<PAGE>

               UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549

                                  FORM 10-KSB

  [X]ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
     ACT OF 1934 (the "Exchange Act") for the fiscal year ended
     September 30, 1999.

  [_]TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934.

                        Commission File Number: 0-27234

                             PHOTON DYNAMICS, INC.
                (Name of small business issuer in its charter)

<TABLE>
<S>                                            <C>
                 California                                      94-3007502
       (State or other jurisdiction of              (I.R.S. Employer Identification No.)
       incorporation or organization)
</TABLE>

                            6325 San Ignacio Avenue
                              San Jose, CA 95119
                   (Address of principal executive offices)

                                (408) 226-9900
                          (Issuer's telephone number)

     Securities registered pursuant to Section 12(b) of the Exchange Act:
                                     None

     Securities registered pursuant to Section 12(g) of the Exchange Act:
                                 Common Stock

Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past 90 days.   YES [X]  NO
[_]

Check if disclosure of delinquent filers in response to Item 405 of Regulation
S-B is not contained in this form, and no disclosure will be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-KSB or any amendment to
this Form 10-KSB.  [X]

Revenue for the year ended September 30, 1999 was $31,562,000.

The aggregate market value of the voting stock held by non-affiliates of the
registrant, based on the closing price of the Common Stock on October 20,
1999, as reported on the Nasdaq National Market, was approximately
$172,674,192. Shares of Common Stock held by each officer and director and by
each person who owns 5% or more of the outstanding Common Stock have been
excluded from this computation in that such persons may be deemed to be
affiliates. This determination of affiliate status is not necessarily a
conclusive determination for other purposes.

As of of October 20, 1999, the registrant had 7,816,041 shares outstanding of
Common Stock.

Transitional Small Business Disclosure Format (check one)  Yes [_]  No [X]

                      DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant's Proxy Statement for its 2000 Annual Meeting of
Shareholders are incorporated by reference in Part III of this Form 10-KSB
report.
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                             PHOTON DYNAMICS, INC.

                          ANNUAL REPORT ON FORM 10-KSB

                               TABLE OF CONTENTS


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No.                                                                                               Page
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                                     PART I

<S>       <C>                                                                                     <C>
Item 1.   Description of Business................................................................   3
Item 2.   Description of Property................................................................  15
Item 3.   Legal Proceedings .....................................................................  15
Item 4.   Submission of Matters to a Vote of Security Holders....................................  15

                                    PART II

Item 5.   Market for Common Equity and Related Stockholder Matters...............................  16
Item 6.   Management's Discussion and Analysis of Financial Condition and Results of Operations..  18
Item 7.   Consolidated Financial Statements .....................................................  22
Item 8.   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure...  36

                                    PART III

Item 9.   Directors, Executive Officers, Promoters and Control Persons...........................  37
Item 10.  Executive Compensation.................................................................  38
Item 11.  Security Ownership of Certain Beneficial Owners and Management.........................  38
Item 12.  Certain Relationships and Related Transactions.........................................  38
Item 13.  Exhibits and Reports on Form 8-K.......................................................  38
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  The statements contained in this report on Form 10-KSB that are not purely
historical are forward-looking statements within the meaning of Section 27A of
the Securities Act of 1933 and Section 21E of the Securities Exchange Act of
1934, including statements regarding the Company's expectations, hopes,
intentions, or strategies regarding the future. All forward-looking statements
included in this document are based on information available to the Company on
the date hereof, and the Company assumes no obligation to update any such
forward-looking statements. It is important to note that the Company's actual
results could differ materially from those in such forward-looking statements.
You should consult the risk factors listed from time to time in the Company's
reports on Form 10-QSB and annual reports to shareholders. Among the factors
that could cause actual results to differ materially are those discussed under
"Risks Relating to the Business of PDI" and elsewhere in this Form 10-KSB.

                                    PART I

ITEM 1: DESCRIPTION OF BUSINESS

Overview

  Photon Dynamics, Inc. ("PDI" or the "Company") is a leading worldwide
supplier of array test, inspection and repair systems for the flat panel
display ("FPD") industry. PDI's systems are used to control, monitor and
refine the manufacturing process to increase the yield of FPDs, to reduce
materials loss, to transition new FPD designs from research and development to
commercial production and to assist in the rapid start-up of new FPD
manufacturing facilities. While certain aspects of the manufacturing processes
for FPDs are similar to manufacturing processes for semiconductor devices,
materials costs represent a substantially higher percentage of the cost of an
FPD as compared with semiconductor devices. As a result, the need for array
test and inspection of FPDs goes beyond the need to improve yields as FPD
manufacturers seek to identify defects early in the manufacturing process
either to avoid investment of further materials cost or to repair the defect
before further manufacturing steps make it less accessible. PDI believes that
more of its systems have been used by manufacturers of active matrix liquid
crystal displays ("AMLCDs") and other advanced FPDs to array test, inspect and
repair high resolution FPDs than any other currently available system. PDI
believes that the experience it has acquired from the wide use of its systems
has enabled it to become a leading technical innovator of array test,
inspection and repair equipment for advanced FPD manufacturers. PDI offers a
variety of products to inspect almost all current types of commercially
produced FPDs and to address all key areas of AMLCD test, inspection and
repair throughout all major stages of the manufacturing life cycle, from
research and development through commercial production as noted below:

  . PDI's array test products include test systems that locate, count and
    characterize electrical array faults, contamination and other defects on
    partially completed FPD substrates.

  . PDI's inspection products perform flat panel cell and module inspection
    to detect and locate optical defects in FPDs.

  . PDI's repair products perform array laser cut and weld repair functions
    based upon information generated by its array test products.

  All of PDI's product lines interface with one another through software
systems used to store data and generate reports and other information used by
FPD manufacturers to increase their yields. PDI's products incorporate
proprietary technologies that enable FPD manufacturers to obtain information
critical to yield improvement and management of manufacturing processes that
had not previously been readily available to FPD manufacturers. PDI's
proprietary Voltage Imaging(TM) and N-Aliasing(TM) technologies, in
conjunction with its proprietary software programs, permit non-contact, full
characterization and image evaluation of almost all commercially produced FPD
displays, regardless of panel size or the FPD technology employed. All of
PDI's product lines are currently being used with video graphics array
("VGA"), super video graphics array ("SVGA"), extended graphics array ("XGA"),
and super extended graphics array ("SXGA") displays and are designed for use
with next generation ultra extended graphics array ("UXGA") displays.

                                       3
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Industry Background

  Overview of Flat Panel Display Market. The market for FPDs has grown
significantly in recent years as the result of the increasing popularity of
portable computers and other electronic devices that display textual or
graphical information. The weight and thin form factor of FPDs enable new
display applications not supported by the previously predominant monitor
technology, cathode ray tubes. Laptop and notebook computers, personal digital
assistants, portable video games, digital phones, and a variety of devices for
the automotive, technical, medical, and military markets are examples of
electronic products in markets that cannot be served by cathode ray tube
technology.

  Different applications for FPDs have varying cost, size and performance
requirements, and alternative FPD technologies have been developed to address
these different applications. Different types of FPDs that are currently being
produced to address certain segments in the broader FPD market include liquid
crystal ("LCD"), plasma, electroluminescent, field emissive displays, organic
light emitting diode, digital micro-mirror devices and mini and micro displays
utilizing liquid crystal on silicon. Currently the most common type of FPD is
the LCD, which first emerged in the form of watch and calculator displays in
the 1970's. The most advanced form of LCD available today is the thin-film
transistor, AMLCD, which utilizes three individual emissive transistors at
each pixel. This enables the AMLCD both to produce full color images and to
operate at much faster refresh rates than earlier passive monochrome LCDs. The
color capability, resolution, speed, and picture quality of AMLCDs currently
make these displays the preferred choice for high performance portable
computers, multimedia and other applications requiring the display of video
and graphics. The trend toward higher resolution video and graphic displays
has been reflected in the evolution from VGA displays (640 x 480 lines of
resolution) to SVGA displays (800 x 600 lines of resolution) to XGA displays
(1,024 x 768 lines of resolution) which in turn are being replaced by next-
generation SXGA displays (1,280 x 1,024 lines of resolution) and soon UXGA
displays (1,600 x 1,200 lines of resolution). To achieve higher resolution
display capability and enhanced picture quality, the number of pixels
integrated in AMLCDs has increased, which in turn increases the complexity of
the manufacturing process.

  The AMLCD Flat Panel Display Manufacturing Process. The manufacture of
AMLCDs is an extremely complex process, which is developed and refined for
different panel sizes and resolutions through research and development, pre-
production prototyping and commercial production. Manufacturing an AMLCD
involves a series of three principal steps. The first step is to build an
array of thin-film transistors on a glass substrate through a process which is
essentially the same as that used to create electronic circuitry on a
semiconductor device. In a high-quality color AMLCD, each pixel, the smallest
addressable dot on the display, is represented by three transistors, one for
each of the primary colors, i.e., red, green and blue. The next step involves
attaching a color filter to the transistor-embedded substrate and injecting
liquid crystal material between the color filter and the transistor array. The
color filter enables the display to attain color capability by selectively
filtering out the light emissions from each multi-color pixel array to produce
the desired color mix in the displayed image. At this second step, the "cell"
for each pixel is created through the combination of transistors and a color
filter. The last step in the process is to package the display and attach the
electronics that will interpret and convert the electronic signals directed by
the computer or other electronic system to the AMLCD and cause it to display
the desired text, graphics and video images. This step also involves sealing
the FPD and installing the electronics that connect the FPD to other
electronic devices like a computer.

  Current Yield and Cost Problems Experienced by FPD Manufacturers. While
there are many similarities between the techniques used to manufacture
semiconductor devices and FPDs such as AMLCDs, the manufacture of FPDs is
different in a number of ways that expose the FPD manufacturer to potentially
greater risk from yield loss throughout the manufacturing process. The cost
structure for the manufacture of FPDs is very different from semiconductor
devices in that materials costs represent a much larger percentage of the
total product cost to the FPD manufacturer. Second, the manufacture of FPDs
combines both electrical manufacturing techniques as well as a number of
complex non-electrical manufacturing steps such as the manufacture and
alignment of the color filter at exacting physical tolerances. Third, because
of the visual function performed by FPDs, an FPD must satisfy certain visual
criteria and have consistent resolution, color and quality to be

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acceptable to the end user. Some types of visual deficiencies such as
variations in screen brightness, color or blurred resolution are unrelated to
electrical defects and can cause substantial yield losses. These defects
cannot be detected by traditional automated semiconductor array test
equipment. Due to these factors, the AMLCD industry continues to experience
substantial yield losses and to incur significant materials costs in the
manufacture of FPDs.

  The ability of FPD manufacturers to improve yields of AMLCDs and other FPDs
depends in large part on their ability to test and inspect displays during the
manufacturing process and to use test and inspection data to refine the
manufacturing process. Through inspection, the FPD manufacturer seeks to
identify defects at an early stage in the process to repair and save the
product or to avoid adding more cost to a defective product. PDI estimates
that 80% of the overall cost of manufacturing a typical full color AMLCD is
incurred in later stage manufacturing steps after the primary transistor array
has been developed on the glass substrate. PDI believes that material costs
can be reduced through in-process testing if yield defects in the
manufacturing process can be properly detected at earlier stages. In addition,
systematized inspection provides qualitative feedback to the FPD manufacturer
and enables it to address yield problems and enhance the manufacturing
process. Because of this critical role of yield in reducing FPD manufacturing
costs, the FPD industry is now generally recognizing the need for automated
FPD array test, inspection and repair equipment and seeking yield-enhancing
solutions at all stages of the FPD manufacturing process. PDI believes that
this need has become much more acute recently as AMLCDs have become
increasingly more complex, and the market has evolved from existing standard
displays to the higher resolution displays.

Products

  PDI offers a variety of products to inspect almost all commercially produced
FPDs. All of PDI's systems use similar software based controls, processing and
graphical user interfaces. Products can be networked together so that FPD
defect data can be stored, analyzed and used throughout the manufacturing
process. All of PDI's systems are capable of providing fully automated
functionality through robotics purchased from third party vendors.

  Array Test Systems. PDI's array test systems use its proprietary Voltage
Imaging(TM) technology to detect, locate, quantify and characterize electrical
contamination and other defects in AMLCD arrays after the completion of the
first major step of production, the construction of the transistor array on
the glass substrate. The systems incorporate a computer workstation and
proprietary image processing software to display pixel images and information
which not only allows manufacturers to determine whether individual pixels or
lines of pixels are functional but also allows them to find more subtle
defects such as individual pixel voltage variations early in the production
process. In addition, these systems generate point and line defect data files
specifying the exact location of each defect, which can then be used for
statistical process control or downloaded to PDI's repair systems to affect
repairs. The systems also perform key procedures involved in the array testing
process including running test sequences and loading, unloading and sorting
substrates. The array test systems can be adapted to test different panel
sizes in less than three hours as compared with systems using probe card
technology, which PDI estimates can require up to sixteen hours. The currently
available ArrayChecker system is an enhanced version of earlier array test
systems that uses optimized processing software, graphical user interface and
materials transport features. These features have been designed to enable the
ArrayChecker system to achieve throughput rates that are similar to
conventional probe card based systems while providing the same functionality,
flexibility and cost-efficient features of the earlier array test systems.

