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 June 30, 2008


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: 000-27234

PHOTON DYNAMICS, INC.

(Exact name of registrant as specified in its charter)


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

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
(Do not check if a smaller reporting company)

Smaller reporting company o

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 August 1, 2008, there were 17,816,320 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 June 30, 2008 and September 30, 2007		3
	Condensed Consolidated Statements of Operations for the Three and Nine Months Ended June 30, 2008 and 2007		4
	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended June 30, 2008 and 2007		5
	Notes to Condensed Consolidated Financial Statements		6
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations		23
Item 3	Quantitative and Qualitative Disclosures About Market Risk		41
Item 4	Controls and Procedures		42

	PART II OTHER INFORMATION
Item 1	Legal Proceedings		44
Item 1A	Risk Factors		45
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds		57
Item 3	Defaults Upon Senior Securities		57
Item 4	Submission of Matters to a Vote of Security Holders		58
Item 5	Other Information		58
Item 6	Exhibits		58
Signatures			59
EXHIBIT 10.60
EXHIBIT 10.61
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1

PART I. FINANCIAL INFORMATION

ITEM 1. Financial Statements

PHOTON DYNAMICS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)


	June 30,			September 30,
	2008			2007
	(in thousands)
ASSETS
Current assets:
Cash and cash equivalents	$	60,672		$	41,170
Short-term investments		10,156			42,640
Accounts receivable, net of allowance for doubtful accounts of $52 and $239 at June 30, 2008 and September 30, 2007, respectively		36,894			11,934
Inventories		21,409			13,292
Refundable customs obligations		632			560
Other current assets		5,066			3,661

Total current assets		134,829			113,257
Long-term investments		1,000			1,176
Land, property and equipment, net		9,725			10,583
Other assets		6,174			5,365
Intangible assets, net		8,348			11,023
Goodwill		6,857			6,857

Total assets	$	166,933		$	148,261


LIABILITIES AND SHAREHOLDERS’ EQUITY

Current liabilities:
Accounts payable	$	22,112		$	4,217
Warranty		5,823			3,217
Employee note payable		2,733			—
Customs obligations		438			4,114
Other current liabilities		11,963			9,874
Deferred gross margin		1,699			3,236

Total current liabilities		44,768			24,658


Non-current liabilities:
Long-term employee note payable		2,667			5,381
Other non-current liabilities		—			38

Total non-current liabilities		2,667			5,419


Commitments and contingencies

Shareholders’ equity:
Common stock, no par value		302,413			300,290
Accumulated deficit		(182,352	)		(181,503	)
Accumulated other comprehensive loss		(563	)		(603	)

Total shareholders’ equity		119,498			118,184

Total liabilities and shareholders’ equity	$	166,933		$	148,261

See accompanying notes to condensed consolidated financial statements.

PHOTON DYNAMICS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)


	Three Months Ended					Nine Months Ended
	June 30,					June 30,
	2008		2007			2008			2007
	(in thousands, except per share data)
Product revenue	$	41,387	$	11,356		$	94,884		$	39,462
Customer support and spare parts revenue		4,734		3,074			12,506			10,331

Total revenue		46,121		14,430			107,390			49,793


Product cost of revenue		23,157		10,027			58,438			36,272
Customer support and spare parts cost of revenue		1,829		1,188			5,383			4,497

Total cost of revenue		24,986		11,215			63,821			40,769


Gross margin		21,135		3,215			43,569			9,024


Operating expenses:
Research and development		7,309		6,213			18,681			21,343
Selling, general and administrative		9,216		5,831			24,072			17,197
Restructuring charge (benefit)		—		(95	)		—			1,368
Impairment of property and equipment		—		—			—			2,834
Gain on sale of property and equipment		—		—			(49	)		—
Amortization of intangible assets		892		254			2,675			999

