PHTN Photon Dynamics (MM)

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

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

For the quarterly period ended December 31, 2007

OR

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to

Commission file number: 0-27234

5970 Optical Court
San Jose, California 95138-1400
(Address of principal executive offices including zip code)

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

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

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o       Accelerated filer þ       Non-accelerated filer o       Smaller reporting company o

(Do not check if a smaller reporting company)

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

     As of February 1, 2008, there were 17,743,683 shares outstanding of the Registrant’s Common Stock, no par value.

 

 

INDEX

				Page
		PART I FINANCIAL INFORMATION
Item 1		Financial Statements (unaudited)			3
		Condensed Consolidated Balance Sheets as of December 31, 2007 and September 30, 2007			3
		Condensed Consolidated Statements of Operations for the Three Months Ended December 31, 2007 and 2006			4
		Condensed Consolidated Statements of Cash Flows for the Three Months Ended December 31, 2007 and 2006			5
		Notes to Condensed Consolidated Financial Statements			6
Item 2		Management’s Discussion and Analysis of Financial Condition and Results of Operations			20
Item 3		Quantitative and Qualitative Disclosures About Market Risk			35
Item 4		Controls and Procedures			36
		PART II OTHER INFORMATION
Item 1		Legal Proceedings			38
Item 1A		Risk Factors			38
Item 2		Unregistered Sales of Equity Securities and Use of Proceeds			38
Item 3		Defaults Upon Senior Securities			38
Item 4		Submission of Matters to a Vote of Security Holders			39
Item 5		Other Information			39
Item 6		Exhibits			39
Signatures					40
EXHIBIT 10.51
EXHIBIT 10.52
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1

PART I. FINANCIAL INFORMATION

See accompanying notes to condensed consolidated financial statements.

See accompanying notes to condensed consolidated financial statements.

PHOTON DYNAMICS, INC.

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

     The Company accounts for certain of its product sales as arrangements with multiple deliverables. For arrangements with multiple deliverables, the Company recognizes revenue for the delivered items if the delivered items have value to the customer on a standalone basis, the amount of revenue for delivered elements is not subject to refund, the delivery or performance of the undelivered items is considered probable and substantially in the control of the Company, the Company has met defined customer acceptance experience levels for the delivered items, and the fair value of undelivered items, such as installation and system upgrade rights, can be reliably determined. The Company allocates revenue to the delivered items based on the lesser of the amount due and billable upon shipment and the difference between the total amount due at time of shipment and the allocated fair value of the undelivered elements, with the remaining amount recognized after installation and acceptance when the final amount becomes due. Revenue is deferred when more than 20% of the total value of the contract is not billable to the customer until the occurrence of a future event. Installation and other services are not essential to the functionality of the products that may be accounted for as arrangements with multiple deliverables as these services do not alter the product capabilities, do not require specialized skills or tools and can be performed by other vendors.

     For new products that have not been demonstrated to meet product specifications, 100% of revenue is deferred until customer acceptance.

     The Company recognizes revenue on the sale of spare parts when the product has been shipped, risk of loss has passed to the customer and collection of the resulting receivable is probable.

     For arrangements that include engineering services that are essential to the functionality of a product or involve significant customization or modification of the product, the Company recognizes revenue using the percentage-of-completion method, as described in SOP 81-1 “Accounting for Performance of Construction-Type and Certain Production-Type Contracts,” if the Company believes it is able to make reasonably dependable estimates of the extent of progress toward completion. The Company measures progress toward completion using an input method based on the ratio of costs incurred to date, principally labor, to total estimated costs of the project. These estimates are assessed continually during the term of the contract, and revisions are reflected when changed conditions become known. In some cases, the Company accepts engineering services contracts for which the Company is not able to reasonably estimate the amount of revenues or costs under the contract. In these situations, provided that the Company is reasonably assured that no loss will be incurred under the arrangement, the Company recognizes revenues and costs based on a zero profit model, which results in the recognition of equal amounts of revenues and costs, until the engineering professional services are complete. In situations where the Company accepts engineering services contracts that are expected to be losses at the time of acceptance in order to gain experience in developing new technology that could be used in future products and services, provisions for losses on contracts are recorded when estimates indicate that a loss will be incurred on a contract.

     The Company has a policy to record provisions as necessary, based on historical rates for estimated sales returns, which are booked in the same period that the related revenue is recorded and netted against revenue.

      Accounting Changes : In the first quarter of fiscal 2008, the Company adopted the Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”) and related guidance. See Note 12 for further discussion.

      Recent Accounting Pronouncements. In December 2007, the FASB issued Statement of Accounting Standards No. 141 (revised 2007) “Business Combinations” (“SFAS No. 141R”). SFAS No. 141R retains the fundamental requirements in Statement 141 “Business Combinations” while providing additional definitions, such as the definition of the acquirer in a purchase and improvements in the application of how the acquisition method is applied. The provisions of SFAS No. 141R will be effective for the Company in fiscal years beginning October 1, 2009. The Company is evaluating the impact of this statement on its results of operations, financial position and cash flows.

     In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value for Financial Assets and Financial Liabilities — Including an Amendment of FASB Statement No. 115” (“SFAS No. 159”). SFAS No. 159 permits an entity to choose to measure many financial instruments and certain other items at fair value at specified election dates. Subsequent unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. The provisions of SFAS No. 159 will be effective for the Company in fiscal years beginning October 1, 2008. The Company is evaluating the impact of this statement on its results of operations, financial position and cash flows .

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

     In September 2006, the FASB issued Statement of Financial Accounting Standards No.157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. The provisions of SFAS No. 157 will be effective for the Company in fiscal years beginning October 1, 2008. The Company is evaluating the impact of this statement on its results of operations, financial position and cash flows .

NOTE 3 — GOODWILL AND OTHER PURCHASED INTANGIBLE ASSETS

Goodwill

     The carrying value of goodwill was approximately $6.9 million at both December 31, 2007 and September 30, 2007. There were no additions or adjustments to goodwill during the three months ended December 31, 2007. There have been no significant events or circumstances negatively affecting the valuation of goodwill subsequent to the Company’s annual impairment test performed during the fourth quarter of fiscal 2007.

     At December 31, 2007, approximately $153,000 of goodwill relates to the Company’s purchase of assets from Summit Imaging in May 2003, while approximately $6.7 million relates to the Company’s purchase of Salvador Imaging in July 2007.

Intangible Assets

     The components of intangible assets as of December 31, 2007 were as follows:

     The following table summarizes the activity during the three months ended December 31, 2007:

     Based on intangible assets recorded at December 31, 2007, and assuming no subsequent additions to, or impairment of, the underlying assets, the remaining amortization expense relating to intangible assets at December 31, 2007, is approximately $2.5 million in the remainder of fiscal 2008 and $2.9 million, $2.8 million and $1.9 million in fiscal years 2009 through 2011, respectively.

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

NOTE 4 — RESTRUCTURING AND OTHER CHARGES

November 2006 Restructure

     On November 16, 2006, the Company announced its intention to discontinue its PanelMaster ^TM product line. The Company recorded this restructuring plan in accordance with Statement of Financial Accounting Standards No. 146 “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS No. 146”). The Company recorded a restructuring charge of approximately $446,000 in the three months ended December 31, 2006, which was comprised of approximately $173,000 for employee severance and related benefits for ten employees and approximately $273,000 related to impairing certain manufacturing assets associated with the product line. These charges are reflected in “Restructuring charge” in the Company’s Condensed Consolidated Statements of Operations. All amounts were paid out in the six months ended March 31, 2007.

April 2005 Restructure

     During the third quarter of fiscal 2005, the Company implemented a restructuring plan to relocate all activities in its Markham, Canada location — consisting of research and development related to the Company’s PanelMaster ^TM inspection systems — to the Company’s Daejon, Korea and San Jose, California locations. The Company recorded this restructuring plan in accordance with SFAS No. 146. The Company recorded an initial restructuring charge of approximately $676,000 in its third quarter of fiscal 2005, which was comprised of approximately $430,000 for employee severance and related benefits for 32 employees and approximately $246,000 related to contract termination costs associated with excess facilities. All amounts were paid out by September 30, 2006, except for approximately $38,000 of contract termination costs associated with the lease and this liability was reflected in “Other current liabilities” in the Company’s Consolidated Balance Sheets. During the three months ended December 31, 2006, the Company paid approximately $2,000 in cash and incurred approximately $1,000 in foreign currency translation effects on the liability. At September 30, 2007, the outstanding liability balance was approximately $25,000. During the three months ended December 31, 2007, the Company paid approximately $1,000 in cash.

NOTE 6 — STOCK-BASED COMPENSATION PLANS

     Effective October 1, 2005, Photon Dynamics adopted the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004) “Share-Based Payments” (“SFAS No. 123R”). SFAS No. 123R establishes accounting for stock-based awards exchanged for employee services. Accordingly, stock-based compensation cost is measured on the grant date, based on the fair value of the award, and is recognized as an expense over the employee’s requisite service period.