  Flat Panel Inspection Systems. PDI's Flat Panel Inspection ("FIS") systems
use PDI's proprietary N-Aliasing(TM) technology to inspect almost any type and
size of commercially available FPD panel for optical defects after the
completion of the cell stage of production. FIS systems are also designed to
perform inspection after final module assembly of FPD panels. The systems use
a single high-resolution camera and workstation operating PDI's N-Aliasing(TM)
software to quantitatively measure critical optical qualities such as
contrast, luminance and color balance and to precisely locate blemish, line,
cluster, and individual pixel defects. Test data generated by the systems is
displayed on a video monitor to permit immediate visual interpretation and can
be

                                       5
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stored or sent to a repair system to affect repairs. Inspection systems
comprise a family of products that offer different levels of resolution,
functionality and flexibility to suit customers' needs. Currently available
systems include PanelMaster 300, SpotLite, Muralook, and MicroMaster. The
systems are available either as stand-alone units or as modular systems
designed to be integrated with manufacturers' materials handling equipment.

  Array Repair Systems. PDI's repair systems use a laser to repair defects in
AMLCD and passive LCD panels. These repair systems can use defect files
downloaded from PDI's array test or inspection systems to automatically locate
the defects in the panel so that the operator can decide whether or not to
repair them. This capability saves operator time searching for the defects
among the hundreds of thousands of pixels on a display.

Intellectual Property

  PDI has been issued thirty-four active U.S. patents with respect to its FPD
array test, inspection and repair technologies and has some U.S. and foreign
applications pending. PDI has a number of U.S. patents related to its Voltage
Imaging(TM) technology and has applied for U.S., Japanese and Korean patents
related to this technology as well as its repair and inspection technology. No
patents are scheduled to expire before 2008, subject to payment of applicable
maintenance fees. In addition, PDI and Ishikawajima-Harima Heavy Industries
Co., Ltd. ("IHI") have jointly filed patent applications in Japan relating to
some aspects of the array test systems.

  PDI frequently reviews its inventions and attempts to determine which
inventions will provide substantial differentiation between PDI's products and
those of its competitors. In certain cases, PDI may also choose to keep an
invention or a process as a trade secret. Trade secrets are routinely employed
in PDI's manufacturing processes. PDI has entered into non-disclosure
agreements to protect its proprietary technology with its employees and
consultants and, in some instances, with its suppliers, its customers and IHI.
Because of rapid technological developments in the electronics and FPD
industries and the broad and rapidly developing patent coverage in such
industries, the patent position of any manufacturer, including PDI, is subject
to uncertainties and may involve complex legal and factual issues.
Consequently, although PDI holds certain patents and is currently processing
additional patent applications, there can be no assurance that patents will
issue from any pending applications. Furthermore, claims allowed by any
existing or future patents issued to PDI may be challenged, invalidated or
circumvented, and any rights granted thereunder may not provide adequate
protection to PDI. Others may develop technologies that are similar or
superior to PDI's technology, duplicate PDI's technology or design around the
patents owned by PDI. In addition, effective copyright and trade secret
protection may be unavailable or limited in certain foreign countries.

  In addition, litigation may be necessary in the future to enforce PDI's
patents and other intellectual property rights, to protect PDI's trade
secrets, to determine the validity and scope of the proprietary rights of
others, or to defend against claims of infringement or invalidity. Such
litigation could result in substantial costs and diversion of resources and
could have a material adverse effect on PDI's results of operations or
financial condition. Moreover, PDI may be required to participate in
interference proceedings to determine the priority of inventions, which could
also result in substantial cost to PDI. See "Risks Relating to the Business of
PDI--PDI May Be Unable to Protect Its Proprietary Information and Procedures."

Research and Development

  The market for FPD array test, inspection and repair systems is
characterized by rapid and continuous technological development and product
innovation. PDI believes that continued and timely development of new products
and enhancements to existing products is necessary to maintain its competitive
position. Accordingly, PDI devotes a significant portion of its personnel and
financial resources to research and development programs and seeks to maintain
close relationships with customers to remain responsive to their product
needs. PDI's current research and development efforts are directed to
increasing the performance of its flat panel inspection and array test systems
and expanding the application of its inspection systems for use in other
related markets. Because the software incorporated by PDI into its products
represents a significant portion of the value added by these products, almost
one-half of PDI's research and development personnel are focused on software
development.

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  PDI's research and development expenses were $5.2 million, or 16% of
revenue, in fiscal 1999 as compared to $5.9 million, or 26% of revenue, in
fiscal 1998. Research and development expenses consist primarily of salaries,
project materials and other costs associated with PDI's ongoing efforts to
improve and enhance PDI's products.

  PDI has obtained substantial development funding from IHI with respect to
PDI's array test systems. IHI has provided funding for initial feasibility
studies and development of the first prototypes of array test systems, and
since 1990, IHI has provided PDI in excess of $8 million in research and
development funding with respect to the array test systems. In exchange for
this funding, IHI has been granted certain licenses and joint ownership rights
to the developed technology. See "Risks Relating to the Business of PDI--PDI
Depends on Its Relationship with IHI to Market Its Products in Asia and
Elsewhere."

  PDI has entered into contracts with the U.S. government and private
companies, including IHI, to develop products, which PDI is then able to sell
with certain restrictions. PDI generally owns all of the intellectual property
developed under these contracts. However, PDI has licensed certain rights to
its array test technology to the U.S. government which may transfer its
license to a third party for use in products sold to U.S. customers in the
event that PDI becomes unable to deliver array test systems to U.S. customers.

Customers, Sales and Service

  PDI sells its products to leading FPD manufacturers. Sales to LG
Electronics, Inc. represented 16% and 27% of revenue in fiscal 1999 and fiscal
1998, respectively. Overall, PDI's top four customers contributed 78% of
revenue in fiscal 1999 as compared to 92% of revenue in fiscal 1998.
International sales accounted for 99% and 96% of revenue in fiscal 1999 and
fiscal 1998, respectively. See "Risks Relating to the Business of PDI--The
Future Performance of PDI Depends in Part on Future Growth in the Japanese,
Taiwanese and Korean Markets," "--PDI's International Operations Create
Specialized Risks that Can Negatively Affect Its Business" and "--A Few
Customers Have Accounted for a Significant Percentage of PDI's Revenues."

  PDI's revenue is obtained primarily from FPD manufacturers and, to a lesser
extent, through IHI, a value-added reseller in Japan, and a sales
representative in Taiwan. During fiscal 1997, PDI entered into a memorandum of
understanding with IHI expanding the number of product lines sold and serviced
in Japan by IHI from one to three. In the quarter ended June 30, 1997, PDI
shipped its first inspection and repair systems to IHI. During fiscal 1999 and
fiscal 1998, PDI continued to work under the provisions of the memorandum of
understanding with IHI. Sales to IHI were $8.3 million in fiscal 1999 as
compared to $10.1 million in fiscal 1998. A final agreement with IHI may not
be negotiated on a timely basis or on terms favorable to PDI. See "Risks
Relating to the Business of PDI--PDI Depends on Its Relationship with IHI to
Market Its Products in Asia and Elsewhere."

  In the U.S., PDI maintains its sales and service office at its headquarters
in San Jose, California. In Asia, PDI has subsidiaries in Tokyo, Japan and
Seoul, Korea that provide direct sales, marketing and service support. In
Japan, PDI's products are also serviced by IHI.

  PDI generally sells its products on net-30 day terms to its customers with a
small portion held back until final acceptance. However, a substantial portion
of its customers, primarily foreign, remits payments on significantly longer
terms. PDI generally warrants its products for a period of one year from final
acceptance by customers. Installation is generally included in the price of
the product. PDI's field service providers provide customers with repair and
maintenance services. Customers may enter into repair and maintenance service
contracts covering PDI's products. PDI provides customer training for a fee to
enable its customers to perform routine service and provides telephone
consultation services generally free of charge. PDI does not consider its
business to be seasonal in nature, but it may become cyclical with respect to
the capital equipment procurement practices of major FPD manufacturers.

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Manufacturing and Suppliers

  PDI's principal manufacturing activities take place in San Jose, California
and consist primarily of final assembling and testing of subassemblies which
are acquired from third party vendors. Some of the components and
subassemblies included in PDI's systems are obtained from a single source or a
limited group of suppliers. For example, PDI has obtained all of the high-
speed image processing systems, materials handling platforms and ultra-high
resolution cameras used in its products from single source suppliers. PDI has
not entered into any formal agreements with such suppliers, other than long-
term purchase orders, and, in some cases, volume pricing agreements. The
partial or complete loss of such suppliers could:

  . increase PDI's manufacturing costs

  . delay product shipments while PDI qualifies a new supplier

  . require redesigning PDI's products and could, therefore, have an
    adverse effect on PDI's results of operations and damage customer
    relationships

  Further, a significant increase in the price of one or more of the
components supplied by these suppliers could increase PDI's cost of goods sold
and reduce its profit margins.

  PDI schedules production based upon customer purchase orders and anticipated
orders during the planning cycle. PDI generally expects to be able to accept a
customer order, build the required machinery and ship to the customer within
sixteen weeks. Quality control is maintained through incoming inspection of
components, in-process inspection during equipment assembly and final
inspection and operation of all manufactured equipment prior to shipment. PDI
works in close collaboration with its employees, customers and suppliers and
trains all of its employees in basic quality. Although PDI conducts final
testing of its systems and assembles some components under limited clean room
conditions, most manufacturing occurs in standard manufacturing space.

  PDI has granted certain exclusive rights to IHI to manufacture array test
systems developed prior to June 1997 for Japan, Korea and the remaining IHI
territory. Under the terms of PDI's agreements with IHI, PDI retains the right
to manufacture certain critical components for the array test systems and to
sell these components to IHI at prices that are established annually, and IHI
has the right to manufacture and assemble the balance of the array test
systems to be sold in its territories. To date, IHI has allowed PDI to
manufacture all array test systems for IHI, which has acted as a reseller in
Japan and performed customization of the array test systems for the Japanese
market and its individual customers in that market. To the extent IHI
determines in the future to fully exercise its contractual right to
manufacture and sell these systems for the IHI territory, such action would
reduce PDI's revenue attributable to these IHI manufactured array test
systems. See "Risks Relating to the Business of PDI--PDI Depends on Its
Relationship with IHI to Market Its Products in Asia and Elsewhere".

Backlog

  As of September 30, 1999, PDI's backlog was $20.2 million as compared to
$8.3 million as of September 30, 1998. In addition, 73% of PDI's backlog at
fiscal 1999 year-end was comprised of orders from three customers as compared
to 82% of orders comprised of one customer in fiscal 1998. PDI's backlog
consists of customer orders for which it has accepted purchase orders and
assigned shipment dates within the next twelve months. All orders are subject
to delay or cancellation with limited or no penalty to the customer. Because
of possible changes in product delivery schedules and cancellation of product
orders, orders received by PDI in any particular quarter may vary
significantly. Because PDI's sales will often reflect orders shipped in the
same quarter they are received, PDI's backlog may vary significantly and, at
any particular date, is not necessarily indicative of actual sales for any
succeeding period.

Competition

  The FPD equipment industry is highly competitive. PDI faces substantial
competition from established companies, many of which are larger companies,
have greater financial, engineering and manufacturing resources

                                       8
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than PDI and have larger service organizations and long-standing customer
relationships with major FPD manufacturers. Furthermore, in the event that PDI
is unsuccessful in negotiating a new agreement with IHI, IHI may compete with
PDI selling PDI's array test systems in Japan, Korea and the remaining IHI
territory. See "Risks Relating to the Business of PDI--PDI Depends on Its
Relationship with IHI to Market Its Products in Asia and Elsewhere." Sales to
IHI were $8.3 million in fiscal 1999 as compared to $10.1 million in fiscal
1998. PDI also expects to face additional competition from new entrants into
the FPD equipment industry and from competitors utilizing new technologies.
PDI's competitors are expected to continue to improve the design and
performance of their products and to introduce new products with competitive
price/performance characteristics. In addition, PDI's customers may choose to
develop proprietary technology and FPD equipment, which may obviate or lessen
their need to purchase PDI's products. PDI's customers may also use multiple
technologies and solutions, including competitors' products, to replicate the
functionality of PDI's systems. Competitive pressures may necessitate price
reductions, which could adversely affect PDI's results of operations. Although
PDI believes that it has certain technological and other advantages over its
competitors, realizing and maintaining such advantages will require a
continued high level of investment by PDI in engineering, research and
development, marketing and customer service and support. PDI may not have
sufficient resources to continue to make such investments. Even if sufficient
funds are available, PDI may not be able to make the technological advances
necessary to maintain such competitive advantages.

