not later than 120 days after the end ofthe fiscal year covered by this Annual Report on Form 10-K,and certain information to be included in the Proxy Statement isincorporated herein by reference.**Item 10.*****Directors and Executive Officers of the Registrant***     The information required by this Item with respect to ExecutiveOfficers may be found under the caption, “ExecutiveOfficers of the Registrant” at the end of Part I,Item 1 of this Annual Report on Form 10-K. Theinformation required by this Item with respect to Directors,including information with respect to our audit committee andour audit committee financial experts, may be found under thesection entitled “Proposal 1 — Election ofDirectors” appearing in the Proxy Statement. Suchinformation is incorporated herein by reference. The informationrequired by this Item with respect to compliance withSection 16(a) of the Securities Exchange Act of 1934 andour code of ethics may be found in the sections entitled“Section 16(a) Beneficial Ownership ReportingCompliance” and “Proposal 1 — Electionof Directors — Code of Business Conduct andEthics,” 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 byreference to the information from the Proxy Statement under thesection entitled “Executive Compensation.”**Item 12.*****Security Ownership of Certain Beneficial Owners and    Management and Related Stockholder Matters***     The information required by this Item with respect to securityownership of certain beneficial owners and management isincorporated herein by reference to the information from theProxy Statement under the section entitled “SecurityOwnership of Certain Beneficial Owners and Management.” Theinformation required by this Item with respect to securitiesauthorized for issuance under our equity compensation plans isincorporated herein by reference to the information from theProxy Statement under the section entitled “EquityCompensation Plan Information.”**Item 13.*****Certain Relationships and Related Transactions***     The information required by this Item is incorporated herein byreference to the information from the Proxy Statement under thesection entitled “Certain Relationships and RelatedTransactions.”**Item 14.*****Principal Accountant Fees and Services***     The information required by this Item is incorporated herein byreference to the information from the Proxy Statement under thesection entitled “Proposal 2 — Ratificationof Selection of Independent Registered Public AccountingFirm.”**PART IV****Item 15.*****Exhibits and Financial Statement Schedules***     (a) 1. *Financial Statements*     See Index to Consolidated Financial Statements in Item 8 ofthis Annual Report on Form 10-K, which is incorporatedherein by reference.     2. *Financial Statement Schedules*     The following financial statement schedule is filed as part ofthis annual report on Form 10-K. All other financialstatement schedules have been omitted because they are eithernot applicable or the required information is shown in theconsolidated financial statements or notes thereto.
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**SCHEDULE II****PHOTON DYNAMICS, INC.****VALUATION AND QUALIFYING ACCOUNT**                        **Year Ended September 30,**     **Balance at** **Charged to** **Charged to** **Balance at**    **Beginning** **(Credited to)** **Other** **End of**    **of Period** **Expense** **Accounts** **Deductions** **Period**             **(In thousands)**    Allowance for doubtful accounts:                         2005 $497   (324)  —   (20) $153      2004 $726   —(1)  —   (229)(2) $497      2003 $1,466   3,132(1)  —   (3,872)(2) $726  (1)     Includes charges to expense from discontinued operations of    approximately $0, $0 and $2.9 million in fiscal 2005, 2004    and 2003, respectively. (2)     Includes write-offs of uncollectible accounts from discontinued    operations of approximately $0, $0 and $3.9 million in    2005, 2004 and 2003, respectively.
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     3. *Exhibits*     See the Exhibit Index which follows the signature page ofthis Annual Report on Form 10-K, which is incorporatedherein by reference.     (b) *Exhibits*     See Item 15(a) above.     (c) *Financial Statement Schedules*     See Item 15(a) above.
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**SIGNATURES**     Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the registrant has duly causedthis 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, 2005**POWER OF ATTORNEY**     KNOW ALL PERSONS BY THESE PRESENT, that each person whosesignature appears below constitutes and appoints Jeffrey A.Hawthorne and Maureen L. Lamb, and each of them, actingindividually, as his attorney-in-fact, each with full power ofsubstitution and resubstitution, for him or her and in his orher name, place and stead, in any and all capacities, to signany and all amendments to this Annual Report on Form 10-K,and to file the same, with all exhibits thereto, and otherdocuments in connection therewith, with the Securities andExchange Commission, granting unto said attorneys-in-fact andagents, and each of them, full power and authority to do andperform each and every act and thing requisite and necessary tobe done in connection therewith and about the premises, as fullyto all intents and purposes as he or she might or could do inperson, hereby ratifying and confirming all that saidattorneys-in-fact and agents, or any of them, or their or his orher substitute or substitutes, may lawfully do or cause to bedone by virtue hereof.     **Pursuant to the requirements of the Securities Exchange Actof 1934, this report has been signed below by the followingpersons on behalf of the registrant and in the capacities and onthe dates indicated.**       **Signature** **Title** **Date**          /s/ JEFFREY A. HAWTHORNE