     The effect of recording stock-based compensation for three months ended December 31, 2007 and 2006 was as follows:

Equity Incentive and Other Programs

     The Company’s equity incentive program is a long-term retention program that is intended to attract and retain qualified management and technical employees and align stockholder and employee interests. At December 31, 2007, the equity incentive program consisted of:

The 2005 Equity Incentive Plan . Under this plan, officers, key employees, consultants and all other employees may be granted restricted stock units, options to purchase shares of the Company’s stock, and other types of equity awards. This plan permits the grant of equity awards for up to 2,250,000 shares of common stock. Under this plan, stock options generally have a vesting period of 50 to 60 months, are generally exercisable for a period of seven to

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

ten years from the date of issuance and are granted at prices not less than the fair market value of the Company’s common stock at the grant date. Certain option awards provide for accelerated vesting if there is a change of control. Restricted stock units may be granted under the 2005 Equity Incentive Plan with varying criteria such as time-based or performance-based vesting. Under the 2005 Equity Incentive Plan, restricted stock units generally vest annually over a three- to four-year period from the date of grant. Restricted stock units issued in the Company’s one-time stock option exchange program vest over a two- to three-year period from the date of exchange.

2006 Non-Employee Directors’ Stock Incentive Plan . Under this plan, non-employee directors may be granted restricted stock units, options to purchase shares of the Company’s stock, and other types of equity awards. This plan permits the grant of equity awards for up to 600,000 shares of common stock. Under this plan, stock options generally have a vesting period of 12 to 48 months, are generally exercisable for a period of ten years from the date of issuance and are granted at prices not less than the fair market value of the Company’s common stock at the grant date. Restricted stock units may be granted under this plan with varying criteria such as time-based vesting. Under this plan, restricted stock units generally vest annually over a three- to four-year period from the date of grant.

     Prior to vesting, restricted stock units under both plans do not have dividend equivalent rights, do not have voting rights, and the shares underlying the restricted stock units are not considered issued and outstanding. Shares are issued on the date the restricted stock units vest. The majority of shares issued are net of statutory withholding requirements that are paid by Photon Dynamics on behalf of its directors and employees. As a result, the actual number of shares issued will be less than the number of restricted stock units granted. Furthermore, the liability for most of the withholding amounts to be paid by Photon Dynamics will be recorded as a reduction in Common Stock when the restricted stock units vest.

     In addition to its equity incentive programs, the Company’s employee stock purchase plan provides that eligible employees may contribute up to 10% of their eligible earnings through accumulated payroll deductions toward the semi-annual purchase of the Company’s common stock. Participants purchase shares on the last day of each offering period. The price at which shares are purchased is equal to 85% of the lower of the fair market value of a share of common stock on the first day of the offering period or on the purchase date. Offering periods are typically six months in length.

Valuation and Other Assumption

     The fair value of each option award is estimated on the date of grant using the Black-Scholes valuation model using a multiple options approach, consistent with the provisions of SFAS No. 123R and SEC SAB No. 107. All options are amortized over the requisite service periods of the awards, which are generally the vesting periods. The Black-Scholes valuation model requires the input of the following assumptions:

Expected Volatility . The Company estimates the volatility of its stock options at the date of grant using implied volatilities from traded options on the Company’s stock. The Company believes that the use of implied volatility is more reflective of market conditions and a better indicator of expected volatility than the use of historical volatility.

Expected Term . The expected term of options granted is derived from a numerical model of the Company’s stock price and represents the period of time that options granted are expected to be outstanding. The Company estimates the expected term of options granted based on its historical experience of grants, exercises and post-vesting cancellations.

Risk-Free Interest Rate . The risk-free rate is based on a risk-free zero-coupon spot interest rate at the time of grant with remaining terms equivalent to the expected term of the option grants.

Expected Dividends . The Company has never declared or paid any cash dividends and does not presently plan to pay cash dividends in the foreseeable future. Consequently, the Company uses an expected dividend yield of zero in the Black-Scholes valuation model.

Forfeitures . The Company uses historical data and future expectations of employee turnover to estimate pre-vesting forfeitures. As required by SFAS No. 123R, the Company records stock-based compensation expense only for those awards that are expected to vest. In the three months ended December 31, 2006, the Company adjusted its estimated forfeiture rate in order to better reflect the actual number of instruments for which the requisite service was to be rendered. As required by SFAS No. 123R, the Company calculated a cumulative adjustment to compensation cost for the effect on the then-current and prior periods of this change in estimate. This adjustment, consisting of approximately a $300,000 reduction of compensation expense, was recorded in the three months ended December 31, 2006.

     The fair value of the Company’s employee stock purchase plan is estimated on the first day of the offering period using the Black-Scholes valuation model, consistent with the provisions of SFAS No. 123R, SEC SAB No. 107, and FASB Technical Bulletin No. 97-1, “Accounting under Statement 123 for Certain Employee Stock Purchase Plans with a Look-Back Option.”

     The Company did not have a stock plan Offering Period during the three months ended December 31, 2007. The Company determined the fair value of the stock purchased under its stock purchase plan in the three months ended December 31, 2006 using the following weighted-average valuation assumptions:

     SFAS No. 123R requires the use of option pricing models that were not developed for use in valuing employee stock options. The Black-Scholes option-pricing model was developed for use in estimating the fair value of short-lived exchange traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock.

     Compensation expense on restricted stock units is determined using the fair value of Photon Dynamics’ common stock on the date of the grant. The resulting compensation expense is recognized over the related service period.

     The aggregate intrinsic value in the table above represents the total pretax intrinsic value, based on the Company’s closing stock price of $8.30 as of December 31, 2007, which would have been received by the option holders had all option holders with in-the-money options exercised their options as of that date.

     The total intrinsic value of options exercised during the three months ended December 31, 2007 was approximately $2,400. The total cash received from employees as a result of stock option exercises during the three months ended December 31, 2007 was approximately $1,700. In connection with these exercises, the tax benefits realized by the Company were minimal.

     The Company settles employee stock option exercises with newly issued common shares.

     As of December 31, 2007, the unrecorded deferred stock-based compensation balance related to stock options was $908,000 and will be recognized over an estimated remaining weighted-average amortization period of 1.7 years.

      Restricted Stock Units

     The following table summarizes the restricted stock unit activity for the indicated period:

     As of December 31, 2007, there was approximately $998,000 of unrecognized stock-based compensation related to restricted stock units granted under the Company’s equity incentive plans. The unrecognized stock-based compensation is expected to be recognized over an estimated remaining weighted-average amortization period of 1.2 years.

      Employee Stock Purchase Plan

     The Company did not have a stock plan Offering Period during the three months ended December 31, 2007 and so did not incur any compensation cost in connection with its employee stock purchase plan in the three months ended December 31, 2007.

     The Plan shares are replenished through shareholder approval at the Annual Shareholder meeting. At December 31, 2007, a total of 829,915 shares were reserved and available for issuance under this Plan.

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 7 — NET INCOME (LOSS) PER SHARE

     Basic earnings (loss) per share is computed by dividing income (loss) available to common shareholders by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings (loss) per share is computed by dividing income (loss) available to common shareholders by the weighted-average number of shares of common stock outstanding during the period increased, in periods of net income, to include the number of additional shares of common stock that would have been outstanding if the dilutive potential shares of common stock had been issued. The dilutive effect of outstanding options and restricted stock units is reflected in diluted earnings per share by application of the treasury stock method, which includes consideration of stock-based compensation required by SFAS No. 123R and Statement of Financial Accounting Standards No. 128, “Earnings per Share.”

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

NOTE 8 — COMMITMENTS AND CONTINGENCIES

Purchase Agreements

     The Company maintains certain open inventory purchase commitments with suppliers to ensure a smooth and continuous supply chain for key components. The Company’s obligation in these purchase commitments is generally restricted to a forecasted time horizon as mutually agreed upon between the parties. The Company’s open inventory purchase commitments were approximately $12.3 million as of December 31, 2007 and $28.0 million as of September 30, 2007.

     During the three months ended December 31, 2006, the Company incurred charges of approximately $650,000 to establish a reserve for costs associated with the cancellation of certain purchase orders.

Warranty Obligations

     The Company generally offers warranty coverage for a period of 12 months from final acceptance or 14 months from shipment, whichever is shorter. Upon product shipment, the Company records the estimated cost of warranty coverage, primarily material and labor to repair and service the equipment. Factors that affect the Company’s warranty liability include the number of installed units under warranty, product failure rates, material usage rates and the efficiency by which the product failure is corrected. The Company assesses the adequacy of its recorded warranty liability quarterly and adjusts the amount as necessary.