Employees

  As of September 30, 1999, PDI employed 106 persons. Many of PDI's employees
are highly skilled, and PDI's success will depend, in part, upon its ability
to retain such employees and attract new qualified employees who are in great
demand. PDI has never had a work stoppage or strike, and no employees are
represented by a labor union or covered by a collective bargaining agreement.
PDI considers its employee relations to be good. See "Risks Relating to the
Business of PDI--The Inability to Attract or Loss of PDI's Key Employees Could
Negatively Affect PDI."

Facilities

  PDI's corporate headquarters is located in San Jose, California and consists
of a 50,000 square foot facility. The lease expires in 2002. PDI also leases
office space for its sales and service operations in Tokyo, Japan and Seoul,
Korea.

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                     RISKS RELATING TO THE BUSINESS OF PDI

The Operating Results of PDI Are Volatile and Difficult to Predict

  PDI has experienced and expects to continue to experience significant
fluctuations in its quarterly results of operations. PDI derives most of its
revenue from the sale of a relatively small number of systems, which typically
range in price from $400,000 to $1.5 million. As a result, the timing of the
sale of a single system could have a significant impact on PDI's quarterly
revenue and results of operations. For example, PDI may experience
unanticipated shipment reschedulings, cancellations by customers or unexpected
manufacturing difficulties, which may cause revenue for that quarter to fall
below expectations. This would adversely affect PDI's results of operations
for that quarter. PDI's backlog at the beginning of each quarter is not
necessarily indicative of actual sales for any succeeding period. Orders may
be delayed or cancelled with limited or no penalty. PDI's sales often reflect
orders shipped in the same quarter they are received. Many factors may
influence PDI's results of operations in a particular quarter. These include:

  . volume, mix and timing of the receipt of orders from major customers

  . competitive pricing pressures

  . costs of components and subsystems

  . PDI's ability to design, manufacture and introduce new products on a
    cost-effective and timely basis

  . delay between incurrence of expenses to further develop marketing and
    service capabilities and realization of benefits from such improved
    capabilities

  . fluctuations in foreign exchange rates

  . introduction and announcement of new products by PDI's competitors

  . changing conditions in the FPD market worldwide

  In particular, due to substantial differences in gross margin for PDI's
products, changes in the product volume and product mix could result in
substantial fluctuations in PDI's gross margin. Furthermore, PDI believes that
the current economic conditions in Asia could have a negative impact on PDI's
results of operations. If the Asian currencies fall from current levels
against the U.S. dollar, PDI could experience lower average sales prices for
its products, or PDI's customers may fail to place new orders for PDI's
equipment. Accordingly, PDI's results of operations are subject to significant
quarterly variation.

The Future Performance of PDI Depends in Part on Future Growth in the
Japanese, Taiwanese and Korean Markets

  PDI's sales to Japan, Taiwan and Korea may be adversely affected by the
overall health of these economies, including the effects of currency exchange
rate fluctuations on the global competitiveness of Japanese, Taiwanese and
Korean FPD manufacturers. A downturn in economic conditions in Asia could
result in PDI's customers failing to place new orders for PDI's equipment.
Similarly, the failure of the Japanese, Taiwanese and Korean FPD markets to
grow as anticipated would harm PDI's business.

PDI's International Operations Create Specialized Risks that Can Negatively
Affect Its Business

  99% of PDI's revenue for fiscal 1999 was attributable to sales outside the
United States as compared to 96% of revenue for fiscal 1998. Furthermore, most
of the major FPD manufacturers and many of PDI's principle customers are
located in Asia. PDI expects that international sales and, in particular,
sales to Asia will continue to represent a significant portion of its total
sales. Sales to customers outside the U.S. are subject to a number of
specialized risks. These risks include:

  .governmental controls

                                      10
<PAGE>

  .unavailability of limited effective copyright and trade secret
     protection

  .compliance with a wide variety of foreign and U.S. export laws

  .compliance with technical standards established by foreign regulatory
     bodies

  .political and economic instability

  .trade restrictions

  .changes in tariffs and taxes

  .longer payment cycles typically associated with international sales

  .greater difficulty of administering business overseas

  .general economic conditions

  Although substantially all of PDI's direct international sales are
denominated in U.S. dollars, both direct sales by PDI and sales through IHI
may be affected by changes in demand resulting from fluctuations in interest
and foreign currency exchange rates. If PDI's sales are denominated in foreign
currency, its revenue and results of operations may be directly affected by
fluctuations in foreign currency exchange rates.

A Few Customers Have Accounted for a Significant Percentage of PDI's Revenues

  The FPD industry is extremely concentrated. Although PDI's largest customers
have changed from year to year, direct sales to PDI's top four end user
customers in fiscal 1999 and fiscal 1998 accounted for 78% and 92%,
respectively, of its total revenue. PDI currently has no long-term purchase
commitments with its customers, and sales are generally made through purchase
orders. Orders are subject to delay or cancellation with limited or no penalty
to the customer. A reduction, delay or cancellation of orders from one or more
of its significant customers or the loss of one or more customers could
adversely affect PDI's business.

Downturns or Slowdowns in the Flat Panel Display Industry May Lower PDI's
Revenues

  PDI's business depends, in large part, upon the capital equipment
expenditures of FPD manufacturers, which in turn depend on the current and
anticipated market demand for FPDs and products utilizing FPDs. The FPD
industry may become highly cyclical and experience periodic downturns or
slowdowns in growth. This would reduce capital equipment expenditures by FPD
manufacturers and, in turn, adversely affect PDI's operations. In addition,
PDI must continually invest in engineering, research and development and
marketing in order to penetrate targeted foreign markets and maintain
extensive worldwide customer service and support capabilities. These
requirements may limit its ability to reduce expenses during downturns or
slowdowns in growth in the FPD industry, which would adversely affect PDI's
operating margins.

If PDI Does Not Compete Effectively in the Flat Panel Display Industry, then
It Will Lose Market Share and Its Business Will Be Harmed

  The FPD equipment industry is highly competitive. PDI faces substantial
competition from established companies, many of which are larger companies
that have greater financial, engineering and manufacturing resources than PDI
and have larger service organizations and long-standing customer relationships
with major FPD manufacturers. These companies include International Business
Machines/Micronics Japan Corporation, NTN, Minato, Hoya, Advantest, and
Otsuka.

  In particular, the future performance of PDI will depend upon its ability to
continue to compete successfully in the Japanese, Taiwanese and Korean
markets, the three largest markets for FPD array test, inspection and repair
equipment. PDI's ability to compete in such markets in the future depends, in
part, on the following factors:

  . continuing free trade between Japan, Taiwan, Korea, and the U.S.

                                      11
<PAGE>

  . continuing ability of PDI to develop products in a timely manner that
    meet the technical requirements of its Japanese, Taiwanese and Korean
    customers

  . continuing ability of PDI to maintain satisfactory relationships with
    leading companies in the Japanese, Taiwanese and Korean FPD industry

  PDI believes that many Japanese, Taiwanese and Korean companies with which
it competes may have a competitive advantage in Japan, Taiwan and Korea
because of the preference of some customers for local equipment suppliers who
have longer standing or closer business relationships with these customers.

  PDI expects it may face additional competition from new entrants into the
FPD equipment industry and from competitors utilizing new technologies. PDI's
competitors can be expected to continue to improve the design and performance
of their products and to introduce new products with competitive
price/performance characteristics. In addition, PDI's customers may choose to
develop proprietary technology and FPD equipment, which may obviate or lessen
their need to purchase PDI's products. PDI's customers may also use multiple
technologies and solutions, including competitors' products, to replicate the
functionality of PDI's systems. Competitive pressures may necessitate price
reductions, which could harm PDI's results of operations. PDI may not have
sufficient resources to continue to make investments in research and
development. Even if sufficient funds are available, PDI may not be able to
make the technological advances necessary to maintain competitive advantages.

PDI Depends on Its Relationship with IHI to Market Its Products in Asia and
Elsewhere

  PDI has granted to IHI exclusive manufacturing and sales rights to its array
test systems developed prior to June 1997 in Japan, Korea, a number of other
Asian countries, Saudi Arabia, Australia, New Zealand, India, and Sri Lanka.
Under the terms of this relationship, PDI reserves the rights to manufacture
some critical components and to sell the components to IHI for inclusion in
array test systems to be sold by IHI in its territory. In fiscal 1999, 26% of
PDI's revenue was derived from sales to IHI as compared to 45% of revenue in
fiscal 1998. To date, IHI has allowed PDI to manufacture all array test
systems sold by IHI in the IHI territory. If IHI decides to exercise its
contractual rights to manufacture and sell PDI's systems in its territories,
such action could reduce PDI's revenue attributable to these IHI manufactured
array test systems and may adversely affect PDI's results of operations. Given
the concentration of FPD manufacturers in the IHI territory, PDI is highly
dependent on the success of its relationship with IHI to market and sell the
array test systems in these markets. If IHI decides to reduce its internal
budgets, staffing levels, research and development funding, or other
allocations of its resources for the development, manufacture, sale, and
support of array test systems in Japan, PDI's inability to compete in this
market may harm PDI's results of operations.

PDI May Be Unable to Develop and Introduce New Products or Enhancements to Its
Existing Products and Processes in a Timely Manner that Satisfy Customer
Needs, Achieve Market Acceptance or Address Technological Changes in the Flat
Panel Display Industry

  The market for PDI's products is characterized by rapidly changing
technologies and frequent new product introductions. PDI believes that its
future success will depend, in part, upon its ability to continue to enhance
its existing products and to develop and manufacture new products. PDI may not
be successful in introducing, marketing or managing the manufacture of its new
or recently introduced products. Furthermore, PDI may not be able to develop
and introduce new products or enhancements to its existing products and
processes in a timely manner which satisfy customer needs, achieve market
acceptance or address technological changes in the FPD industry. The failure
to develop products and introduce them successfully and in a timely manner
could compromise PDI's competitive position. PDI has experienced delays in the
development of performance specifications required by new and existing
customers in the past and could experience such delays in the future.
Development efforts related to other performance parameters may not be
successful. PDI believes that future orders of array test systems will depend,
in part, on its ability to achieve requested performance parameters. In order
to develop new products successfully, PDI depends on close relationships with
its customers. If products have performance, reliability or quality problems
or shortcomings, then PDI may experience:

  . reduced orders

                                      12
<PAGE>

  . higher manufacturing costs

  . delays in collecting accounts receivable

  . additional warranty and service expenses

  In addition, future sales of PDI's products will depend, in part, on the
acceptance of PDI's array test or inspection technologies by a broader group
of customers. Such customers include additional international customers and
FPD manufacturers which currently do not perform the type of FPD array test or
inspection offered by PDI's products or which utilize differing technologies
for, or methods of, inspection. There is a large capital commitment involved
in the construction and operation of an FPD manufacturing facility. As a
result, the decision by an FPD manufacturer to purchase PDI's array test or
inspection systems involves a significant technological and financial
commitment as compared to current alternatives such as human inspection and
open/short array testers. If PDI is not successful in obtaining broader
acceptance of its technologies, then its business may be harmed.

Some Components and Subassemblies Included in PDI's Products Are Obtained from
a Single or Limited Group of Suppliers

  Some of the components and subassemblies included in PDI's systems are
obtained from a single source or a limited group of suppliers. For example,
PDI has obtained high-speed image processing systems, materials handling
platforms and ultra-high resolution cameras used in its products from single
source suppliers. PDI has not entered into any formal agreements with such
suppliers, other than long-term purchase orders, and, in some cases, volume
pricing agreements. The partial or complete loss of such suppliers could:

  . increase PDI's manufacturing costs or delay product shipments while
    PDI qualifies a new supplier,

  . require redesigning PDI's products, or

  . potentially damage customer relationships.

  Even if alternative suppliers are qualified, the components may be attained
at a significant increase in price or on less favorable terms to PDI.

An Industry Shift Away from AMLCD Technology Would Harm PDI's Results

  Currently, the predominant technology used in the FPD industry is AMLCD
technology. PDI's revenue is derived primarily from sales of products related
to AMLCD technology used in a substantial portion of all FPDs. An industry
shift away from AMLCD technology or the emergence of new competing
technologies may reduce the demand for PDI's products and adversely affect
PDI's business.

PDI May Be Unable to Protect Its Proprietary Information and Procedures

  PDI's success and competitive position depend, in part, on its proprietary
technology. PDI relies on patent, trade secret, trademark, and copyright law
to protect its intellectual property. Any patent owned or licensed by PDI may
be invalidated, circumvented, challenged, or licensed to others. Furthermore,
PDI's pending or future patent applications may not be issued with the scope
of the claims sought by PDI, if at all. Even if issued, rights granted under
these patents may not provide significant competitive advantages to PDI.
Others may also develop technologies that are similar or superior to PDI's
technology, duplicate PDI's technology or design around the patents owned by
PDI. In addition, effective copyright and trade secret protection may be
unavailable or limited in certain foreign countries. The steps PDI has taken
may not prevent misappropriation of its technology. In addition, litigation
may be necessary in the future to enforce PDI's patents and other intellectual
property rights, to protect PDI's trade secrets, to determine the validity and
scope of the proprietary rights of others, or to defend against claims of
infringement or invalidity. Such litigation could result in substantial costs
and diversion of resources and could adversely affect PDI's results of
operations.