Total operating expenses		17,417		12,203			45,379			43,741


Income (loss) from operations		3,718		(8,988	)		(1,810	)		(34,717	)
Interest income and other, net		423		327			1,886			3,337

Income (loss) before income taxes		4,141		(8,661	)		76			(31,380	)
Provision for income taxes		255		72			559			278

Net income (loss)	$	3,886	$	(8,733	)	$	(483	)	$	(31,658	)


Net income (loss) per share:
Basic	$	0.22	$	(0.52	)	$	(0.03	)	$	(1.91	)

Diluted	$	0.21	$	(0.52	)	$	(0.03	)	$	(1.91	)


Weighted average number of shares:
Basic		17,786		16,635			17,759			16,605
Diluted		18,624		16,635			17,759			16,605

See accompanying notes to condensed consolidated financial statements.

PHOTON DYNAMICS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)


	Nine Months Ended
	June 30,
	2008			2007
	(in thousands)
Cash flows from operating activities:
Net loss	$	(483	)	$	(31,658	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation		2,333			3,653
Amortization of intangible assets		2,675			999
Stock-based compensation		1,982			1,513
Restructuring charge		—			178
Impairment of property and equipment		—			2,834
Foreign currency translation adjustment gain recognized upon liquidation of a subsidiary		—			(928	)
Gain on sale of property and equipment		(49	)		—
Accretion of non-interest bearing notes payable		—			23
Changes in operating assets and liabilities:
Accounts receivable		(24,960	)		10,414
Inventories		(6,840	)		428
Other current assets		(1,477	)		(471	)
Other assets		(1,010	)		(284	)
Accounts payable		17,895			(224	)
Other current liabilities		752			(1,022	)
Deferred gross margin		(1,537	)		(851	)
Other liabilities		(38	)		(23	)

Net cash used in operating activities		(10,757	)		(15,419	)


Cash flows from investing activities:
Purchase of property and equipment		(2,823	)		(1,040	)
Proceeds from sale of property and equipment		250			—
Purchase of short-term investments		(13,621	)		(82,711	)
Maturities and sales of short-term investments		46,290			78,264

Net cash provided by (used in) investing activities		30,096			(5,487	)


Cash flows from financing activities:
Issuance of common stock		161			1,364
Capital lease payments		(80	)		(68	)

Net cash provided by financing activities		81			1,296


Effect of exchange rate changes on cash and cash equivalents		82			(72	)

Net increase (decrease) in cash and cash equivalents		19,502			(19,682	)
Cash and cash equivalents at beginning of period		41,170			47,935

Cash and cash equivalents at end of period	$	60,672		$	25,253

See accompanying notes to condensed consolidated financial statements.

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 1 — BASIS OF PRESENTATION

Basis of Presentation. The accompanying unaudited condensed consolidated financial statements of Photon Dynamics, Inc. (“Photon Dynamics” or the “Company”) have been prepared in accordance with generally accepted accounting principles in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, the unaudited interim financial statements reflect all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation of the financial position, results of operations and cash flows for the periods indicated.

These financial statements and notes should be read in conjunction with “Item 8. Financial Statements and Supplementary Data” included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2007. Operating results for the three and nine months ended June 30, 2008, are not necessarily indicative of the results that may be expected for any other interim period or for the full fiscal year ending September 30, 2008.

The condensed consolidated balance sheet as of September 30, 2007 is derived from the Company’s audited consolidated financial statements as of September 30, 2007, included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2007 filed with the Securities and Exchange Commission on January 24, 2008, but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

Description of Operations and Principles of Consolidation. Photon Dynamics, Inc. is a global supplier utilizing advanced digital imaging technology for both Liquid Crystal Display yield enhancement systems for the flat panel display industry and high-performance digital imaging systems for defense, surveillance, industrial inspection and medical imaging applications. The consolidated financial statements include the accounts of the Company, its wholly owned subsidiaries that are not considered variable interest entities (“VIEs”) and all VIEs for which the Company is the primary beneficiary. All intercompany accounts and transactions have been eliminated.