     The warranty liability at December 31, 2006 includes costs associated with the Company’s agreement with one customer to replace two ArrayChecker ^TM systems. In the fourth quarter of fiscal 2006, the Company agreed to replace two of the four original Generation 7 test systems sold to a customer with a newer version of the Company’s Generation 7 test systems. Even though all four original Generation 7 systems had been used by the customer in full production, reliability and uptime issues had impacted the production capability of the fabrication lines in which they operated. The replacement systems cost of approximately $3.0 million was accrued as warranty expense in the quarter ended September 30, 2006. Approximately $2.7 million of warranty liability associated with this exchange was satisfied during the three months ended June 30, 2007 when the machines were replaced.

Legal Proceedings

     The Company and certain of its directors and former officers were named as defendants in a lawsuit captioned Amtower v. Photon Dynamics, Inc., No. CV797876, filed on April 30, 2001 in the Superior Court of the State of California, County of Santa Clara. The trial of this case commenced on April 3, 2006. On a motion for non-suit, the court dismissed all claims against all directors on April 20, 2006. On May 5, 2006, as a result of jury verdict, judgments were entered in favor of the Company and its former officers. The plaintiff, a former officer of the Company, had asserted several causes of action arising out of alleged misrepresentations made to the plaintiff regarding the existence and enforcement of the Company’s insider trading policy. The plaintiff had sought damages in excess of $6 million for defendants’ alleged refusal to allow plaintiff to sell shares of the Company’s stock in May 2000, plus unspecified emotional distress and punitive damages. On June 30, 2006, the plaintiff filed a timely notice of appeal. On July 28, 2006, the Court awarded the Company approximately $445,000 in fees and costs. The award bore interest at the statutory rate of 10% simple interest per annum. Collection of the award was stayed during the plaintiff’s appeal of the verdict. On January 16, 2008, the Sixth District Court of Appeals for the State of California upheld the trial court’s judgment and award.

     As of December 31, 2007, the Company has paid approximately $6.3 million, net of VAT amounts refundable, to foreign customs authorities in connection with its settlements regarding underpayment of customs duties for warranty parts and expects to pay an additional $1.3 million more to settle all known amounts with foreign customs authorities. The Company has not received waivers from any governmental agency and cannot guarantee that additional payment obligations will not arise related to these prior activities. The ultimate resolution of this matter or other matters could entail further expense in the form of duties, interest and penalties under applicable laws. For example, the Company has commenced voluntary discussions with U.S. government agencies, including Customs, the Census Bureau and the Bureau of Industry and Security, regarding certain filing obligations that were not complied with in connection with its exports. Although the products in question were not restricted under export control laws and no fees were associated with these filings, the voluntary disclosure of the Company’s failure to comply with U.S. filing obligations may subject the Company to penalties and result in additional expenses, which could be material and the extent of which the Company is currently unable to predict.

     In January 2008, the Company responded to inquiries relating to its recent restatement from the SEC’s Enforcement Division and will continue to cooperate fully with the SEC to address any further questions they may have.

     From time to time, Photon Dynamics is subject to certain other legal proceedings and claims that arise in the ordinary course of business. Additionally, in the ordinary course of business the Company may potentially be subject to future legal proceedings that could individually, or in the aggregate, have a material adverse effect on the Company’s financial condition, liquidity or results of operations. Litigation in general, and intellectual property and securities litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict.

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 9 — SEGMENT REPORTING AND GEOGRAPHIC INFORMATION

     Statement of Accounting Financial Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information,” establishes standards for reporting information about operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance of the company. The Company’s chief operating decision maker is considered to be the Company’s Chief Executive Officer (“CEO”).

     Prior to fiscal 2007, the Company operated in one operating segment, the Flat Panel Display segment. A second operating segment, the High-Performance Digital Imaging segment, was created in July 2007 when the Company purchased Salvador Imaging, Inc. Each reportable segment is separately managed and the financial results are reviewed by the CEO. Each reportable segment contains closely related products that are unique to the particular segment:

•

Flat Panel Display Segment . Includes test and repair equipment used in the flat panel display industry to collect and analyze data from the liquid crystal display production lines and to diagnose and repair defects in the production line.

•

High-Performance Digital Imaging Segment . Includes high-performance digital cameras used in the defense, industrial and scientific/medical industries for a variety of applications. In the defense industry, high-performance digital camera applications include targeting, unmanned vehicle guidance, discrimination of decoy versus real targets and daytime and nighttime surveillance. Industrial customers use high-performance digital cameras for inspection, metrology and machine guidance. Scientific and medical industry applications include X-ray, fluoroscopy, mammography, veterinary x-ray and semiconductor process monitoring and non-destructive testing.

     The CEO allocates resources to and assesses the performance of each operating segment based upon several metrics, including orders, net sales and operating income (loss) before interest and taxes.

     The Company derives the segment results from its internal management reporting system. The accounting policies Photon Dynamics uses to derive reportable segment results are substantially the same as those used for external reporting purposes. The Company generally allocates expenses from sales and marketing, corporate functions (Including management, finance, legal and human resources expenses) and information technology groups between its two operating segments, which are included in the operating results reported below. The Company does not allocate certain operating expenses including equity-based compensation, restructuring and asset impairment charges and other associated adjustments, which it manages separately at the corporate level. Management does not consider the unallocated costs in measuring the performance of the reportable segments. Segment operating income (loss) excludes interest income, interest expense and other financial charges and income taxes.

     With the exception of goodwill and intangibles, the Company does not identify assets by operating segment, nor does the CEO evaluate operating segments using discrete asset information. In the three months ended December 31, 2007 there was approximately $26,000 of inter-segment revenue that has been adjusted for in the operating results reported below.

     Segment information is summarized as follows:

     The following is a summary of the Company’s consolidated revenue by country based on the location to which the product was shipped:

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

     All customers in the above table were customers in the Flat Panel Display segment.

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

     All customers in the above table were customers in the Flat Panel Display segment.

NOTE 10 — FINANCIAL INSTRUMENTS

     Photon Dynamics may use financial instruments, such as forward exchange and currency option contracts, to hedge a portion of, but not all, existing and anticipated foreign currency denominated transactions or existing account balances. The terms of currency instruments used for hedging purposes are generally consistent with the timing of the transactions or balances being hedged. Under its foreign currency risk management strategy, the Company utilizes derivative instruments to protect against unanticipated fluctuations in earnings and cash flows caused by volatility in currency exchange rates. However, these derivative instruments do not fully hedge the Company’s exposure to foreign exchange rate risk. This financial exposure is monitored and managed by the Company as an integral part of its overall risk management program, which focuses on the volatility in the financial markets and seeks to reduce the potentially adverse effects that the volatility of these markets may have on its operating results.

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

     The Company conducts business internationally in several currencies. As such, it is exposed to fluctuations in foreign currency exchange rates. The Company’s exposure to foreign exchange rate fluctuations arises in part from: (1) translation of the financial results of foreign subsidiaries into U.S. dollars in consolidation; (2) the re-measurement of non-functional currency assets, liabilities and intercompany balances into U.S. dollars for financial reporting purposes; and (3) non-U.S. dollar denominated sales to foreign customers. The Company defines its exposure as the risk of changes in the functional-currency-equivalent cash flows (generally U.S. dollars) attributable to changes in the related foreign currency exchange rates.

     In the three months ended December 31, 2007, the Company entered into forward sales contracts in order to manage foreign currency risk associated with certain intercompany balances denominated in Japanese yen. These contracts require the Company to exchange currencies at rates agreed upon at the contract’s inception and have terms designed to match the timing of payment from the yen-denominated accounts receivable. Because the impact of movements in currency exchange rates on forward contracts offsets the related impact on the balance of the intercompany accounts, these financial instruments mitigate the risk that might otherwise result from certain changes in currency exchange rates. The Company did not designate these forward sales contracts as hedging instruments, as defined by SFAS No. 133, and, as such, records the changes in the fair value of these derivatives in “Interest income and other, net” in the Company’s condensed consolidated statements of operations. Total net losses from changes in fair values of all forward exchange contracts for the three months ended December 31, 2007 were approximately $15,000 and are include in “Interest income and other, net” in the Condensed Consolidated Statement of Operations. At December 31, 2007, the Company had one foreign exchange forward contract outstanding to sell approximately $3.0 million in Japanese Yen. The fair value of this open contract at December 31, 2007 was approximately $79,000 and was included in “Other current liabilities” in the Consolidated Balance Sheet. The contract will expire in the second quarter of fiscal 2008.

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 11 — NOTES PAYABLE

     In connection with the purchase of Salvador Imaging the Company issued a promissory note to a trust. The trustee, David W. Gardner, became an officer of the Company as a result of the acquisition and holds approximately 6% of the outstanding stock in the Company. The note bears interest at 5% per annum. At December 31, 2007 approximately $5.4 million was outstanding, which included approximately $114,000 in interest. Approximately $2.7 million in principle related to this note will be due in October 2008 and approximately $2.6 million in principle due in January 2010.

NOTE 12 — INCOME TAXES

      Tax Provision . For the three months ended December 31, 2007 and 2006, the Company recorded a provision for income taxes of approximately $141,000 and $101,000, respectively. The Company had a provision for income taxes despite a net loss position in both periods due primarily to foreign income taxes. The effective tax rates for both periods is lower than the statutory rate due to tax benefits arising from net operating loss carryforwards.