                                      13
<PAGE>

  Competitors in both the U.S. and foreign countries, many of which have
substantially greater resources and have made substantial investments in
competing technologies, may have applied for or obtained or may in the future
apply for and obtain patents that will prevent, limit or interfere with PDI's
ability to manufacture and sell its products. PDI has not conducted an
independent review of patents issued to third parties. Third parties may
assert infringement claims, successful or otherwise, against PDI. An adverse
outcome in the defense of a patent suit could subject PDI to significant
liabilities to third parties, require disputed rights to be licensed from
third parties or require PDI to cease selling its products. Even successful
defenses of patent suits can be both costly and time-consuming and adversely
affect PDI's business.

The Inability to Attract or Loss of PDI's Key Employees Could Negatively
Affect PDI

  The future success of PDI is dependent, in part, on its ability to retain
certain key personnel. PDI also needs to attract additional skilled personnel
in all areas of its business to continue to grow. There can be no assurance
that PDI will be able to retain its existing personnel or attract additional
qualified employees in the future. The loss of such persons could result in
disruption of PDI's business and stock price volatility and could adversely
affect PDI's results of operations. PDI has not entered into long-term
contracts with any of its employees and does not maintain key employee life
insurance.

The Disruption or Failure of Computer Programs and Systems Due to Their
Inability to Process Date/Time Information between the Twentieth and Twenty-
First Century May Cause an Interruption in and Negatively Impact PDI's
Business

  The Year 2000 Issue is the result of computer programs being written using
two digits rather than four to define the applicable year. Any of PDI's
computer programs that have date-sensitive software may recognize a date using
"00" as the year 1900 rather than the year 2000. This could result in a system
failure or miscalculations causing disruptions of operations, including, among
other things, a temporary inability to process transactions, send invoices or
engage in similar normal business activities. In addition to PDI's own
systems, PDI relies, directly and indirectly, on external systems of its
customers, creditors, financial organizations, utility providers, and
government entities, both domestic and international. Consequently, PDI could
be affected by disruptions in the operations of these third parties with which
PDI interacts.

  PDI has established a task force to address internal and external Year 2000
issues. To date, PDI has made several modifications to its product software,
its enterprise software and its network software to help ensure Year 2000
compliance. Although PDI believes that its products and internal systems are
currently Year 2000 compliant, third parties with which PDI interacts may not
be Year 2000 compliant. Failure of third party enterprises to achieve Year
2000 compliance could adversely affect PDI's business.

  PDI continues to evaluate the estimated costs associated with the efforts to
prepare for Year 2000 based on actual experience. While the efforts will
involve additional costs, PDI believes that it will be able to manage its
total Year 2000 transition without material adverse effect on its business
operations, products or financial prospects. As of September 30, 1999, PDI had
incurred approximately $36,000 in costs to achieve Year 2000 compliance. The
actual outcomes and results could be affected by many factors. These factors
include:

  . continued availability of skilled personnel

  . cost control

  . ability to locate and correct software code problems

  . critical suppliers and subcontractors meeting their commitments to be
    Year 2000 compliant

  . timely actions by customers

  PDI anticipates that it will remediate all Year 2000 risks and be able to
conduct normal operations without having to establish a Year 2000 contingency
plan. Accordingly, PDI does not have a contingency plan and does

                                      14
<PAGE>

not intend to establish one. Furthermore, PDI may not have foreseen and
corrected all Year 2000 problems which may result in material disruption to
its business.

Earthquakes May Damage PDI's Facilities

  PDI's corporate and manufacturing facilities in San Jose, California are
located near major earthquake faults which have experienced earthquakes in the
past. Although PDI carries limited earthquake insurance, in the event of a
major earthquake or other disaster in or near the San Francisco Bay Area,
PDI's facilities may sustain significant damage, and its operations could be
negatively affected.

Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995

  Many of the statements made by or about PDI in this Form 10-KSB are forward-
looking statements. These forward-looking statements include, but are not
limited to, statements about PDI's industry, plans, objectives, expectations,
intentions, assumptions, and other statements that are not historical facts.
When used in this Form 10-KSB, the words "expect," "anticipate," "intend,"
"plan," "believe," "seek," "estimate," and similar expressions are generally
intended to identify forward-looking statements. Because these forward-looking
statements involve risks and uncertainties, including those described in this
"Risks Relating to the Business of PDI" section, actual results may differ
materially from those expressed or implied by these forward-looking
statements. Market data and other market and industry information presented in
this Form 10-KSB have been obtained from independent industry sources.
Although PDI believes these sources are reliable, PDI has not independently
verified any of such data or information.

ITEM 2: DESCRIPTION OF PROPERTY

  The Company's main headquarters is located in San Jose, California and
consists of a 50,000 square foot facility. The lease expires in 2002. The
Company also leases office space for its sales and service operations in
Tokyo, Japan and Seoul, Korea.

ITEM 3: LEGAL PROCEEDINGS

  The Company is not a party to any material litigation.

ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

  No matters were submitted to a vote of security holders during the quarter
ended September 30, 1999.

                                      15
<PAGE>

                                    PART II

ITEM 5: MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Common Stock

  The Company's Common Stock is traded on the Nasdaq National Market under the
symbol "PHTN." The table below sets forth for the quarters indicated, the
reported high and low sales prices of the Company's Common Stock as reported
on the Nasdaq National Market. Such prices represent inter-dealer prices, and
do not include retail mark-ups or markdowns or commissions and may not
represent actual transactions.

                                  FISCAL 1999

<TABLE>
<CAPTION>
                                                                     High   Low
                                                                     ----- -----
     <S>                                                             <C>   <C>
     1st Quarter....................................................  5.63  2.25
     2nd Quarter....................................................  8.25  3.94
     3rd Quarter.................................................... 12.38  7.00
     4th Quarter.................................................... 25.75 10.63
</TABLE>

                                  FISCAL 1998

<TABLE>
<CAPTION>
                                                                       High Low
                                                                       ---- ----
     <S>                                                               <C>  <C>
     1st Quarter...................................................... 7.38 2.50
     2nd Quarter...................................................... 3.75 2.38
     3rd Quarter...................................................... 5.56 3.19
     4th Quarter...................................................... 3.63 2.00
</TABLE>

  As of September 30, 1999, there were 82 holders of record of the Company's
Common Stock.

                                      16
<PAGE>

SELECTED FINANCIAL DATA

  The following table presents selected financial data of the Company. This
historical data should be read in conjunction with the Consolidated Financial
Statements and the related Notes thereto in Item 7 and "Management's
Discussion and Analysis of Financial Condition and Results of Operations" in
Item 6. No cash dividends were declared in any of the periods presented, and
no cash dividends are expected to be declared in the foreseeable future.

<TABLE>
<CAPTION>
                                            Years Ended September 30,
                                     ------------------------------------------
                                      1999     1998     1997     1996    1995
                                     ------- --------  -------  ------- -------
                                       (In thousands, except per share data)
<S>                                  <C>     <C>       <C>      <C>     <C>
Consolidated Statement of
 Operations Data
Revenue............................  $31,562 $ 22,420  $24,507  $24,763 $18,447
Gross margin.......................   13,301    9,361   10,718   11,507   6,756
Operating income (loss)............    1,180   (1,589)  (2,695)     563     710
Net income (loss)..................  $ 1,170 $ (1,465) $(2,481) $   854 $   377
Basic net income (loss) per share..  $  0.15 $ ( 0.20) $ (0.35) $  0.13 $  0.08
Diluted net income (loss) per
 share.............................  $  0.15 $ ( 0.20) $ (0.35) $  0.12 $  0.08
Shares used in computing:
Basic net income (loss) per share..    7,558    7,231    7,049    6,548   4,448
Diluted net income (loss) per
 share.............................    8,055    7,231    7,049    7,294   5,016
</TABLE>

<TABLE>
<CAPTION>
                                                     September 30,
                                         --------------------------------------
                                          1999    1998    1997    1996    1995
                                         ------- ------- ------- ------- ------
                                                     (In thousands)
<S>                                      <C>     <C>     <C>     <C>     <C>
Consolidated Balance Sheet Data
Working capital......................... $16,458 $14,090 $14,769 $17,290 $  709
Total assets............................  25,288  21,033  23,203  24,958 10,519
Total shareholders' equity..............  18,877  16,489  17,762  19,770  1,857
</TABLE>

UNAUDITED QUARTERLY RESULTS OF OPERATIONS

<TABLE>
<CAPTION>
                                              Fiscal Quarters Ended,
                         -----------------------------------------------------------------
                         December 31, 1998 March 31, 1999 June 30, 1999 September 30, 1999
                         ----------------- -------------- ------------- ------------------
                                                  (In thousands)
<S>                      <C>               <C>            <C>           <C>
Revenue ................      $4,081           $7,227        $9,391          $10,863
Gross margin............       1,261            2,983         4,128            4,929
Net income (loss).......      (1,555)              83         1,002            1,640
<CAPTION>
                                              Fiscal Quarters Ended,
                         -----------------------------------------------------------------
                         December 31, 1997 March 31, 1998 June 30, 1998 September 30, 1998
                         ----------------- -------------- ------------- ------------------
                                                  (In thousands)
<S>                      <C>               <C>            <C>           <C>
Revenue.................      $5,374           $7,362        $5,625           $4,059
Gross margin............       2,645            3,049         2,564            1,103
Net income (loss) ......          46              221            49           (1,781)
</TABLE>
--------

                                      17
<PAGE>

ITEM 6: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
        RESULTS OF OPERATIONS

  This Form 10-KSB contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. To the extent that this Form 10-KSB discusses financial
projections, information or expectations about products or markets of PDI, all
such forward-looking statements are based on information available to PDI on
the date hereof, and PDI assumes no obligation to update any such forward-
looking statements. It is important to note that PDI's actual results could
differ materially from those in such forward-looking statements. PDI's results
will be affected, particularly when measured on a quarterly basis, by the
volume, composition and timing of orders for capital equipment by FPD
manufacturers. Other uncertainties include, without limitation, acceptance of
new products, timing of orders received, costs associated with new product
introductions, managing growth as well as the factors discussed in "Risk
Factors Relating to the Business of PDI."

  The following discussion should be read in conjunction with PDI's condensed
consolidated financial statements and notes thereto.

Comparison of the Years Ended September 30, 1999 and 1998
Results of Operations

The following table sets forth certain operating data as a percentage of total
                                   revenue:

<TABLE>
<CAPTION>
                                                                 Years Ended
                                                                September 30,
                                                                --------------
                                                                 1999    1998
                                                                ------  ------
     <S>                                                        <C>     <C>
     Revenue...................................................  100.0%  100.0%

     Cost of revenue...........................................   57.9    58.2
                                                                ------  ------
     Gross margin..............................................   42.1    41.8
                                                                ------  ------
     Operating expenses:
       Research and development................................   16.4    26.4
       Selling, general and administrative.....................   22.0    24.0
       Asset recovery related to product line disposal.........    0.0    (1.6)
                                                                ------  ------
         Total operating expenses..............................   38.4    48.8
                                                                ------  ------
     Operating income (loss)...................................    3.7    (7.0)
     Other income, net.........................................    0.4     1.0
                                                                ------  ------
     Income (loss) before provision for income taxes...........    4.1    (6.0)
     Provision for income taxes................................    0.4     0.5
                                                                ------  ------
     Net income (loss).........................................    3.7%   (6.5)%
                                                                ======  ======
</TABLE>

Overview

  PDI develops, manufactures and markets on a worldwide basis a variety of
products to inspect virtually all types of FPDs and to address key areas of
AMLCD test, inspection and repair throughout all major stages of the
manufacturing life cycle from research and development through commercial
production.

  PDI's revenue is obtained primarily through sales to FPD manufacturers and,
to a lesser extent, value-added resellers in Japan. PDI's primary value-added
reseller in Japan is IHI with which PDI does not have a long-term agreement.
During fiscal 1997, PDI expanded the scope of its existing arrangement with
IHI, increasing the number of product lines sold and serviced by IHI from one
to three. In the quarter ended June 30, 1997, PDI shipped its first inspection
and repair systems to IHI.

  PDI derives substantially all of its revenue from international sales in
Asia, primarily Japan, Taiwan and Korea, where the majority of volume flat
panel production currently takes place. At present, all worldwide sales are
made in U.S. dollars, whether to direct or value-added resellers. PDI's
revenue is derived primarily from the sale of its products.