The Company currently operates in two segments: Flat Panel Display and High-Performance Digital Imaging. From fiscal 2003 to 2007 the Company operated in one segment: Flat Panel Display. The Company commenced operations in the High-Performance Digital Imaging segment with its July 2007 acquisition of Salvador Imaging, Inc. (“Salvador Imaging”). Revenues from the Flat Panel Display segment accounted for more than 96% of the Company’s consolidated revenues during both the three and nine months ended June 30, 2008, and 100% of the Company’s consolidated revenues during both the three and nine months ended June 30, 2007.

Management Estimates and Assumptions. The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Examples of estimates made by management include estimates of product life cycles, restructuring charges, stock-based compensation volatility and forfeiture rates and litigation and contingency assessments. Examples of assumptions made by management include assumptions regarding whether the criteria for revenue recognition were met, the calculation of the allowance for doubtful accounts, inventory write-downs, warranty accruals and when investment impairments are other than temporary. Actual results could differ from those estimates and assumptions.

Revenue Recognition. Photon Dynamics derives revenue primarily from the sale and installation of equipment, non-warranty services, the sale of spare parts and revenue from non-recurring engineering contracts.

The Company recognizes revenue on the sale and installation of equipment when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the selling price is fixed or determinable and collectibility is reasonably assured. Persuasive evidence of an arrangement exists when a sales quotation outlining the terms and conditions of the arrangement has been issued to the customer and a purchase order has been received from the customer accepting the terms of the sales quotation and stating, at a minimum, the number of systems ordered, terms and conditions of the sale and the value of the overall arrangement.

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 received customer acceptance certificates 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 may not be essential to the functionality of the products and 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 first 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.

The Company recognizes customer support revenue for non-warranty services either ratably over the term of the maintenance contract, if a contract has been entered into, or as labor and expenses are incurred, if there is no contract.

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 13 for further discussion.

Recent Accounting Pronouncements. In March 2008, the Financial Accounting Standards Board (“FASB”) issued Statement of Accounting Standards No. 161, “Disclosures about Derivative Instruments and Hedging Activities — an amendment of SFAS No. 133” (“SFAS No. 161”). This statement changes the disclosure requirements for derivative instruments and hedging activities. SFAS No. 161 requires the Company to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities,” and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows. SFAS No. 161 will be effective for the Company’s interim period beginning January 1, 2009. The Company is currently 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 February 2008, the FASB adopted FASB Staff Position Statement of Financial Accounting Standards No. 157-2, “Effective Date of FASB Statement No. 157” (“SFAS No. 157-2”). SFAS No. 157 “Fair Value Measurements” (“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. SFAS No. 157-2 delays the effective date of SFAS No.157 for one year for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). The provisions of SFAS No. 157 will be effective for the Company in fiscal years beginning October 1, 2008, unless the Company elects the delayed adoption date For the portion of SFAS No. 157 impacted by SFAS No. 157-2. The Company is currently evaluating the impact of this statement on its results of operations, financial position and cash flows.

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141 (revised 2007) “Business Combinations” (“SFAS No. 141R”). SFAS No. 141R defines the acquirer as the entity that obtains control of one or more businesses in the business combination, establishes the acquisition date as the date that the acquirer achieves control and requires the acquirer to recognize the assets acquired, liabilities assumed and any noncontrolling interest at their fair values as of the acquisition date. In addition, SFAS No. 141R requires expensing of acquisition-related and restructure-related costs, remeasurement of earn-out provisions at fair value, measurement of equity securities issued for purchase at the date of close of the transaction and non-expensing of in-process research and development related intangibles. SFAS No. 141R will be effective for the Company in fiscal years beginning October 1, 2009. The Company is currently 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 currently evaluating the impact of this statement on its results of operations, financial position and cash flows.

NOTE 2 — MERGER WITH ORBOTECH LTD.