      Adoption of FIN 48 . On October 1, 2007, the Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes” and prescribes a recognition threshold and measurement attributes for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Under FIN 48, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. Additionally, FIN 48 provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.

     As a result of the implementation of FIN 48, the Company identified that it had unrecognized tax benefits of approximately $3.3 million as of October 1, 2007; however, approximately $2.9 million of these unrecognized tax benefits was fully offset by a valuation allowance. As a result, the Company increased the long-term liability for income taxes payable by approximately $365,000 and accounted for the increase as a cumulative effect of change in accounting principle that resulted in a corresponding decrease in accumulated deficit.

     In accordance with FIN 48, the Company recognizes interest and penalties related to unrecognized tax benefits as a component of income taxes. Interest and penalties were immaterial at the date of adoption and were included in the unrecognized tax benefits. There was no change to the Company’s unrecognized tax benefits for the three months ended December 31, 2007.

     The Company is subject to taxation in the U.S. and various states and foreign jurisdictions. All the Company’s tax years will be open to examination by the U.S. federal tax authority and most state tax authorities in which the Company operates due to the Company’s net operating loss and overall credit carryforward position.

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

      This Quarterly Report on Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements included or incorporated by reference in this Quarterly Report on Form 10-Q other than statements of historical fact may be forward-looking statements. You can identify these and other forward-looking statements by the use of words such as “may,” “will,” “could,” “would,” “should,” “plans,” “anticipates,” “relies,” “expects,” “intends,” “believes,” “estimates,” “predicts,” “potential,” “continue” or the negative of such terms, or other comparable terminology. Forward-looking statements also include the assumptions underlying or relating to any such statements. These forward-looking statements are based on current expectations as of the filing date of this Quarterly Report on Form 10-Q and involve a number of uncertainties and risks. These uncertainties and risks include, but are not limited to: our ability to remediate material weaknesses in our internal controls; our ability to attract and retain qualified employees; possible further changes in our customs duty liability; possible civil and criminal liability in connection with customs duty issues; the adoption of new technology by our existing and potential customers; our customers’ response to prevailing economic and market conditions; the changing customer investment climate, which could lead to the impairment of our assets; our ability to successfully migrate our manufacturing operations offshore; our ability to maintain competitive pricing; the introduction of competing products having technological and/or pricing advantages, which would reduce the demand for our products; our ability to operate and integrate our newly acquired subsidiary; and failure to comply with a variety of Untied States and foreign federal, state and local laws and regulation, which could lead to the Company incurring additional penalties, interest and other expenses. As a result, our actual results and end user demand may differ substantially from expectations.

      Our actual results could differ materially from those projected in the forward-looking statements included herein as a result of a number of factors, risks and uncertainties, including the risk factors set forth in Part II Item 1A. “Risk Factors” in this Quarterly Report on Form 10-Q. The information included in this Quarterly Report on Form 10-Q is as of the filing date with the Securities and Exchange Commission and future events or circumstances could differ significantly from the forward-looking statements included herein. Accordingly, we caution readers not to place undue reliance on such statements and we expressly assume no obligation to update the forward-looking statements included in this report after the date hereof except as required by law.

      The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements and notes thereto in Item 1 above and with our financial statements and notes thereto for the year ended September 30, 2007, contained in our Annual Report on Form 10-K , as filed with the SEC on January 24, 2008.

BUSINESS AND COMPANY OVERVIEW

Our Company

     Photon Dynamics is a global supplier utilizing advanced digital imaging technology for Liquid Crystal Display yield enhancement systems and high-performance digital imaging systems for defense, surveillance, industrial inspection and medical imaging applications. From fiscal 2003 to 2007 we operated in one operating segment: Flat Panel Display. We commenced operations in the High-Performance Digital Imaging segment in July 2007 with our acquisition of Salvador Imaging, Inc., an international supplier of high-performance digital cameras for markets other than the flat panel display industry. Our Flat Panel Display segment is still our largest business segment, accounting for more than 91% and 99% of our consolidated revenues during the three months ended December 31, 2007 and the twelve months ended September 30, 2007, respectively.

Flat Panel Display Segment

   Flat Panel Display Market

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

     Active matrix liquid crystal display (“AMLCD”) is the most prevalent and one of the highest performing types of flat panel display available today. An AMLCD uses liquid crystal to control the passage of light. The basic structure of an AMLCD panel consists of two glass panels sandwiching a layer of liquid crystal. The front glass panel is fitted with a color filter, while the back glass panel has transistors fabricated on it. When voltage is applied to a transistor, the liquid crystal is bent, allowing light to pass through to form a pixel. A light source is located at the back of the panel and is called a backlight unit. The front glass panel is fitted with a color filter, which gives each pixel its own color. The combination of these pixels in different colors forms the image on the panel.

     The manufacture of active matrix liquid crystal displays is an extremely complex process, which has been developed and refined for different substrate glass sizes. Glass panels are initially manufactured on large glass substrates which are subsequently cut down to the panel size needed for the application. Each progressive increase in initial glass substrate size is referred to by its “generation.” Manufacturing an active matrix liquid crystal display involves a series of three principal phases — the Array Phase, the Cell Assembly Phase and the Module Assembly Phase. At various points in the manufacturing process, the flat panel display manufacturer uses test and inspection equipment to identify defects to permit repair and to avoid wasting costly materials on continued manufacturing of a defective product.

     We are a leading global supplier of integrated yield enhancement solutions for the flat panel display market. Our yield management products include our test and repair equipment that are used primarily in the Array phase of production. Our customers use our systems to collect and analyze data from the production line and quickly diagnose and repair process-related defects, thereby allowing manufacturers to decrease material costs and improve throughput. Our customers use our systems to increase manufacturing yields of high performance flat panel displays used in a number of products, including notebook and desktop computers, televisions and advanced mobile electronic devices such as cellular phones, personal digital assistants and portable video games.

     We generate revenue from the sale of our ArrayChecker ^TM and ArraySaver ^TM test and repair equipment and customer support, which includes the sale of spare parts. We have also generated revenue from the sale of our PanelMaster ^TM inspection equipment, which was used primarily in the Cell Assembly phase of flat panel display manufacture; however, in November 2006, we announced the discontinuation of our PanelMaster ^TM inspection products.

     We sell our products to manufacturers in the flat panel display industry. Our customers are located primarily in South Korea, Taiwan, Japan, and China. We derive most of our revenue from a small number of customers, and we expect this to continue for the foreseeable future. A substantial percentage of our revenue is derived from the sale of a small number of yield management systems that in fiscal 2007 ranged in price from $450,000 to $3.4 million. Therefore, the timing of the sale of a single system could have a significant impact on our quarterly results.

     Our flat panel display products are manufactured in both San Jose, California and Daejon, Korea. Our manufacturing activities consist primarily of final assembly and test of components and subassemblies, which are purchased from third party vendors. We schedule production based upon customer purchase orders and anticipated orders during the planning cycle. We generally expect to be able to accept a customer order, build the required machinery and ship to the customer within 20 to 36 weeks.

     We do not consider our business to be seasonal in nature, but it is cyclical with respect to the capital equipment procurement practices of flat panel display manufacturers and is impacted by the investment patterns of these manufacturers in different global markets. We do consider consumer demand for flat panel display products to be seasonal, with peak demand occurring in the latter half of each calendar year. This end-user seasonality drives capacity decisions by flat panel display manufacturers and has a limited influence on the flat panel display manufacturers’ overall investment patterns. However, because new fabrication facilities and upgrades to existing facilities represent significant financial investments and take time to implement, we consider flat panel display manufacturers to have cyclical investment patterns.

   Flat Panel Display Industry Trends

     In calendar year 2007, the majority of flat panel display manufacturers scaled back their investment plans and factory utilization rates until they could evaluate television manufacturing costs, holiday season demand and consumer electronics market issues such as brand strength and high-definition programming formats and availability. As a result, we experienced both lower levels of bookings due to factory investment delays and lower revenue in our fiscal year 2007 as compared to fiscal year 2006. While our bookings increased in the first quarter of fiscal 2008, we again experienced lower levels of revenue. Demand for notebook, monitor and television LCD products was strong during 2007 compared to 2006. Relatively strong demand and the delay in adding new manufacturing capacity during the second half of 2006 and 2007 resulted in supply approaching equilibrium with demand. Industry sources show that panel prices have begun to stabilize due to tightening supply, which improved the profitability of LCD

manufacturers in the second half of the 2007 calendar year. Flat panel display manufacturers’ efforts to balance supply with demand were realized, improving the health of the flat panel display industry. With supply and demand equilibrium, flat panel display prices stabilized and in some cases increased. Across the industry, flat panel display manufacturers returned to profitability in mid-2007. The combination of delayed manufacturing capacity investments over the past five quarters and strong demand for IT and television displays has created a capacity shortfall, particularly for larger-sized panels. Flat panel display manufacturers are now investing to add capacity into existing Generation 5, Generation 6 and Generation 7 lines as well as accelerating Generation 8 plans in order meet forecasted demand. Growth in notebook display demand and robust flat-screen television adoption fuel an optimistic outlook for stable supply and demand in calendar years 2008 and 2009. While we expect that flat panel display manufacturers will again begin to make new factory investments and upgrades to existing factories during the second half of calendar year 2008, we can provide no assurances that this anticipated industry recovery will occur. In addition, we do not anticipate future investments made by flat panel display manufacturers to approach the levels of investment during calendar years 2004 through 2006 and as such, do not expect our flat panel display revenues to approach levels achieved in prior fiscal years.