                                      18
<PAGE>

  In August 1999, PDI entered into an agreement with CR Technology, Inc.
("CRT"), a California corporation, whereby PDI will acquire all of the
outstanding common and preferred shares of CRT in exchange for approximately
2,000,000 shares of PDI's Common Stock. This transaction is intended to be
accounted for as a pooling of interests. The transaction must be approved by a
vote of CRT's and PDI's shareholders. The agreement terminates on December 31,
1999 if the merger has not occurred by that date. As of September 30, 1999,
approximately $307,000 of expenses related to the business combination have
been capitalized as prepaid expenses and will be expensed in the period that
the combination is consummated.

Results of Operations

  Revenue. Revenue increased 41% from $22.4 million in fiscal 1998 to $31.6
million in fiscal 1999. The increase in revenue for fiscal 1999 as compared to
fiscal 1998 was due to a significant increase in customer shipments,
particularly to Taiwan, which reflects growth in the FPD industry. Fiscal 1998
saw a decrease in capital spending by FPD manufacturers located in Asia as a
result of the adverse economic conditions experienced by the region at that
time. As of September 30, 1999, PDI's backlog was approximately $20.2 million
as compared to approximately $8.3 million as of September 30, 1998. There can
be no assurance that PDI's backlog will translate into further revenues.

  International sales accounted for $31.3 million and $21.4 million of revenue
in fiscal 1999 and fiscal 1998, respectively. Sales to Japan decreased to $8.3
million, or 26% of revenue, in fiscal 1999 from $10.2 million, or 45% of
revenue, in fiscal 1998. Sales to Taiwan increased significantly to $11.0
million, or 35% of revenue, in fiscal 1999 from $0.8 million, or 4% of
revenue, in fiscal 1998. Sales to Korea increased to $12.0 million, or 38% of
revenue, in fiscal 1999 from $10.3 million, or 46% of revenue, in fiscal 1998.

  Because PDI derives substantially all of its revenue from the sale of a
relatively small number of systems, which typically range in price from
$400,000 to $1.5 million, the timing of the sale of a single system could have
and has had a significant impact on PDI's revenue in any particular period.

  For the quarter ended March 31, 1999, revenue included a non-recurring
$500,000 fee paid by a Japanese company to purchase manufacturing rights.

  Gross Margin. Gross margin as a percent of revenue increased slightly to
42.1% in fiscal 1999 from 41.8% in fiscal 1998. The increase in gross margin
for fiscal 1999 was due, in large part, to manufacturing efficiencies
resulting from higher production volumes. In addition, PDI implemented
engineering programs during the last half of fiscal 1999 to decrease the cost
of its products. This was offset by several system upgrade orders and
shipments to Taiwan, which had gross margins lower than typical shipments sold
by PDI. PDI has increased its shipments to Taiwan to expand PDI's customer
base. Overall gross margins will fluctuate on a quarterly basis due to PDI's
production volume and product mix, among other factors.

  Research and Development. PDI decreased its research and development
expenses to $5.2 million, or 16% of revenue, in fiscal 1999 from $5.9 million,
or 26% of revenue, in fiscal 1998. The decrease in spending for fiscal 1999 as
compared to fiscal 1998 was primarily due to decreased spending in the areas
of outside consultants and prototype materials. In fiscal 1998, PDI was
working on a number of product enhancements that it believed would improve its
ability to sell into volume production environments. Because this work is now
complete, PDI reduced its spending on outside consultants and prototype
materials during fiscal 1999 as compared to fiscal 1998. PDI expects that its
investment in research and development will increase incrementally in fiscal
2000 as a result of new product development projects.

  Selling, General and Administrative. Selling, general and administrative
expenses increased to $6.9 million, or 22% of revenue, in fiscal 1999 from
$5.4 million, or 24% of revenue, in fiscal 1998. The increase in these
expenses for fiscal 1999 as compared to fiscal 1998 was due to higher
commissions and other selling expenses related to increases in orders and
revenue. Expenses related to business development activities have also
contributed to the increase in these expenses. Selling, general and
administrative expenses may increase in fiscal 2000 and in future periods
depending on factors such as the level of PDI's revenue and operating
expenses. Selling expenses may also fluctuate based on PDI's product and
territorial sales mix, which have different sales channels and associated cost
structures.

                                      19
<PAGE>

  Asset Recovery Related to Product Line Disposal. During the quarter ended
December 31, 1997, PDI received a payment of $350,000 in settlement of a
dispute related to the cancellation of its Defect Monitoring Tool ("DMT")
product line. In September 1996, PDI ceased operations of its DMT product
line. The DMT product group had worked exclusively on a single customer
project not in the FPD market. As a result of the cancellation of this
project, PDI had expensed the associated inventory and assets of this product
line which were not transferred to other products.

  Interest Income. Interest income in fiscal 1999 increased to $251,000 from
$245,000 in fiscal 1998 as a result of higher average cash and investment
balances throughout the fiscal year.

  Interest Expense and Other. Interest expense and other consists of interest
expense, foreign exchange gains and losses, and other miscellaneous income and
expenses. Interest expense and other in fiscal 1999 increased to $124,000 from
$13,000 in fiscal 1998 as a result of less other miscellaneous income in
fiscal 1999 as compared to fiscal 1998.

  Provision for Income Taxes. The provision for income taxes in fiscal 1999
was related to alternative minimum taxes incurred by PDI in the U.S. and
foreign taxes currently payable. No U.S. income taxes were incurred in fiscal
1998 because of PDI's net operating loss. As of September 30, 1999, PDI had
available federal and state net operating loss carryforwards of approximately
$12.1 million and $0.3 million, respectively. PDI also had federal and state
research and development tax credit carryforwards of approximately $1.3
million and $0.8 million, respectively. The net operating loss and credit
carryforwards will expire at various times beginning in 2000 through 2018, if
not utilized. As of September 30, 1999, PDI had deferred tax assets of
approximately $9.7 million, which have been fully reserved with a deferred tax
valuation allowance and which consist primarily of net operating loss,
research and development tax credit carryforwards, and reserves and other
accrued expenses not yet deductible for income tax purposes. These deferred
tax assets will be recognized in future periods as taxable income is realized
and consistent profits are reported.

Liquidity and Capital Resources

  PDI has financed its growth primarily by a combination of equity financing,
loans, lines of credit, and cash flows from operations. As of September 30,
1999, PDI had working capital of $16.5 million of which $6.7 million was cash
and cash equivalents and short-term investments.

  Cash provided by operating activities was $0.8 million for fiscal 1999.
Working capital items that significantly impacted cash balances were accounts
receivable, inventories, accounts payable, and accrued expenses and other
liabilities. PDI's accounts receivable balance increased $5.0 million to
$11.0 million in fiscal 1999 from $6.0 million in fiscal 1998 due to higher
shipments. This higher level of shipments resulted in a $2.3 million decrease
in inventories to $4.5 million in fiscal 1999 from $6.8 million in fiscal
1998. Accounts payable increased $0.3 million from $1.5 million in fiscal 1998
to $1.8 million in fiscal 1999 due to the purchase of additional materials
required to meet the increased production requirements. The increase of $1.1
million in accrued expenses and other liabilities to $4.0 million in fiscal
1999 from $2.9 million in fiscal 1998 is attributable to the higher number of
systems under warranty in addition to higher commission and bonus expenses
associated with increases in orders and revenue.

  Capital expenditures in fiscal 1999 and fiscal 1998 were $0.9 million and
$0.7 million, respectively. Spending levels in fiscal 1999 and fiscal 1998
were in line with PDI's normal annual capital requirements.

  PDI has entered into a $3.5 million line of credit with a bank which expires
in March 2000. This line of credit is secured by substantially all of PDI's
assets and contains certain financial and other covenants. PDI is eligible to
borrow against accounts receivable and a portion of inventories. Borrowings
under this line of credit bear interest at prime rate plus 1.00% to 1.25%
(9.25% to 9.50% as of September 30, 1999). As of September 30, 1999, no
amounts were outstanding under this bank line of credit, and PDI was in
compliance with all bank covenants.

                                      20
<PAGE>

  PDI believes that cash and cash equivalents, short-term investments,
borrowings from the line of credit and cash flows from operations will be
sufficient to satisfy working capital requirements and capital equipment needs
for at least the next twelve months. As of September 30, 1999, PDI had no
material outstanding commitments to purchase or lease capital equipment.

  PDI believes that success in its industry requires substantial capital in
order to maintain the flexibility to take advantage of opportunities as they
may arise. PDI may, from time to time, invest in or acquire complementary
businesses, products or technologies and may seek additional equity or debt
financing to fund such activities. There can be no assurance that such funding
will be available to PDI on commercially reasonable terms. The sale of
additional equity or convertible debt could result in dilution to PDI's
shareholders.

Year 2000 Computer System Compliance

  The Year 2000 Issue is the result of computer programs being written using
two digits rather than four to define the applicable year. Any of PDI's
computer programs that have date-sensitive software may recognize a date using
"00" as the year 1900 rather than the year 2000. This could result in a system
failure or miscalculations causing disruptions of operations, including, among
other things, a temporary inability to process transactions, send invoices or
engage in similar normal business activities. In addition to PDI's own
systems, PDI relies, directly and indirectly, on external systems of its
customers, creditors, financial organizations, utility providers, and
government entities, both domestic and international. Consequently, PDI could
be affected by disruptions in the operations of these third parties with which
PDI interacts.

  PDI has established a task force to address internal and external Year 2000
issues. To date, PDI has made several modifications to its product software,
its enterprise software and its network software to help ensure Year 2000
compliance. Although PDI believes that its products and internal systems are
currently Year 2000 compliant, third parties with which PDI interacts may not
be Year 2000 compliant. Failure of third party enterprises to achieve Year
2000 compliance could adversely affect PDI's business.

  PDI continues to evaluate the estimated costs associated with the efforts to
prepare for Year 2000 based on actual experience. While the efforts will
involve additional costs, PDI believes that it will be able to manage its
total Year 2000 transition without material adverse effect on its business
operations, products or financial prospects. As of September 30, 1999, PDI had
incurred approximately $36,000 in costs to achieve Year 2000 compliance. The
actual outcomes and results could be affected by many factors. These factors
include:

  .  continued availability of skilled personnel

  .  cost control

  .  ability to locate and correct software code problems

  .  critical suppliers and subcontractors meeting their commitments to be
     Year 2000 compliant

  .  timely actions by customers

  PDI anticipates that it will remediate all Year 2000 risks and be able to
conduct normal operations without having to establish a Year 2000 contingency
plan. Accordingly, PDI does not have a contingency plan and does not intend to
establish one. Furthermore, PDI may not have foreseen and corrected all Year
2000 problems which may result in material disruption to its business.

                                      21
<PAGE>

ITEM 7: CONSOLIDATED FINANCIAL STATEMENTS

Index to Consolidated Financial Statements

<TABLE>
<CAPTION>
                                                                          Page
                                                                          ----
<S>                                                                       <C>
Report of Ernst & Young LLP, Independent Auditors........................  23
Consolidated Balance Sheets at September 30, 1999 and September 30,
 1998....................................................................  24
Consolidated Statements of Operations for the Years Ended September 30,
 1999 and 1998...........................................................  25
Consolidated Statements of Cash Flows for the Years Ended September 30,
 1999 and 1998...........................................................  26
Consolidated Statements of Shareholders' Equity for the Years Ended
 September 30, 1999 and 1998.............................................  27
Notes to Consolidated Financial Statements...............................  28
</TABLE>

                                       22
<PAGE>

               REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors and Shareholders
Photon Dynamics, Inc.

  We have audited the accompanying consolidated balance sheets of Photon
Dynamics, Inc. as of September 30, 1999 and 1998, and the related consolidated
statements of operations, shareholders' equity, and cash flows for the years
then ended. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.

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

  In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of Photon Dynamics, Inc. as of September 30, 1999 and 1998, and the
consolidated results of its operations and its cash flows for the years then
ended in conformity with generally accepted accounting principles.


                                                 /s/ Ernst & Young LLP


San Jose, California
October 18, 1999

                                      23
<PAGE>

                             PHOTON DYNAMICS, INC.

                          CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                          September 30,
                                                        ------------------
                                                          1999      1998
                                                        --------  --------
                                                         (In thousands,
                                                          except share
                                                              data)
<S>                                                     <C>       <C>
                        ASSETS
Current assets:
  Cash and cash equivalents............................ $  5,223  $  5,562
  Short-term investments...............................    1,500       --
  Accounts receivable, net of allowance of $1,141 ($850
   in 1998)............................................   11,058     6,027
  Inventories..........................................    4,477     6,767
  Prepaid expenses and other current assets............      611       276
                                                        --------  --------
Total current assets...................................   22,869    18,632
Property, equipment and leasehold improvements, net....    1,692     1,798
Other assets...........................................      727       603
                                                        --------  --------
Total assets........................................... $ 25,288  $ 21,033
                                                        ========  ========
         LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
  Accounts payable..................................... $  1,849  $  1,486
  Accrued expenses and other liabilities...............    4,050     2,936
  Deferred revenue.....................................      512       116
  Current portion of capital lease obligation..........      --          4
                                                        --------  --------
Total current liabilities..............................    6,411     4,542
Capital lease obligation, net of current portion.......      --          2
Commitments and contingencies
Shareholders' equity:
  Preferred stock, no par value, 5,000,000 shares
   authorized, none issued and outstanding.............      --        --
  Common stock, no par value, 20,000,000 shares
   authorized, 7,814,321 and 7,324,615 shares issued
   and outstanding as of September 30, 1999 and 1998,
   respectively........................................   39,851    38,918
  Accumulated deficit..................................  (20,977)  (22,147)
  Accumulated other comprehensive income...............        3      (197)
  Notes receivable from shareholders...................      --        (85)
                                                        --------  --------
Total shareholders' equity.............................   18,877    16,489
                                                        --------  --------
Total liabilities and shareholders' equity............. $ 25,288  $ 21,033
                                                        ========  ========
</TABLE>

          See accompanying notes to consolidated financial statements.