On June 26, 2008, the Company entered into an Agreement and Plan of Merger and Reorganization (the “Merger Agreement”) among Orbotech Ltd. (“Orbotech”), PDI Acquisition, Inc., an indirect wholly-owned subsidiary of Orbotech (“Merger Sub”) and the Company. The Merger Agreement provides that, upon the terms and conditions set forth therein, Merger Sub will be merged with and into the Company (the “Merger”), with the Company surviving the Merger as an indirect wholly-owned subsidiary of Orbotech. The board of directors of the Company has unanimously approved the Merger and the Merger Agreement. At the effective time and as a result of the Merger, each outstanding share of the Company’s common stock will be converted into the right to receive $15.60 in cash, without interest. Consummation of the Merger is subject to the conditions described in the Merger Agreement, including approval by the shareholders of the Company, antitrust and other regulatory approvals, and other customary closing conditions. Orbotech expects to finance the purchase price through a combination of the Company’s cash on hand at closing and debt financing. Consummation of the Merger is not subject to any financing condition. The transaction is expected to close during the second half of calendar year 2008.

Under the terms of the Merger Agreement, the Company may be required to pay Orbotech a termination fee of $9,000,000 in the following circumstances:

	•		Following the termination by the Company to accept a superior proposal (as defined in the Merger Agreement);

	•		Following the termination by Orbotech, if the Company’s Board of Directors changes its recommendation or recommends a competing proposal, or fails to reaffirm its recommendation following the public announcement of a competing proposal;

	•		Following the public announcement of a competing proposal that is not withdrawn prior to the special meeting, if (i) such termination results from a failure to obtain the required shareholder vote and (ii) within twelve months after such termination, the Company enters into a definitive agreement relating to an alternative acquisition or consummates an alternative acquisition; or

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

•

Following the receipt by the Company of a competing proposal that is not withdrawn on or prior to the outside date, if (i) the required shareholder vote is not obtained and (ii) within twelve months after such termination, the Company enters into a definitive agreement relating to an alternative acquisition or consummates an alternative acquisition.

In addition, under the terms of the Merger Agreement, the Company has agreed to reimburse up to $2,000,000 of Orbotech’s reasonable out-of pocket expenses if the merger agreement is terminated as a result of the failure to obtain the required shareholder vote or as a result of the Company’s breach or material failure to perform any of its representations, warranties or covenants contained in the Merger Agreement; provided, however, that in the event that the Company pays the $9,000,000 termination fee to Orbotech, it will not be required to also reimburse its expenses.

In addition, under the terms of the Merger Agreement, Orbotech may be required to pay the Company a termination fee of $9,000,000 if the Merger Agreement is terminated because clearance by the Committee on Foreign Investment in the United States (“CFIUS”) has not been obtained and all other conditions to the completion of the merger have been met, and following three business days’ notice to Orbotech, Orbotech does not waive the CFIUS closing condition.

The foregoing description of the Merger and the Merger Agreement is qualified in its entirety by reference to the full text of the Merger Agreement, a copy of which has been filed as an exhibit to the Company’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on June 26, 2008.

NOTE 3 — FINANCIAL STATEMENT COMPONENTS


	June 30,			September 30,
	2008			2007
	(in thousands)
Inventories:
Raw materials	$	10,402		$	7,465
Work-in-process		10,281			4,491
Finished goods		726			1,336

Total	$	21,409		$	13,292


Other current liabilities:
Compensation	$	5,696		$	4,897
Professional fees		3,082			2,441
Other accrued expenses		3,185			2,536

Total	$	11,963		$	9,874


Deferred gross margin:
Deferred system revenue	$	17,007		$	10,269
Deferred cost of revenue		(15,308	)		(7,033	)

Total	$	1,699		$	3,236


Accumulated other comprehensive loss:
Foreign currency translation adjustments	$	(512	)	$	(543	)
Unrealized losses on available—for-sale securities		(51	)		(60	)

Total	$	(563	)	$	(603	)

NOTE 4 — GOODWILL AND OTHER PURCHASED INTANGIBLE ASSETS

Goodwill

The carrying value of goodwill was approximately $6.9 million at both June 30, 2008 and September 30, 2007. There were no additions or adjustments to goodwill during the nine months ended June 30, 2008. 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. Should the annual impairment test performed in the fourth quarter of fiscal 2008 indicate that the carrying value of goodwill may not be fully recoverable, the Company may be required to record impairment charges for these assets.