High-Performance Digital Imaging Segment

   High-Performance Digital Imaging Market

     High-performance digital cameras are used in the defense, industrial and scientific/medical industries for a variety of applications. In the defense industry, high-performance digital camera applications include targeting, unmanned vehicle guidance, discrimination of decoy versus real targets and daytime and nighttime surveillance. Industrial customers use high-performance digital cameras for inspection, metrology and machine guidance. Scientific and medical industry applications include X-ray and fluoroscopy.

     The principal types of high-performance digital cameras include charge-coupled device (“CCD”) cameras, complementary metal-oxide-semiconductor (“CMOS”) cameras, and electron multiplying charge-coupled device (“EMCCD”) cameras. CCD cameras are typically used in applications where very high quality imagery is needed, such as medical, scientific and astronomical applications. While CMOS cameras typically do not offer image quality as high as their CCD counterparts, CMOS offers the advantages of allowing for readouts at higher speeds and higher levels of on-chip circuit integration. CMOS cameras are typically used for industrial machine vision. In EMCCD cameras, an on-chip gain mechanism is employed, which makes it possible to capture images at extremely low light levels. Applications for EMCCDs include night-time perimeter security, military surveillance, astronomy and certain low-light medical applications ranging from cell biology to radiology.

     We offer standard and custom CCD, CMOS and EMCCD cameras to meet the needs of a broad range of defense, industrial and scientific/medical markets. All of our camera products incorporate low noise, precision analog design coupled with proprietary thermal stabilization to provide high quality imaging performance.

     We perform design, assembly, testing and quality control of our high performance digital cameras in-house at our Colorado Springs facility. We utilize an outsourcing strategy for the manufacture of a majority of our components and subassemblies. Production lead times are six to twelve weeks, and camera production is based on customer purchase orders and anticipated orders.

     We are focusing our current research and development on highly-sensitive color and monochrome cameras that can be used to provide daytime and nighttime surveillance capabilities for defense applications and cameras with unique inspection capabilities for industrial applications.

   High-Performance Digital Imaging Industry Trends

     The defense industry is the chief market for products within our High-Performance Digital Imaging segment. If we are successful in developing and marketing our products in this segment, we may significantly increase our revenue derived directly or indirectly from U.S. government contracts awarded to our customers or us under various U.S. government programs. The funding of such programs is subject to the overall U.S. government budget and appropriation decisions and processes which are driven by numerous factors, including geo-political events and macroeconomic conditions that are beyond our control. The unique risks associated with depending on the U.S. government as a significant source of segment revenue are described further in Part II, Item 1A “Risk Factors” in this Quarterly Report on Form 10-Q.

     Although we acquired Salvador Imaging’s existing product base, we are developing new product evaluation units and are actively engaged in marketing and sales activities. We anticipate that the sales cycle for these markets will be lengthy and it is uncertain if and when we will generate significant and sustainable revenue from this new venture.

Backlog

     Our backlog consists of work-in-process and unshipped system orders, unearned revenue and systems in deferred gross margin. As of December 31, 2007, our total backlog was approximately $108.6 million, a majority of which we expect to ship, or to recognize as revenue, within the next six to twelve months. This compares to a total backlog of $60.5 million as of September 30, 2007. All orders are subject to delay or cancellation and any assessable penalties or other provisions may not be collectible or enforceable against our customers due to the limited number of customers. We may also be unable to obtain reimbursement for any costs incurred on a cancelled or postponed order. Because of possible changes in product delivery schedules and cancellation of product orders, among other factors, our backlog may vary significantly and, at any particular date, is not necessarily indicative of actual sales for any succeeding period.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

     The preparation of our financial statements and the related disclosures in conformity with accounting principles generally accepted in the United States requires our management to make judgments, assumptions and estimates that affect the amounts reported. Certain of the significant accounting policies used in the preparation of our financial statements are considered to be critical accounting policies, as defined below.

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

     Estimates and assumptions about future events and their effects cannot be determined with certainty. We base our estimates on historical experience and on various other assumptions that are believed to be applicable and reasonable under the circumstances. These estimates may change as new events occur, as additional information is obtained and as our operating environment changes. In addition, management is periodically faced with uncertainties, the outcomes of which are not within its control and will not be known for prolonged periods of time. These uncertainties are discussed in Part II, Item 1A “Risk Factors” in this Quarterly Report on Form 10-Q.

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

Revenue Recognition

     Note 1 of our “Notes to Condensed Consolidated Financial Statements” in Part I Item 1 of this Quarterly Report on Form 10-Q provides a description of our revenue recognition policy. For each arrangement for the sale and installation of equipment, we recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or the services have been rendered, the selling price is fixed or determinable and collectibility is reasonably assured, the latter of which is subject to judgment. If we determine that any of these criteria are not met, we defer revenue recognition until such time as we determine that all of the criteria are met.

     In addition, for arrangements with multiple deliverables, we make additional judgments as to whether each item has value to the customer on a stand-alone basis, whether there is objective and reliable evidence of the fair value of the undelivered items and whether the amounts of revenue for each element are subject to refund. Our determination of whether deliverables within a multiple element arrangement can be treated separately for revenue recognition purposes involves significant estimates and judgments, such as whether fair value can be established on undelivered elements and/or whether delivered elements have stand-alone value to the customer. Changes to our assessment of the accounting units in an arrangement and/or our ability to establish fair values could significantly change the timing of revenue recognition.

     We may, at various times, have a significant deferred gross margin balance relative to our consolidated revenue. Recognition of this deferred revenue over time can have a material impact on our consolidated revenue in any period and result in significant fluctuations.

     We have a policy to record a provision as necessary for estimated sales returns in the same period as the related revenue is recorded, which is netted against revenue. These estimates are based on historical sales returns and other known factors which have not varied widely in the past and we do not reasonably expect these factors to significantly change in the foreseeable future. If the historical data we use to calculate these estimates does not properly reflect future returns, additional provisions may be required. Historically, we have not experienced the return of any of our flat panel display systems upon which we have recognized revenue. Due to the relatively high prices of our systems, the return of one of these systems as a sales return would have a material adverse effect on our results of operations.

Allowance for Doubtful Account

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

     Historically, losses due to customer bad debts in our flat panel display business have been immaterial, and we expect that this will not change in the foreseeable future. However, if a single customer was unable to make payments, additional allowances may be required. Accordingly, the inability of a single customer to make required payments could have a material adverse effect on our results of operations.

Inventories

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

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

Warranty

     Our warranty policy generally states that we will provide warranty coverage for a period of 12 months from final acceptance or 14 months from shipment, whichever is shorter. We record the estimated cost of warranty coverage, primarily material and labor to repair and service the equipment, upon product shipment when the related revenue is recognized. Our warranty obligation is affected by product failure rates, consumption of field service parts and the efficiency by which the product failure is corrected. We estimate our warranty cost based on historical data related to these factors.

Goodwill and Intangible Assets

     We do not amortize either goodwill or intangible assets with indefinite useful lives, but rather we review these assets for impairment at least annually and more frequently if there are indicators of impairment. The process for evaluating the potential impairment of goodwill or intangible assets with indefinite useful lives is highly subjective and requires significant judgment at many points during the analysis. Should actual results differ from our estimates, revisions to the recorded amount of goodwill or intangible assets with indefinite useful lives could be reported.

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

Stock-Based Compensation

     We estimate the fair value of stock options using a Black-Scholes valuation model, consistent with the provisions of Statement of Financial Accounting Standards No. 123R, “Share-Based Payments” (“SFAS No. 123R”) and SEC Staff Accounting Bulleting No. 107. SFAS No. 123R requires the use of option pricing models that were not developed for use in valuing employee stock options. The Black-Scholes option-pricing model was developed for use in estimating the fair value of short-lived exchange traded options that have no vesting restrictions and are fully transferable.

     The Black-Scholes option-pricing model requires the input of highly subjective assumptions, including expected volatility, expected life, expected dividend rate, and expected risk-free interest rate of return. The assumptions for expected volatility and expected life are the two assumptions that significantly affect the grant date fair value. The expected dividend rate and expected risk-free interest rate of return are not significant to the calculation of fair value.