                                       24
<PAGE>

                             PHOTON DYNAMICS, INC.

                     CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                                Years Ended
                                                               September 30,
                                                              ----------------
                                                               1999     1998
                                                              -------  -------
                                                              (In thousands,
                                                                except per
                                                                share data)
<S>                                                           <C>      <C>
Revenue.....................................................  $31,562  $22,420
Cost of revenue.............................................   18,261   13,059
                                                              -------  -------
Gross margin................................................   13,301    9,361
                                                              -------  -------
Operating expenses:
  Research and development..................................    5,180    5,911
  Selling, general and administrative.......................    6,941    5,389
  Asset recovery related to product line disposal...........      --      (350)
                                                              -------  -------
Total operating expenses....................................   12,121   10,950
                                                              -------  -------
Operating income (loss).....................................    1,180   (1,589)
Interest income.............................................      251      245
Interest expense and other..................................     (124)     (13)
                                                              -------  -------
Income (loss) before provision for income taxes.............    1,307   (1,357)
Provision for income taxes..................................      137      108
                                                              -------  -------
Net income (loss)...........................................  $ 1,170  $(1,465)
                                                              =======  =======
Basic net income (loss) per share...........................  $  0.15  $ (0.20)
                                                              =======  =======
Diluted net income (loss) per share.........................  $  0.15  $ (0.20)
                                                              =======  =======
Shares used in computing basic net income (loss) per share..    7,558    7,231
                                                              =======  =======
Shares used in computing diluted net income (loss) per
 share......................................................    8,055    7,231
                                                              =======  =======
</TABLE>


          See accompanying notes to consolidated financial statements.

                                       25
<PAGE>

                             PHOTON DYNAMICS, INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                           Years Ended
                                                          September 30,
                                                         ----------------
                                                          1999     1998
                                                         -------  -------
                                                         (In thousands)
<S>                                                      <C>      <C>
Operating activities:
Net income (loss)....................................... $ 1,170  $(1,465)
Adjustments to reconcile net income (loss) to net cash
 provided by (used in) operating activities:
  Depreciation and amortization.........................     965    1,170
  Unrealized loss on investments........................      (2)     --
  Changes in operating assets and liabilities:
    Accounts receivable.................................  (5,031)   3,758
    Inventories.........................................   2,290   (1,691)
    Prepaid expenses and other current assets...........    (335)     235
    Other assets........................................    (124)     171
    Accounts payable....................................     363   (1,180)
    Accrued expenses and other liabilities..............   1,114      447
    Deferred revenue....................................     396     (160)
                                                         -------  -------
Net cash provided by operating activities...............     806    1,285
Investing activities:
Purchases of property and equipment, net................    (859)    (742)
Purchases of short-term investments.....................  (1,500)     --
                                                         -------  -------
Net cash used in investing activities...................  (2,359)    (742)
Financing activities:
Payments on capital lease obligations...................      (6)      (4)
Proceeds from issuance of common stock..................     933      345
Proceeds from notes receivable to shareholders..........      85       30
                                                         -------  -------
Net cash provided by financing activities...............   1,012      371
                                                         -------  -------
Effect of exchange rate changes on cash.................     202     (183)
                                                         -------  -------
Net increase (decrease) in cash and cash equivalents....    (339)     731
Cash and cash equivalents at beginning of year..........   5,562    4,831
                                                         -------  -------
Cash and cash equivalents at end of year................ $ 5,223  $ 5,562
                                                         =======  =======
Supplemental disclosure of cash flow information:
Interest paid........................................... $     1  $     9
                                                         =======  =======
Income taxes paid....................................... $    82  $    21
                                                         =======  =======
</TABLE>

          See accompanying notes to consolidated financial statements.

                                       26
<PAGE>

                             PHOTON DYNAMICS, INC.

                CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

<TABLE>
<CAPTION>
                                                                Accumulated     Notes
                                   Common Stock                    Other      Receivable      Total
                                 ----------------- Accumulated Comprehensive     from     Shareholders'
                                  Shares   Amount    Deficit   Income (Loss) Shareholders    Equity
                                 --------- ------- ----------- ------------- ------------ -------------
                                                   (In thousands, except share data)
<S>                              <C>       <C>     <C>         <C>           <C>          <C>
Balance at September 30, 1997..  7,147,714 $38,573  $(20,682)      $ (14)       $(115)       $17,762
Net loss.......................        --      --     (1,465)        --           --          (1,465)
Net translation adjustments....        --      --        --         (183)         --            (183)
                                                                                             -------
Total comprehensive loss.......                                                               (1,648)
                                                                                             -------
Issuance of common stock.......    176,901     345       --          --           --             345
Repayment of notes receivable..        --      --        --          --            30             30
                                 --------- -------  --------       -----        -----        -------
Balance at September 30, 1998..  7,324,615  38,918   (22,147)       (197)         (85)        16,489
Net income.....................        --      --      1,170         --           --           1,170
Net translation adjustment.....        --      --        --          202          --             202
Net unrealized loss on
 investments...................        --      --        --          (2)          --              (2)
                                                                                             -------
Total comprehensive income.....                                                                1,370
                                                                                             -------
Issuance of common stock.......    489,706     933       --          --           --             933
Repayment of notes receivable..        --      --        --          --            85             85
                                 --------- -------  --------       -----        -----        -------
Balance at September 30, 1999..  7,814,321 $39,851  $(20,977)      $   3        $ --         $18,877
                                 ========= =======  ========       =====        =====        =======
</TABLE>


          See accompanying notes to consolidated financial statements.

                                       27
<PAGE>

                             PHOTON DYNAMICS, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1--Summary of Significant Accounting Policies

  Organization. The Company is a leading worldwide supplier of array test,
inspection and repair systems for the flat panel display ("FPD") industry. The
Company's systems are used to control, monitor and refine the manufacturing
process to increase the yield of FPDs, to reduce materials loss, to transition
new FPD designs from research and development to commercial production and to
assist in the rapid start-up of new FPD manufacturing facilities.

  A significant portion of the Company's total revenue is attributable to
sales outside the U.S. Most of the major FPD manufacturers and many of the
Company's principle customers are located in Asia, primarily Japan, Taiwan and
Korea. The Company's revenue is obtained primarily from FPD manufacturers and,
to a lesser extent, a value-added reseller in Japan, and a sales
representative in Taiwan.

  Revenue Recognition. The Company generally recognizes revenue from product
sales upon shipment, which usually precedes final acceptance. The Company also
provides its customers with one-year service contracts. The revenue from these
contracts is recognized ratably over the contract period.

  Principles of Consolidation. The consolidated financial statements include
the accounts of the Company and its subsidiaries, all of which are wholly-
owned. Significant intercompany accounts and transactions have been eliminated
in consolidation.

  Use of Estimates. The preparation of the financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the amounts in the financial statements
and accompanying notes. Actual results could differ from those estimates.

  Cash and Cash Equivalents. The Company considers all highly liquid
investments with a maturity of three months or less when purchased to be cash
equivalents.

  Short-Term Investments. Short-term investments consist of marketable
securities with a maturity of less than one year but not less than three
months. Short-term investments are recorded at fair value.

  Inventories. Inventories are priced at the lower of cost or market using the
first-in, first-out ("FIFO") method for all inventories. Inventories consisted
of the following:

<TABLE>
<CAPTION>
                                                                   September 30,
                                                                   -------------
                                                                    1999   1998
                                                                   ------ ------
                                                                        (In
                                                                    thousands)
     <S>                                                           <C>    <C>
     Raw materials................................................ $1,351 $1,888
     Work-in-progress.............................................  2,469  2,144
     Finished goods...............................................    657  2,735
                                                                   ------ ------
                                                                   $4,477 $6,767
                                                                   ====== ======
</TABLE>

                                      28
<PAGE>

                             PHOTON DYNAMICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Property, Equipment and Leasehold Improvements. Property, equipment and
leasehold improvements are stated on the basis of cost. Equipment includes
assets recorded under capital lease obligations. Depreciation is computed
principally by the straight-line method for financial reporting purposes.
Estimated useful lives for financial reporting purposes ranges from three to
five years. Equipment recorded under capital lease obligations is amortized by
the straight-line method using the lesser of the lease term or the life of the
related asset. Property, plant and equipment consisted of the following:


<TABLE>
<CAPTION>
                                                                September 30,
                                                               ----------------
                                                                1999     1998
                                                               -------  -------
                                                               (In thousands)
     <S>                                                       <C>      <C>
     Equipment................................................ $ 5,286  $ 4,455
     Office furniture and fixtures............................     326      322
     Leasehold improvements...................................     534      510
                                                               -------  -------
                                                                 6,146    5,287
     Less accumulated depreciation and amortization...........  (4,454)  (3,489)
                                                               -------  -------
                                                               $ 1,692  $ 1,798
                                                               =======  =======
</TABLE>

  Installation and Warranty. The Company generally warrants its systems for
material and labor for a period of twelve months from the date of
installation. A provision for the estimated cost of installation and warranty
is recorded upon shipment.

  Foreign Currency Translation. The financial statements of foreign
subsidiaries have been translated into U.S. dollars in accordance with FASB
Statement No. 52, Foreign Currency Translation. All balance sheet accounts
have been translated using the exchange rates in effect at the balance sheet
date. Income statement amounts have been translated using the average exchange
rate for the year. Translation adjustments are included as a separate
component of shareholders' equity. Foreign currency transaction gains and
losses are included in results of operations and have been immaterial for all
periods presented.

  Stock Based Compensation. The Company accounts for its stock option and
employee stock purchase plans in accordance with the provisions of APB Opinion
No. 25, Accounting For Stock Issued to Employees ("APB 25") and related
Interpretations. Pro forma information regarding earnings per share is
disclosed as required by FASB Statement No. 123, Accounting for Stock-Based
Compensation ("FAS 123"). See Note 10.

  Earnings Per Share. Basic and diluted earnings per share are calculated in
accordance with FASB Statement No. 128, Earnings Per Share ("FAS 128"). See
Note 12.

  Comprehensive Income. As of October 1998, the Company adopted FASB Statement
No. 130, Reporting Comprehensive Income ("FAS 130") which establishes new
rules for the reporting and display of comprehensive income and its
components. FAS 130 requires unrealized gains or losses on the Company's
available-for-sale investments and foreign currency translation adjustments,
which prior to adoption were reported separately in shareholders' equity, to
be included in accumulated other comprehensive income. Prior year financial
statements have been reclassified to conform to the requirements of FAS 130.
The adoption of FAS 130 had no impact on the Company's net income (loss) or
shareholder's equity.

  Segment Information. As of October 1998, the Company adopted FASB Statement
No. 131, Disclosures about Segments of an Enterprise and Related Information
("FAS 131"). FAS 131 superseded FASB Statement No. 14, Financial Reporting for
Segments of a Business Enterprise. FAS 131 establishes standards for the way
that public business enterprises report information about operating segments
in annual financial statements and

                                      29
<PAGE>

                             PHOTON DYNAMICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

requires that those enterprises report selected information about operating
segments in interim financial reports. FAS 131 also establishes standards for
related disclosures about products and services, geographic areas, and major
customers. The adoption of FAS 131 did not affect results of operations,
financial position or disclosure of segment information. The Company conducts
business in one operating segment. The Company manufactures and sells array
test, inspection and repair systems for use in the FPD industry. The Company's
management has determined the operating segment based upon how the business is
managed and operated. The Company's principal market is primarily Asian based
FPD manufacturers.

  Impact of Recently Issued Accounting Standards. In June 1998, the FASB
issued Statement No. 133, Accounting for Derivative Instruments and Hedging
Activities ("FAS 133"). The Company is required to adopt FAS 133 for the year
ending September 30, 2001. FAS 133 will require the Company to recognize all
derivatives on the balance sheet at fair value. The Company does not
anticipate that the adoption of FAS 133 will have a significant effect on its
results of operations or financial condition.