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

At June 30, 2008, 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 June 30, 2008 were as follows:


							Non
	Developed			Core			Compete			Customer			Trade
	Technology			Technology			Contract			Relations			Name			Backlog			Total
	(in thousands)
Gross carrying amount at June 30, 2008	$	7,346		$	3,988		$	2,348		$	910		$	640		$	110		$	15,342
Accumulated amortization		(2,470	)		(2,753	)		(1,368	)		(209	)		(147	)		(47	)		(6,994	)

Net carrying amount at June 30, 2008	$	4,876		$	1,235		$	980		$	701		$	493		$	63		$	8,348

The components of intangible assets as of September 30, 2007 were as follows:


							Non
	Developed			Core			Compete			Customer			Trade
	Technology			Technology			Contract			Relations			Name			Backlog			Total
	(in thousands)
Gross carrying amount at September 30, 2007	$	7,346		$	3,988		$	2,348		$	910		$	640		$	110		$	15,342
Accumulated amortization		(1,094	)		(2,111	)		(1,041	)		(38	)		(27	)		(8	)		(4,319	)

Net carrying amount at September 30, 2007	$	6,252		$	1,877		$	1,307		$	872		$	613		$	102		$	11,023

The following table summarizes the activity during the nine months ended June 30, 2008:


							Non
	Developed			Core			Compete			Customer			Trade
	Technology			Technology			Contract			Relations			Name			Backlog			Total
	(in thousands)
Balance as of September 30, 2007	$	6,252		$	1,877		$	1,307		$	872		$	613		$	102		$	11,023
Amortization during the period		(1,376	)		(642	)		(327	)		(171	)		(120	)		(39	)		(2,675	)

Balance as of June 30, 2008	$	4,876		$	1,235		$	980		$	701		$	493		$	63		$	8,348

Based on intangible assets recorded at June 30, 2008, and assuming no subsequent additions to, or impairment of, the underlying assets, the remaining amortization expense relating to intangible assets at June 30, 2008, is expected to be approximately $718,000 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 impairment charges for these assets.

NOTE 5 — RESTRUCTURING AND OTHER CHARGES

March 2007 Impairment of Property and Equipment

During the three months ended March 31, 2007, the Company recorded approximately $2.8 million of charges to impair property and equipment.

As a result of the implementation of the Company’s offshore manufacturing program, management performed an impairment assessment of its manufacturing facilities and equipment. Based on that assessment management determined that the Company’s 128,520 square foot U.S. facility leased by the Company was not impaired but that the 22,000 square foot U.S. manufacturing facility owned by the Company was impaired. In accordance with the provisions of Statement of Financial Accounting Standards No. 144,

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

“Accounting for the Impairment or Disposal of Long-lived Assets,” the Company recorded an impairment charge of approximately $2.0 million based on the difference between the carrying amount of the assets over the assets’ appraised fair value. In addition, the Company incurred an impairment charge of approximately $834,000 as a result of the write-off of certain capital equipment that was determined to have no additional future use. These charges are reflected in “Impairment of Property and Equipment” in the Company’s Condensed Consolidated Statements of Operations.