     In addition, SFAS No. 123R requires us to develop an estimate of the number of share-based awards that will be forfeited due to employee turnover. Adjustments in the estimated forfeiture rates can have a significant effect on reported share-based compensation, as we recognize the cumulative effect of a rate adjustment for all expense amortization after October 1, 2005 in the period the estimated forfeiture rates are adjusted. If we adjust forfeiture rates higher than the previously estimated forfeiture rate, we would make an adjustment that would result in a decrease to the expense recognized in the financial statements. If a revised forfeiture rate is lower than the previously estimated forfeiture rate, we would make an adjustment that would result in an increase to the expense recognized in the financial statements. These adjustments would affect our gross margin; research and development expenses; and selling, general and administrative expenses.

Contingencies and Litigation

     We are subject to the possibility of losses from various contingencies. Considerable judgment is necessary to estimate the probability and amount of any loss from such contingencies. We make an assessment of the probability of an adverse judgment resulting from current and threatened litigation. We accrue the cost of an adverse judgment if, in our estimation and based on the advice of legal counsel, the adverse judgment is probable and we can reasonably estimate the ultimate cost of such a judgment.

     We were not engaged in any significant litigation matter as of December 31, 2007. On January 16, 2008, the Sixth District Court of Appeals for the State of California upheld the trial court’s judgment and award in the appeal of the plaintiff in the Amtower v. Photon Dynamics, Inc. lawsuit. This lawsuit is described in Part II, Item 1. “Legal Proceedings” in this Quarterly Report on Form 10-Q.

     Our total revenue decreased 25% for the three months ended December 31, 2007 over the same period of the prior fiscal year and decreased 34% sequentially from the three months ended September 30, 2007. Revenues from our Flat Panel Display segment constituted approximately 91% and 99% of our total revenues in the three months ended December 31, 2007 and the twelve months ended September 30, 2007, respectively. The overall decrease is a result of a slow down in orders from flat panel display manufacturers as they re-assess market conditions.

     Consolidated revenue by country based on the location to which the product was shipped was as follows:

     For each country, the changes in revenue from the three months ended December 31, 2007 as compared to the same period in the prior fiscal year are a result of the investment patterns of flat panel display manufacturers, which in turn depend on the current and anticipated market demand for products utilizing flat panel displays.

Operating Segments

     Prior to fiscal 2003, we operated in three operating segments. In fiscal 2003, we implemented plans to exit our printed circuit board assembly inspection business and our cathode ray tube display and high quality glass inspection business. From fiscal 2003 to 2007 we operated in one segment: the Flat Panel Display segment. A second operating segment, the High-Performance Digital Imaging segment, was created in July 2007 when we purchased Salvador Imaging.

     A description of the products and services as well as financial data for our Flat Panel Display segment and our High-Performance Digital Imaging segment reportable segments can be found in Note 9 “Segment Reporting and Geographic Information” in the Notes to Condensed Consolidated Financial Statements in Part I, Item 1 “Financial Statements” in this Quarterly Report on Form 10-Q. We do not allocate certain operating expenses, including equity-based compensation, restructuring and asset impairment charges and other associated adjustments.

Flat Panel Display Segment

     Our Flat Panel Display segment primarily generates revenue from the sales of our ArrayChecker ^TM and ArraySaver ^TM test and repair equipment and from customer support, which includes the sales of spare parts.

     Selected operating data for the Flat Panel Display segment for the three months ended December 31, 2007 and 2006 is as follows:

   Revenue

     Revenue decreased 31% for the three months ended December 31, 2007 over the same period of the prior fiscal year and decreased 39% sequentially from the three months ended September 30, 2007. As discussed above, flat panel display manufacturers scaled back utilization of existing capacity while they re-assessed the timing of new factory investments and upgrades to existing factories. This process resulted in reductions and delays of many of our customers’ investment plans. We expect that flat panel display manufacturers will again begin to make new factory investments and upgrades to existing factories during the second half of the 2008 calendar year, but we can provide no assurances that this anticipated industry recovery will occur.

      ArrayChecker ^TM and ArraySaver ^TM Product Revenue. Our ArrayChecker ^TM and ArraySaver ^TM test and repair equipment operate in the Array phase of AMLCD production and are built to handle the different generation sizes of substrate glass. Total revenue from our test and repair equipment, as a percentage of total Flat Panel Display segment revenue, is as follows:

     In general, we have seen a shift from our Generation 6 and earlier products to our Generation 7 and 8 products as flat panel display manufacturers move to larger size glass substrates in the manufacturing process. However, in the three months ended December 31, 2007, we saw an increase in revenue from the sales of our earlier-generation machines as compared to the same period in the prior year as we recognized revenue on ArrayChecker ^TM systems used by one of our customers to increase capacity in a Generation 6 fab line. Our products in each new generation contain new performance and control features designed specifically to enhance yield improvement and process control. As a result, in recent history we generally have experienced increases in our average selling prices of between 10% and 20% in each new generation product. As with prior generation products, our Generation 6, 7 and 8 ArrayChecker ^TM products have had greater average selling prices than previous generations. However, the average selling prices of our Generation 6 and 7 ArraySaver ^TM products were relatively flat as compared to the prior generations due primarily to a more competitive environment in the array repair market. There is no assurance that we will be successful at achieving or sustaining average selling price increases on our future generation products.

     The revenue mix of our ArrayChecker ^TM and ArraySaver ^TM test and repair products has been driven by the investment decisions of our customers as they invest in both new manufacturing capacity and upgrades to existing facilities.

     Revenue from our ArrayChecker ^TM and ArraySaver ^TM test and repair products includes revenue recognized at the time of shipment and revenue recognized upon final customer acceptance. Our sales terms are typically 60% to 90% of the sales price due upon shipment with the remaining portion due after installation and upon final customer acceptance. Revenue for the three months ended December 31, 2007 included a lower absolute dollar value of revenue related to the receipt of final customer acceptances following completed installation of our products compared to the same period in fiscal 2007.

      Customer Support and Spare Parts Revenue. Customer support and spare parts revenue generally represents ongoing sales of spare parts and service to our installed equipment base. Revenue from customer support and spare parts represented approximately 24% and 21% of the Flat Panel Display segment revenue for the three months ended December 31, 2007 and 2006, respectively. Revenues in the three months ended December 31, 2007 were lower in absolute dollars than in the comparative prior year period. Revenues in the three months ended December 31, 2007 were higher as a percentage of total revenue than in the comparative prior year period due to the more stable nature of our customer support and spare parts revenue. In periods where revenue from new ArrayChecker ^TM and ArraySaver ^TM products declines, revenue from support and spare parts increases as a percentage of total revenues.

   Gross Margin

     Gross margins, as a percentage of revenue, remained relatively flat in the three months ended December 31, 2007 as compared to the same period in the prior fiscal year. The relatively high mix of higher-margin ArrayChecker ^TM systems and savings from decreased headcount in the three months ended December 31, 2007 were partially offset by additional costs associated with the under-utilization of our San Jose facilities as compared to the same period in the prior fiscal year.

   Research and Development

     Our research and development expenses consisted primarily of salaries, related personnel costs, depreciation, prototype materials and fees paid to consultants and outside service providers, all of which relate to the design, development, testing, pre-manufacturing and improvement of our products.

     Our overall research and development spending decreased in the three months ended December 31, 2007 as compared to the same period in the prior fiscal year due primarily to lower spending on Generation 6 and 7 test and repair product development programs in the period and to savings from decreased headcount. These savings were partially offset by increased spending on certain Generation 8 and other development programs as we continue to improve our product lines.

   Selling, General and Administrative

     Our selling, general and administrative expenses consisted primarily of salaries and related expenses for marketing, sales, finance, administration and human resources personnel, as well as costs for auditing, commissions, insurance, legal and other corporate expenses.

     Selling, general and administrative spending increased in the three months ended December 31, 2007 as compared to the same period in the prior fiscal year due primarily to additional legal and professional fees associated with the restatement of our fiscal 2002 through 2006 financial statements, as contained in our Annual Report on Form 10-K for the fiscal year ended September 30, 2007.

   Amortization of Intangible Assets

     Our amortization expenses decreased in the three months ended December 31, 2007 as compared to the same period in the prior fiscal year due primarily to certain intangible assets having become fully amortized. The remaining intangible assets relate to our July 2004 acquisition of Quantum Composers and our August 2004 acquisition of Tucson Optical Research Corporation.

     Based on intangible assets recorded at December 31, 2007, and assuming no subsequent additions to, or impairment of the underlying assets, we expect our amortization to be approximately $379,000 in the remainder of fiscal 2008.