NOTE 2--Accrued Expenses and Other Liabilities

  Accrued expenses and other liabilities consisted of the following:

<TABLE>
<CAPTION>
                                                                  September 30,
                                                                  -------------
                                                                   1999   1998
                                                                  ------ ------
                                                                       (In
                                                                   thousands)
     <S>                                                          <C>    <C>
     Warranty.................................................... $1,418 $1,105
     Compensation................................................  1,232    855
     Other accrued expenses......................................  1,400    976
                                                                  ------ ------
                                                                  $4,050 $2,936
                                                                  ====== ======
</TABLE>

NOTE 3--Notes Receivable from Shareholders

  Notes receivable from shareholders arose from certain employees exercising
their stock options and advances to purchase stock on the open market. The
notes bear interest at 6.83% per annum and are secured by the shares
purchased. As of September 30, 1999, all notes receivable from shareholders
had been collected.

NOTE 4--Asset Recovery Related to Product Line Disposal

  During the quarter ended December 31, 1997, the Company received a payment
of $350,000 in settlement of a dispute related to the cancellation of its
Defect Monitoring Tool ("DMT") product line. In September 1996, the Company
ceased operations of its DMT product line. The DMT product group had worked
exclusively on a single customer project not in the FPD market. As a result of
the cancellation of this project, the Company had expensed the associated
inventory and assets of this product line which were not transferred to other
products.

NOTE 5--Credit Arrangements

  The Company has entered into a $3.5 million line of credit with a bank which
expires in March 2000. This line of credit is secured by substantially all of
the Company's assets and contains certain financial and other covenants. The
Company is eligible to borrow against accounts receivable and a portion of
inventories. Borrowings under this line of credit bear interest at prime rate
plus 1.00% to 1.25% (9.25% to 9.50% as of September 30, 1999). As of September
30, 1999, no amounts were outstanding under this bank line of credit, and the
Company was in compliance with all bank covenants.


                                      30
<PAGE>

                             PHOTON DYNAMICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


NOTE 6--Shareholders' Equity

  Stock Reserved for Future Issuance. As of September 30, 1999, the Company
has reserved 1,407,849 shares of Common Stock for future issuance.

  Warrants. The Company has warrants outstanding to purchase from the Company
12,067 shares of Common Stock. The purchase price for the shares is $5.40 per
share. These warrants will expire in June 2000.

NOTE 7--Income Taxes

The provision for income taxes consists of the following:

<TABLE>
<CAPTION>
                                                                     Years Ended
                                                                      September
                                                                         30,
                                                                     -----------
                                                                     1999  1998
                                                                     ----- -----
                                                                         (In
                                                                     thousands)
     <S>                                                             <C>   <C>
     Federal--current............................................... $  66 $ --
     State--current.................................................   --    --
     Foreign--current...............................................    71   108
                                                                     ----- -----
     Total.......................................................... $ 137 $ 108
                                                                     ===== =====
</TABLE>

  The provisions for taxes on income differed from the provisions calculated
by applying the federal statutory rate to income before taxes as follows:

<TABLE>
<CAPTION>
                                                                  Years Ended
                                                                   September
                                                                      30,
                                                                  ------------
     <S>                                                          <C>    <C>
<CAPTION>
                                                                  1999   1998
                                                                  -----  -----
                                                                      (In
                                                                  thousands)
     <S>                                                          <C>    <C>
     Expected provision (benefit) at statutory rate.............  $ 444  $(475)
     Alternative minimum taxes..................................     66     28
     Losses (benefited)/not benefited...........................   (373)   555
                                                                  -----  -----
                                                                  $ 137  $ 108
                                                                  =====  =====
</TABLE>

  As of September 30, 1999, the Company has federal and state net operating
loss carryforwards of approximately $12,100,000 and $320,000, respectively.
The Company also has federal and state research and development tax credit
carryforwards of $1,300,000 and $750,000, respectively. The net operating loss
and credit carryforwards will expire at various times beginning in 2000
through 2018, if not utilized.

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

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

                                      31
<PAGE>

                             PHOTON DYNAMICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Significant components of the Company's deferred tax assets are as follows:

<TABLE>
<CAPTION>
                                                             Years Ended
                                                            September 30,
                                                          ----------------
                                                           1999     1998
                                                          -------  -------
                                                          (In thousands)
<S>                                                      <C>      <C>
Deferred tax assets:
   Net operating loss carryforwards....................   $ 4,150  $ 4,902
   Research credit carryforwards.......................     1,800    1,698
   Capitalized research costs..........................       419      538
   Inventory writedowns................................       980      715
   Depreciation........................................       462      613
   Other individually immaterial items.................     1,859    1,446
                                                          -------  -------
   Total deferred tax assets...........................     9,670    9,912
Valuation allowance....................................    (9,670)  (9,912)
                                                          -------  -------
Net deferred tax assets................................   $   --   $   --
                                                          =======  =======
</TABLE>

NOTE 8--Commitments

  The Company leases its main facility in San Jose, California under a
noncancelable operating lease agreement. The lease for the building may be
renewed for one five-year period during fiscal 2002. Total future minimum
payments under noncancelable operating leases with initial terms of one year
or more consisted of the following as of September 30, 1999:

<TABLE>
<CAPTION>
                                                                    Operating
                                                                      Leases
                                                                  --------------
                                                                  (In thousands)
     <S>                                                          <C>
     2000........................................................     $  709
     2001........................................................        727
     2002........................................................         61
                                                                      ------
     Total minimum lease payments................................     $1,497
                                                                      ======
</TABLE>

  Rental expense for the years ended September 30, 1999 and 1998 was $732,000
and $719,000, respectively.

NOTE 9--Financial Instruments

  Concentrations of Credit Risk. Financial instruments that potentially
subject the Company to significant concentrations of credit risk consists
principally of trade accounts receivable. Most of the Company's principle
customers are located in Asia, primarily Japan, Taiwan and Korea. Therefore,
the Company's sales to these countries may be adversely affected by the
overall health of these economies, including the effects of currency exchange
rate fluctuations. The Company generally sells its products on net-30 day
terms to its customers with a small portion held back until final acceptance.
Although a substantial portion of its customers, primarily foreign, remit
payments on significantly longer terms, the Company generally does not require
collateral for its trade accounts receivable. The Company believes its credit
evaluation and monitoring mitigates this credit risk. In fiscal 1999, sales to
three unaffiliated and one affiliated customer represented 26%, 22%, 14% and
16% of total revenue, respectively. In fiscal 1998, sales to two unaffiliated
and one affiliated customer accounted for 45%, 17% and 27%, respectively.
International sales, all of which were export sales, accounted for 99% and 96%
of total revenue in fiscal 1999 and fiscal 1998, respectively.

                                      32
<PAGE>

                             PHOTON DYNAMICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)



  Fair Value of Financial Instruments. The Company has evaluated its fair
value disclosures for financial instruments. The carrying amount reported in
the balance sheet for cash and cash equivalents, short-term investments,
accounts receivable, accounts payable, and accrued expenses approximates its
fair value.

NOTE 10--Employee Stock Purchase and Stock Option Plans

  Employee Purchase Plan. In January 1999, the Board of Directors amended the
1995 Employee Stock Purchase Plan ("Purchase Plan") to increase the number of
shares authorized for issuance to an aggregate of 350,000 shares. The Purchase
Plan permits eligible employees to purchase common stock, through payroll
deductions, at 85% of the lower of the fair market value of the common stock
on the date at the beginning of the two-year offering period or the last day
of the purchase period. Substantially all employees are eligible to
participate in the Purchase Plan. Employees purchased 120,445 shares in fiscal
1999 for $293,000 as compared to 102,343 shares for $239,000 in fiscal 1998.
As of September 30, 1999, 62,172 shares were available for issuance under the
plan.

  Stock Option Plans. Under the 1987 and 1995 Stock Option Plans ("Option
Plans"), the Board of Directors may, at its discretion, grant incentive or
nonqualified stock options to employees and directors. Options granted under
the Option Plans have exercise prices at least equal to the market price at
the date of grant and, subject to termination of employment, expire ten years
from the date of grant, are not transferable other than on death, and are
exercisable in four equal annual installments commencing one year from the
date of grant.

  In November 1998, the Board of Directors authorized the repricing of options
granted to employees effective as of the close of business on November 27,
1998 to the then fair market value of $4.50 per share. Under the terms of the
repricing, employees surrendered 431,833 of existing options in exchange for
353,464 replacement options, which contained a provision that the replacement
options could not be exercised for a six month period and that extended the
original option vesting schedule by six months. The number of replacement
options issued were determined based on a conversion formula. No members of
the Company's Board of Directors participated in the repricing.

  The following table summarizes the Company's stock option activity and
related information:

<TABLE>
<CAPTION>
                                                   Shares Under Weighted Average
                                                      Option     Exercise Price
                                                   ------------ ----------------
   <S>                                             <C>          <C>
   Outstanding as of September 30, 1997...........  1,008,505        $5.24

   Granted........................................    424,700        $3.80
   Exercised......................................   (131,639)       $1.05
   Canceled.......................................   (276,200)       $5.43
                                                    ---------        -----
   Outstanding as of September 30, 1998...........  1,025,366        $5.13

   Granted........................................    766,664        $5.79
   Exercised......................................   (171,069)       $3.42
   Canceled.......................................   (548,951)       $6.59
                                                    ---------        -----
   Outstanding as of September 30, 1999...........  1,072,010        $5.13
                                                    =========        =====
</TABLE>

  273,667 and 279,332 stock option shares are available for grant as of
September 30, 1999 and 1998, respectively. 471,918 and 485,361 stock option
shares are exercisable as of September 30, 1999 and 1998, respectively.

                                      33
<PAGE>

                             PHOTON DYNAMICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  The following table summarizes information about stock options outstanding
as of September 30, 1999:

<TABLE>
<CAPTION>
                                           Options Outstanding                     Options Exercisable
                            --------------------------------------------------- --------------------------
                              Number           Weighted             Weighted      Number       Weighted
   Range of Eexercise       Outstanding    Average Remaining        Average     Outstanding    Average
   Prices                   at 9/30/99  Contractual Life (Years) Exercise Price at 9/30/99  Exercise Price
   ------------------       ----------- -----------------------  -------------- ----------- --------------
   <S>                      <C>         <C>                      <C>            <C>         <C>
   $0.60-$0.90.............     60,974           4.42                $ 0.72        60,974       $ 0.72
   $2.40-$3.60.............    212,454           8.09                $ 3.20        89,642       $ 3.09
   $4.13-$4.13.............    165,000           9.14                $ 4.13        33,500       $ 4.13
   $4.50-$4.50.............    291,651           9.16                $ 4.50       186,906       $ 4.50
   $4.63-$7.50.............    205,631           8.52                $ 5.67        75,756       $ 5.91
   $8.44-$10.63............     60,500           9.13                $10.22        19,900       $ 9.39
   $11.00-$14.38...........     75,800           9.62                $13.10         5,240       $11.00
                             ---------           ----                ------       -------       ------
   $0.60-$14.38............  1,072,010           8.58                $ 5.13       471,918       $ 4.22
</TABLE>

  The weighted average fair value of stock options granted in fiscal 1999 and
fiscal 1998 was $2.66 and $1.99, respectively. The weighted average fair value
of stock purchases under the Purchase Plan in fiscal 1999 and fiscal 1998 was
$1.86 and $1.59, respectively.

  Accounting for Stock Based Compensation Plans. In accordance with the
provisions of FAS 123, the Company applies APB 25 and related Interpretations
in accounting for its stock option and employee stock purchase plans and,
accordingly, does not recognize compensation expense in the statement of
operations because the exercise price of the employees' stock options equals
the market price of the underlying stock on the date of grant. If the Company
had elected to recognize compensation expense based on the fair value of the
options granted at the grant date as prescribed by FAS 123, earnings and
earnings per share would have been adjusted to the pro forma amounts as
follows:

<TABLE>
<CAPTION>
                                                               Years Ended
                                                              September 30,
                                                             ----------------
                                                              1999     1998
                                                             ------- --------
                                                              (In thousands,
                                                             except per share
                                                                   date)
   <S>                                                       <C>     <C>
   Net income (loss) as reported............................ $ 1,170 $ (1,465)
   Net income (loss) pro forma.............................. $   125 $ (2,091)
   Basic and diluted net income (loss) per share--as
    reported................................................ $  0.15 $ ( 0.20)
   Basic and diluted net income (loss) per share--pro
    forma................................................... $  0.02 $ ( 0.28)
</TABLE>

  The effects on pro forma disclosures of applying FAS 123 are not likely to
be representative of the effects on pro forma disclosures of future years
because FAS 123 is applicable only to options granted subsequent to October 1,
1995. Compensation expense for the fair value of each stock option grant is
estimated on the date of grant using the Black-Scholes option pricing model
for the multiple option approach with the following weighted average
assumptions:

<TABLE>
<CAPTION>
                                             Options             ESPP
                                         ----------------  ------------------
                                          1999     1998     1999      1998
                                         -------  -------  -------  ---------
<S>                                      <C>      <C>      <C>      <C>
Expected dividend yield.................     --       --       --         --
Expected stock price volatility.........    0.80     0.80     0.80       0.79
Risk free interest rate.................    4.73%    5.54%    5.31%      5.30%
Expected life of options from date of
 grant                                   2 years  3 years  2 years  1.5 years
</TABLE>


                                      34
<PAGE>

                             PHOTON DYNAMICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

NOTE 11--Retirement Savings Plan

  Under the Company's retirement savings plan (the "401(k) Plan"), a U.S.
employee may defer and invest up to 20% of his or her annual compensation,
subject to an annual dollar limitation. All U.S. full-time employees, twenty-
one years or older, are eligible to participate in the 401(k) Plan. The
Company has not elected to make matching contributions.