     Operating Loss

     Key factors that may impact our future operating income or loss in the Flat Panel Display segment include:

	•		The costs of increasing customer service staff to support potential increased demands from new and existing customers;
	•		The additional costs in connection with inefficiencies of manufacturing newly-introduced products;
	•		The success of our strategy of using both domestic and offshore manufacturing;
	•		The success of outsourcing certain manufacturing to third-party vendors;
	•		The under-utilization of manufacturing facilities as a consequence of industry slowdown, order cancellations or changes in delivery schedules by our customers;
	•		The unanticipated need for additional warranty charges;
	•		The level of spending required on developing new Generations of our ArrayChecker TM and ArraySaver TM products; and
	•		The inability to reduce our expense levels quickly in the event of market downturns, due to the fact that a high percentage of our expenses, including those related to manufacturing, engineering, research and development, sales and marketing and general and administrative functions, is fixed in the short term.

     We will continue to invest in research and development to maintain technology leadership in our products. Our customers must continually improve their display quality performance and production costs in order to be successful in the display market. To meet our customers’ needs, we must improve our product performance in defect detection, repair success, cost of ownership, ease of use and throughput for each of our product generations.

High-Performance Digital Imaging Segment

     Our High-Performance Digital Imaging segment primarily generates revenue from the sales of standard and custom-application CCD, CMOS and EMCCD cameras that are used in the defense, industrial and scientific/medical industries for a variety of applications and non-recurring engineering services contracted by certain customers. While we acquired Salvador Imaging’s existing product base of camera imaging systems, we intend to combine our digital imaging core competencies with Salvador Imaging’s technical strength to develop highly sensitive color and monochrome cameras that can be used to provide daytime and nighttime surveillance capabilities for defense applications and unique inspection capabilities in industrial applications.

     Selected operating data for the High-Performance Digital Imaging segment for the three months ended December 31, 2007 is as follows:

   Revenue

     Our revenue for the High-Performance Digital Imaging segment for the three months ended December 31, 2007 was approximately $1.4 million with no corresponding amounts in the same period of the prior fiscal year. Revenue from our High-Performance Digital Imaging segment includes approximately $517,000 of product sales and approximately $833,000 of revenue from non-recurring engineering contracts.

     We have limited experience in the industries of our new operating segment, but will need to move quickly to expand market share and customer base. While we are developing evaluation units and are actively engaged in marketing and sales activities, we anticipate that the sales cycle for these markets will be lengthy and we are uncertain if we will be able to generate significant and sustainable revenue from this new venture.

   Gross Margin

     Gross margins as a percentage of revenue were approximately 36% in the three months ended December 31, 2007. Our margins depend on the mix of product sales and non-recurring engineering contracts as margins on our non-recurring engineering contracts are typically lower than those on our product revenue.

   Research and Development

     Our research and development expenses consisted primarily of salaries, related personnel costs, depreciation, prototype materials and fees paid to consultants and outside service providers, all of which relate to the design, development, testing, pre-manufacturing and improvement of our products.

     Our overall research and development spending was approximately $113,000 and included costs to complete the projects classified as in-process research and development projects, as identified at the time we acquired Salvador Imaging and which involve the design of certain next generation digital cameras. At the time of acquisition, the identified projects were, on average, approximately 20% complete, and the majority of the projects are expected to be complete by the end of the our third quarter of fiscal 2008, with total additional expected costs to complete the projects of approximately $1.1 million.

   Selling, General and Administrative

     Our selling, general and administrative expenses consisted primarily of salaries and related expenses for marketing, sales, finance, administration and human resources personnel, as well as costs for auditing, commissions, insurance, legal and other corporate expenses.

     Our overall selling, general and administrative costs of approximately $659,000 reflect our efforts to expand our market share and customer base. We expect that our High-Performance Digital Imaging segment will be characterized by lengthy sales cycles as customers expend significant efforts evaluating our products and processes prior to placing an order. During the period that our customers are evaluating our products and before they place an order with us, we may incur substantial sales, marketing and research and development expenses, expend significant management efforts, and increase manufacturing capacity and order long lead-time supplies. Even after this evaluation process, it is possible that a potential customer will not purchase our products.

   Amortization of Intangible Assets

     Our amortization expenses in the three months ended December 31, 2007 were approximately $714,000 and relate to our July 2007 acquisition of Salvador Imaging.

     Based on intangible assets recorded at December 31, 2007, and assuming no subsequent additions to, or impairment of the underlying assets, we expect our amortization to be approximately $2.1 million in the remainder of fiscal 2008.

   Operating Loss

     Key factors that may impact our future operating income or loss in the High-Performance Digital Imaging segment include:

	•		The costs of increasing marketing and customer service staff to increase market share and support potential increased demands from new and existing customers;
	•		The additional costs in connection with inefficiencies of manufacturing newly-introduced products;
	•		The modification, cancellation or termination of contracts and subcontracts by the U.S. government;
	•		The unanticipated need for additional warranty charges; and
	•		The inability to reduce our expense levels quickly in the event of market downturns, due to the fact that a high percentage of our expenses, including those related to manufacturing, engineering, research and development, sales and marketing and general and administrative functions, is fixed in the short term.

     In November 2006, we recorded a restructuring charge of approximately $446,000 associated with the discontinuation of our PanelMaster ^TM products. The charge was comprised of expenses for employee severance and related benefits as a result of planned termination of employees and expenses for impairing certain manufacturing assets associated with the product line. We do not anticipate any additional charges related to this restructuring.

Gain on Sale of Property and Equipment

     During the three months ended December 31, 2007, we recorded a gain on the sale of miscellaneous assets.

Interest Income and Other, Net

     Interest income and other, net consisted primarily of interest income, foreign currency transaction gains and losses and other miscellaneous income and expense. The changes in absolute dollar amounts of interest income and other, net, in the three months ended December 31, 2007 as compared to the same period of the prior fiscal year, are primarily attributable to changes in interest income due to fluctuating interest rates on invested cash, to changes in levels of invested cash and to changes in the effects of foreign currency transaction gains and losses.

Provision for Income Taxes

     The Company had a provision for income taxes despite a net loss position in both the three months ended December 31, 2007 and 2006 due primarily to foreign income taxes. The effective tax rates for the three months ended December 31, 2007 and 2006 were approximately (2)% and (1)%, respectively.

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

Stock-Based Compensation

     We account for stock-based awards exchanged for employee services under SFAS No. 123R. Pursuant to SFAS No. 123R, stock-based compensation cost is measured at the grant date, based on the fair value of the award which is computed using the Black-Scholes option valuation model, and is recognized as expense over the employee requisite service period.

     The effect of recording stock-based compensation for the three months ended December 31, 2007 and 2006 was as follows:

     The overall decrease in stock based compensation was due in part to the Company’s decision not to grant options in either the fourth quarter of fiscal 2007 or the first quarter of fiscal 2008, during which periods the Company was restating its prior fiscal years as described in its Annual Report on Form 10-K for the fiscal year ended September 30, 2007.

     As of December 31, 2007, the unrecorded stock-based compensation balance related to stock options was $908,000 and will be recognized over an estimated remaining weighted average amortization period of 1.7 years, while the unrecorded stock-based compensation balance related to restricted stock units was approximately $998,000 and will be recognized over an estimated remaining weighted average amortization period of 1.2 years.

LIQUIDITY AND CAPITAL RESOURCES

     We have financed our growth primarily by a combination of cash flows from operations and public stock offerings. Working capital was $79.8 million as of December 31, 2007, compared to $88.6 million as of September 30, 2007. A major component of working capital is $70.5 million of cash, cash equivalents and short-term investments as of December 31, 2007, compared to $83.9 million as of September 30, 2007.

Operating Activities

     Cash used in operating activities was approximately $14.3 million in the first three months of fiscal 2008. Cash used in operating activities resulted from our net loss of approximately $8.2 million, adjusted for approximately $1.9 million of non-cash related items and for net cash of approximately $8.0 million used by changes in operating assets and liabilities, the primary source being an increase in inventories of approximately $4.8 million and a decrease in other current liabilities of approximately $6.0 million, respectively, offset in part by an increase in accounts payable of approximately $5.9 million. Our inventory increase is due primarily to the timing of delivery of products in our backlog and to higher levels of first quarter bookings. Other current liabilities decreased due primarily to payments made on customs obligations. The increase in other accounts payable is due primarily to the timing of the increases in inventory levels.

Investing Activities

     Cash provided by investing activities was approximately $13.4 million in the first three months of fiscal 2008. Cash used in investing activities was primarily the result of approximately $13.6 million of net sales and maturities of short-term investments, offset in part by capital expenditures of approximately $404,000.

Financing Activities

     Cash used in financing activities was approximately $25,000 in the first three months of fiscal 2008 resulting from approximately $2,000 of sales of our common stock under our employee equity compensation plans, offset by approximately $27,000 of payments on our capital leases.

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

     We had a bank line of credit that had a $4.0 million borrowing capacity with an interest rate of floating prime. This line of credit expired in October 2007 and we did not renew it.

Contractual Obligations

     The following table summarizes the approximate contractual obligations that we have at December 31, 2007. Such obligations include both non-cancelable obligations and other obligations that are generally non-cancelable except under certain limited conditions.

     We maintain certain open inventory purchase commitments with our suppliers to help provide a smooth and continuous supply chain for key components. Our liability in these purchase commitments is generally restricted to purchase commitments over a forecasted time horizon as mutually agreed upon between the parties and is reflected in “purchase obligations” in the table above. The majority of these purchase commitments are related to our backlog of unshipped orders.

     We have non-cancelable operating leases for various facilities in the United States, South Korea, Taiwan, Japan and China, certain of which permit us to renew the leases at the end of their respective lease terms. Our largest facility is our 128,520 square-foot building in San Jose, California, which is under a non-cancelable operating lease that expires in 2010, with two renewal options at fair market value for additional five year periods. This lease represents the majority of the amounts reflected in the “operating lease obligations” in the table above.

     We have a liability of approximately $5.6 million in a note payable, which is reflected in the “Notes payable, including interest” in the table above. In July 2007, in connection with the purchase of Salvador Imaging the Company issued a promissory note to a trust. The trustee, David W. Gardner, became an officer of the Company as a result of the acquisition. The note bears interest at an annual rate of 5%.

Working Capital

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

IMPACT OF ACCOUNTING PRONOUNCEMENTS

     In December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Accounting Standards No. 141 (revised 2007) “Business Combinations” (“SFAS No. 141R”). SFAS No. 141R retains the fundamental requirements in Statement 141 “Business Combinations” while providing additional definitions, such as the definition of the acquirer in a purchase and improvements in the application of how the acquisition method is applied. The provisions of SFAS No. 141R will be effective for our fiscal year beginning October 1, 2009. We are evaluating the impact of this statement on our results of operations, financial position and cash flows.

     In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value for Financial Assets and Financial Liabilities — Including an Amendment of FASB Statement No. 115” (“SFAS No. 159”). SFAS No. 159 permits an entity to choose to measure many financial instruments and certain other items at fair value at specified election dates. Subsequent unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. The provisions of SFAS No. 159 will be effective for our fiscal year beginning October 1, 2008. We are evaluating the impact of this statement on our results of operations, financial position and cash flows .

     In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. The provisions of SFAS No. 157 will be effective for our fiscal year beginning October 1, 2008. We are evaluating the impact of this statement on our results of operations, financial position and cash flows .

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk

Foreign Currency Exchange Rate Risk

     We are exposed to changes in foreign currency exchange rates primarily related to the operating results of our foreign affiliates. Actual changes in foreign exchange rates could adversely affect our operating results or financial condition. The potential impact depends upon the magnitude of the rate change. We believe our exposure to changes in foreign currency exchange rates for our cash, accounts receivable and accounts payable is limited as the majority of our cash, accounts receivable and accounts payable are denominated in U.S. dollars.

     In the three months ended December 31, 2007, approximately $6.0 million of our revenue was denominated in currencies other than U.S. dollars, primarily in Japanese yen.

     At December 31, 2007, approximately $5.4 million of our cash and cash equivalents and approximately $3.5 million of our accounts receivable were denominated in currencies other than U.S. dollars, primarily in Japanese yen. Our cash and cash equivalents and our accounts receivable are subject to exchange rate risk and will fluctuate with the changes in exchange rates. A hypothetical 10% immediate and uniform adverse move in all currency exchange rates affecting our cash and cash equivalents and our accounts receivable from the rates at December 31, 2007 would decrease the fair value of our cash and cash equivalents by approximately $487,000 and our accounts receivable by approximately $317,000.

     As of December 31, 2007, we had one forward exchange contract outstanding to sell approximately $3.0 million in foreign currency in order to manage foreign currency risk associated with certain intercompany balances denominated in Japanese yen. This contract was not held for trading purposes. Details of this security is included in Note 10 of our “Notes to Condensed Consolidated Financial Statements” included under Part I, Item 1. “Financial Statements.” Gains and losses on this contract are recognized in income. Foreign exchange rate fluctuations did not have a material impact on our financial results for the three months ended December 31, 2007. Our forward exchange contract is subject to exchange rate risk and will fluctuate with the changes in exchange rates. A hypothetical 10% immediate and uniform adverse move in Japanese yen from the rate at December 31, 2007 would decrease the fair value of the contract by approximately $422,000.

     We expect that our revenue, cash, accounts receivable and accounts payable generally will be denominated in U.S. dollars in the foreseeable future and, therefore, our exposure to changes in foreign currency exchange rates for our cash, accounts receivable and accounts payable is currently considered minimal. However, as more of our operations become overseas-based and we begin additional selling in currencies other than the U.S. dollar, our exposure to foreign currencies may increase.

Market Risk

     As of December 31, 2007, we had an investment portfolio of both fixed and variable rate securities of approximately $30.2 million, excluding those classified as cash and cash equivalents. These securities, as with all fixed income instruments, are subject to interest rate risk and will fall in value if market interest rates increase.

     Our market risk as described under the heading “Interest Rate Risk” in Item 7A of our Annual Report on form 10-K for the fiscal year ended September 30, 2007, has not changed significantly.

ITEM 4. Controls and Procedures

     Photon Dynamics maintains disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) that are designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.

     As described in our Annual Report on Form 10-K filed on January 24, 2008 for our fiscal year ended September 30, 2007, we reported three material weaknesses in the design and operating effectiveness of our internal control over financial reporting. A material weakness is a control deficiency or combination of control deficiencies that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. In our Annual Report on Form 10-K we disclosed that in connection with the voluntary review of our practices with respect to the payment of customs duties for warranty parts and with our year-end close and audit processes, a number of issues were discovered, which resulted in the restatement of: (i) our consolidated financial statements for the years ended September 30, 2004, 2005 and 2006 as contained in our Form 10-K for the year ended September 30, 2006; (ii) the unaudited quarterly financial data for the first two quarters in the fiscal year ended September 30, 2007; and (iii) the unaudited quarterly financial data for all quarters in the fiscal year ended September 30, 2006 (as more fully described in Note 2, Restatement of Financial Statements, in our fiscal 2007 Annual Report on Form 10-K). In addition, these issues resulted in adjustments to our fiscal 2007 financial statements. Further analysis of the nature of the adjustments and the associated internal controls led management to conclude that these adjustments were the result of material weaknesses in our internal control over financial reporting. Management identified the following material weaknesses in internal control over financial reporting as of September 30, 2007:

	•		The absence of adequate processes for detecting noncompliance with applicable laws and regulations and our employee code of conduct, evaluating the effect of such noncompliance on our financial statements on a timely and accurate basis, and communicating such noncompliance and related evaluation to our Audit Committee;
	•		The absence of adequate processes and programs in our control environment to educate employees on our employee code of conduct and applicable laws and regulations; and
	•		Insufficient accounting and finance personnel with the knowledge and experience required to ensure an appropriate level of review of financial statement accounts.

     These material weaknesses result in more than a remote likelihood that a material misstatement to any of our significant financial statement accounts will not be prevented or detected in the annual or interim financial statements.

      Remediation of the Material Weakness That Existed as of December 31, 2007

     During the first quarter of fiscal 2008, we continue to undertake the following actions in an effort to remediate the first two material weaknesses described above:

	•		Review and evaluation of our internal controls, including our internal reporting processes, to ensure that legal, regulatory and other matters that could have a significant financial statement effect are identified and evaluated and documented by management and escalated on a timely basis, where appropriate, to the Audit Committee.
	•		Development, with the assistance of outside advisors, of new valuation and declaration processes to ensure compliance with all customs regulations of each of the countries into which we import parts, including replacing manual invoices with an automated customs commercial invoice process that requires review by legal and finance personnel.
	•		Enhanced compliance and ethics training for employees, including implementation of an online compliance system in four languages, increasing awareness of the employee code of conduct through mandatory training for all employees, and reinforcing the ethics policy by requiring an annual ethics certification for all employees.
	•		With respect to personnel who were determined to have known, or who should have known, that the Company’s customs practices were non-compliant, certain of such personnel have been terminated or have otherwise left the Company, and others, including a former executive officer, have had their responsibilities and reporting relationships modified.

     With respect to the third material weakness described above, we continue our search for qualified candidates for those positions identified as being advisable additions to the finance and accounting staff of the Company. In the interim, certain key positions are being performed by temporary employees and contractors until qualified candidates are found and commence employment with us. We are actively engaged in a search for a new chief financial officer with the goal of filling the position as soon as practicable. We are also working to fill other finance positions as soon as practicable.

     Although we have made progress during the first quarter on these actions to remediate the identified material weaknesses, we require additional time to complete the remediation work described above and to test the enhanced controls to ensure that these material weaknesses have been fully remediated and that the enhanced controls are operating effectively. We currently are unable to determine when these material weaknesses will be fully remediated and can provide no assurances on the timing of new hires as part of our remediation efforts.

     Based on the foregoing and our management’s evaluation (with the participation of our chief executive officer and chief financial officer), our chief executive officer and chief financial officer have concluded that, as of December 31, 2008, our disclosure controls and procedures were not effective to provide reasonable assurance that the information required to be disclosed by us in reports that we file or submit under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure, due to the material weakness in our internal control over financial reporting.