NOTE 12--Earnings Per Share

  For the years ended September 30, 1999 and 1998, basic and diluted earnings
per share is computed using the weighted average number of shares of common
stock outstanding. As the Company incurred a loss for the year ended September
30, 1998, the effect of dilutive securities totaling approximately 299,234
from stock options and warrants has been excluded from the computation of
diluted earnings per share as their effect is antidilutive. The following
table sets forth the computation of basic and diluted earnings per share:

<TABLE>
<CAPTION>
                                                                    Years Ended
                                                                    September 30,
                                                                ---------------------
                                                                 1999          1998
                                                                ------        -------
                                                                (In thousands, except
                                                                   per share data)
   <S>                                                          <C>    <C>
   Numerator for basic and diluted earnings per share--net
    income (loss).............................................. $1,170        $(1,465)
   Denominator for basic earnings per share--weighted average
    shares.....................................................  7,558          7,231
   Effect of dilutive securities:
    Employee stock options.....................................    436            --
    Warrants...................................................     61            --
                                                                ------        -------
   Denominator for diluted earnings per share--adjusted for
    weighted average shares from options and warrants..........  8,055          7,231

   Basic net income (loss) per share........................... $ 0.15        $ (0.20)
   Diluted net income (loss) per share......................... $ 0.15        $ (0.20)
</TABLE>

NOTE 13--Related Parties

  During fiscal 1998, the Company sold $6.2 million of its systems to LG
Electronics, Inc. ("LG"), and accounts receivable as of September 30, 1998
included $1.1 million of receivable from LG. During fiscal 1999, the Company
sold $4.9 million of its systems to LG, and accounts receivable as of
September 30, 1999 included $0.3 million of receivable from LG. At September
30, 1998, LG owned approximately 8% of the Company's Common Stock and warrants
to purchase 28,333 shares of Common Stock at an exercise price of $0.60 per
share and also held a seat on the Company's Board of Directors. At September
30, 1999, LG owned less than 1% of the Company's common stock and is no longer
on the Company's Board of Directors.

NOTE 14--Pending Business Combination

  In August 1999, the Company entered into an agreement with CR Technology,
Inc. ("CRT"), a California corporation, whereby the Company will acquire all
of the outstanding common and preferred shares of CRT in exchange for
approximately 2,000,000 shares of the Company's Common Stock. This transaction
is intended to be accounted for as a pooling of interests. The transaction
must be approved by a vote of CRT's and the Company's shareholders. The
agreement terminates on December 31, 1999 if the merger has not occurred by
that date. As of September 30, 1999, approximately $307,000 of expenses
related to the business combination have been capitalized as prepaid expenses
and will be expensed in the period that the combination is consummated.

                                      35
<PAGE>

                             PHOTON DYNAMICS, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


ITEM 8: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

  Not applicable

                                       36
<PAGE>

                                   PART III

  Certain information required by Part III is omitted from this Report in that
the Registrant will file a definitive proxy statement within 120 days after
the end of its fiscal year pursuant to Regulation 14A (the "Proxy Statement")
for its 2000 Annual Meeting of Shareholders to be held November 29, 1999, and
the information included therein is incorporated herein by reference.

ITEM 9: DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT

  With the exception of the table below, the information required by this Item
is incorporated by reference from the Company's Proxy Statement for the 2000
Annual Meeting of Shareholders.

  The following table sets forth certain information concerning the executive
officers of the Company:

<TABLE>
<CAPTION>
     Name                      Age Position(s)
     ----                      --- ----------
     <S>                       <C> <C>
     Mr. Vincent F. Sollitto,
      Jr.....................   51 Chief Executive Officer and President
     Mr. Richard L. Dissly...   55 Chief Financial Officer, Vice President of Operations and
                                   Secretary
     Mr. Jeffrey A.
      Hawthorne..............   41 Vice President, Development
     Dr. William K. Pratt....   62 Chief Technical Officer
</TABLE>

  Mr. Sollitto joined the Company as Chief Executive Officer and President in
June 1996 and became a member of the Board of Directors of the Company in July
1996. From August 1993 to 1996, Mr. Sollitto was the General Manager of
Business Unit Operations for Fujitsu Microelectronics, Inc. From April 1991 to
August 1993, he was the Executive Vice President of Technical Operations at
Supercomputer Systems, Inc. Mr. Sollitto spent twenty-one years in various
positions, including Director of Technology and Process at International
Business Machines Corporation, before joining Supercomputer Systems, Inc. Mr.
Sollitto serves as a director of Irvine Sensors Corporation. Mr. Sollitto is a
graduate of Tufts College where he received a B.S. in electrical engineering
in 1970.

  Mr. Dissly joined the Company in November 1998 as Chief Financial Officer
and Vice President of Operations. He was appointed Secretary of the Company in
October 1999. He has more than twenty years of experience in establishing
profitable business models and systems with several rapidly growing
international electronics companies. Prior to joining the Company, Mr. Dissly
was the Chief Financial Officer of Semaphore Communications from January 1997
to October 1998 and CrossCheck Technology from July 1992 to December 1996. His
responsibilities have included managing operations, strategic planning, MIS,
finance, human resources, and facilities. Mr. Dissly has an MBA from Santa
Clara University and is a licensed Certified Public Accountant.

  Mr. Hawthorne joined the Company in November 1991 as Senior Applications
Engineer, FIS Products. He was promoted to Project Manager, FIS Products and
then General Manager and Vice President, Inspection Products Division in
August 1992 and in September 1994, respectively. From June 1990 to November
1991, he was a consultant with Display Tech, which provided consulting
services in the area of liquid crystal displays. He received a B.S. in
engineering physics from the University of Colorado in 1987 and an M.S. in
optical engineering from the University of Rochester in 1990.

  Dr. Pratt joined the Company in October 1996 as Chief Technical Officer for
Software. From 1988 through 1994, he was Director of Multimedia and Imaging
Technology at Sun Microsystems, Inc. In 1993, he founded Pixelsoft, Inc., a
start-up image processing software development company. Dr. Pratt received a
B.S. in electrical engineering from Bradley University and an M.S. and a Ph.D.
in electrical engineering from the University of Southern California. Dr.
Pratt holds five patents and is the author of several books on image
processing.

  The information required by this Item concerning compliance with section
16(a) of the Exchange Act is incorporated by reference from the Company's
Proxy Statement for the 2000 Annual Meeting of Shareholders under the heading
"Section 16(a) Beneficial Ownership Reporting Compliance."

                                      37
<PAGE>

ITEM 10: EXECUTIVE COMPENSATION

  The information required by this Item is incorporated by reference from the
Company's Proxy Statement for the 2000 Annual Meeting of Shareholders under
the heading "Executive Compensation."

ITEM 11: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

  The information required by this Item is incorporated by reference from the
Company's Proxy Statement for the 2000 Annual Meeting of Shareholders under
the heading "Security Ownership of Certain Beneficial Owners and Management."

ITEM 12: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

  The information required by this Item is incorporated by reference from the
Company's Proxy Statement for the 2000 Annual Meeting of Shareholders under
the heading "Certain Relationships and Related Transactions."

ITEM 13: EXHIBITS AND REPORTS ON FORM 8-K

  (a) The following documents are filed as part of this Form 10-KSB Report:

    (1) Financial Statements: See Index to Financial Statements.

    (2) Exhibits: See Index to Exhibits. The Exhibits listed in the
  accompanying Index to Exhibits are incorporated by reference as part of
  this report.

  (b) Reports on Form 8-K. No reports on Form 8-K were filed during the
quarter ended September 30, 1999.

                                      38
<PAGE>

                                  SIGNATURES

  In accordance with Section 13 or 15(d) of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.

                                       PHOTON DYNAMICS, INC.

Date: October 27, 1999                 By: /s/ Vincent F. Sollitto, Jr.
                                           -------------------------------------
                                                  Vincent F. Sollitto, Jr.
                                            Chief Executive Officer and Director
                                                 (Principal Executive Officer)

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

  Pursuant to the requirements of the Securities Act of 1933, this Annual
Report on Form 10-KSB has been signed by the following persons in the
capacities and on the dates indicated:

<TABLE>
 <C>                <S>                        <C>
 October 27, 1999   Chief Executive Officer     /s/ Vincent F. Sollitto, Jr.
                    and Director                --------------------------------
                    (Principal Executive          Vincent F. Sollitto, Jr.
                    Officer)

 October 27, 1999   Chief Financial Officer       /s/ Richard L. Dissly
                    (Principal Financial and    --------------------------------
                    Accounting Officer)               Richard L. Dissly

 October 27, 1999   Chairman of the Board          /s/ E. Floyd Kvamme
                                                --------------------------------
                                                       E. Floyd Kvamme

 October 27, 1999   Director                         /s/ Barry L. Cox
                                                --------------------------------
                                                        Barry L. Cox

 October 27, 1999   Director                        /s/ Francois J. Henley
                                                --------------------------------
                                                     Francois J. Henley

 October 27, 1999   Director                        /s/ Michael J. Kim
                                                --------------------------------
                                                       Michael J. Kim

 October 27, 1999   Director                       /s/ Malcolm J. Thompson
                                                --------------------------------
                                                   Dr. Malcolm J. Thompson
</TABLE>



                                      39
<PAGE>

                               INDEX TO EXHIBITS

<TABLE>
<CAPTION>
 Number                           Exhibit                             Reference
 ------                           -------                             ---------
 <C>    <S>                                                           <C>
  3.1   Form of Amended and Restated Articles of Incorporation of        A
        the Registrant.
  3.2   Amended and Restated Bylaws of the Registrant.                   D
  4.1   Reference is made to Exhibits 3.1 and 3.2.                       A
 10.1   First Amended and Restated Investor Rights Agreement             A
        between Registrant and the shareholders set forth therein
        dated May 11, 1994.
 l0.2   Fourth Amended Shareholders Agreement for Photon Dynamics,       A
        Inc. between the Registrant and the shareholders set forth
        therein dated May 11, 1994.
 10.3   Form of Indemnification Agreement between the Registrant         A
        and each of its executive officers and directors.
 10.4   1987 Stock Option Plan and Form of Stock Option Agreement.       A,B
 10.5   1995 Stock Option Plan and Forms of Stock Option                 A,B
        Agreements.
 10.6   1995 Employee Stock Purchase Plan.                               A,B
 10.7   Lease agreement between Berg & Berg Developers and Photon        C
        Dynamics, Inc. dated August 6, 1996.
 10.8   Sales Agent Agreement between the Registrant, K.K. Photon        A
        Dynamics and Ishikawajima-Harima Heavy Industries Co., Ltd.
        dated June 1, 1992, the amendment thereto dated November
        17, 1993 and the modification agreement related thereto
        dated January 1, 1995.
 10.9   License Agreement between the Registrant and Ishikawajima-       A
        Harima Heavy Industries Co., Ltd. dated June 1, 1992 and
        the addendum thereto dated November 11, 1993.
 10.10  Commercialization Agreement between the Registrant and           A
        Ishikawajima-Harima Heavy Industries Co., Ltd. dated June
        1, 1992 and the amendment thereto dated November 17, 1993.
 10.13  Form of Amendment to First Amended and Restated Investor         A
        Rights Agreement.
 10.14  Agreement Regarding Change of Control between the                C
        Registrant and Vincent Sollitto dated July 1, 1996.

 10.15  Agreement Regarding Change of Control between the
        Registrant and Richard Dissly dated November 1, 1998.
 10.16  Agreement Regarding Change of Control between the
        Registrant and Jeffrey Hawthrone dated October 15, 1995.

 21.1   Subsidiaries of the Registrant.                                  D
 23.1   Consent of Ernst & Young LLP, Independent Auditors.
 27.1   Financial Data Schedule.
</TABLE>
--------
Key to Exhibits:

(A) Incorporated by reference to Registrants' Registration Statement on Form
    SB-2 filed with the Securities and Exchange Commission on November 15,
    1995.
(B) Management contract or compensatory plan or arrangements required to be
    filed as an exhibit to this report on Form 10-KSB pursuant to Item 13(a)
    of this report.
(C) Incorporated by reference to Registrant's Form10-KSB for the year ended
    September 30, 1996.
(D) Incorporated by reference to Registrant's Form 10-KSB for year ended
    September 30, 1998.

                                      40