February 2007 Restructure

On February 21, 2007, the Company announced the implementation of a company-wide cost reduction plan approved by the board of directors and designed to accelerate the Company’s objective of achieving consistent profitability. Management’s goal was to size the Company’s business in response to the then-current flat panel display market. 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 restructuring plan consisted of reducing the Company’s workforce. Management approved and implemented the plan and determined the benefits that would be offered to the employees being terminated. Management determined that terminations affecting 56 employees would occur on February 21, 2007. All affected employees were notified of their termination and the benefits package was explained in sufficient detail such that each affected employee was able to determine the type and amount of benefits they were entitled to receive.

The Company recorded a restructuring charge of approximately $1.0 million in the three months ended March 31, 2007, which was comprised of employee severance and related benefits. In the three months ended June 30, 2007, the Company reversed approximately $95,000 of the initial charge for severance benefits not paid. These charges are reflected in “Restructuring charge (benefit)” in the Company’s Condensed Consolidated Statements of Operations. All amounts were paid in the nine months ended June 30, 2007.

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 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 (benefit)” in the Company’s Condensed Consolidated Statements of Operations. All amounts were paid in the six months ended March 31, 2007.

NOTE 6 — COMPREHENSIVE INCOME (LOSS)

The components of total comprehensive income (loss) were as follows:


	Three Months Ended						Nine Months Ended
	June 30,						June 30,
	2008			2007			2008			2007
	(in thousands)
Net income (loss)	$	3,886		$	(8,733	)	$	(483	)	$	(31,658	)
Other comprehensive income (loss):
Net change in unrealized gain (loss) on investments		32			(8	)		9			(3	)
Change in foreign currency translation		(157	)		6			31			(87	)(1)

Other comprehensive income (loss)		(125	)		(2	)		40			(90	)

Total comprehensive income (loss)	$	3,761		$	(8,735	)	$	(443	)	$	(31,748	)


(1)		In the quarter ended March 31, 2007, the Company substantially liquidated its net investment in its Canadian subsidiary, Photon Dynamics Canada, Inc., for financial statement purposes. In accordance with the provisions of Statement of Financial Accounting Standards No. 52, “Foreign Currency Translation” the Company recorded a gain on liquidation of its net investment in this subsidiary of approximately $928,000, composed of translation adjustment gains that had accumulated in “Accumulated other comprehensive income (loss)” on the Consolidated Balance Sheet.

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 7 — 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 the three and nine months ended June 30, 2008 and 2007 was as follows:


	Three Months Ended					Nine Months Ended
	June 30,					June 30,
	2008		2007			2008		2007
	(in thousands)
Stock-based compensation expense included in continuing operations: :
Cost of revenue	$	61	$	26		$	233	$	213
Research and development		242		125			411		324
Selling, general and administrative		757		274			1,338		976

Total stock-based compensation expense after income taxes (1)	$	1,060	$	425		$	1,982	$	1,513


Stock-based compensation expense by type of award: :
Employee stock options	$	288	$	274		$	441	$	1,130
Employee stock purchase plan		56		74			56		281
Restricted stock awards		696		159			1,465		184
Amounts capitalized as inventory and deferred gross margin		20		(82	)		20		(82	)

Total stock-based compensation expense after income taxes (1)	$	1,060	$	425		$	1,982	$	1,513


(1)		The income tax benefit on stock-based compensation for all periods presented was not material.

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 June 30, 2008, the equity incentive program consisted of:

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 granted generally have a vesting period of 48 to 60 months, are generally exercisable for a period of seven to 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 granted have been both time-based and performance-based vesting. Restricted stock units granted with time-based vesting generally vest annually over a four-year period from the date of grant. However, restricted stock units issued in the Company’s May, 2007 one-time stock option exchange program vest over a two- to three-year period from the date of exchange. Certain equity awards provide for accelerated vesting if there is a change of control. Restricted stock units granted with performance-based vesting generally vest over four years, as specified by the compensation committee.

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

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

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. Equity awards under this plan provide for accelerated vesting if there is a change of control.

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 employees. As a result, the actual number of shares issued will be less than the number of restricted stock units granted. Shares withheld by the Company for statutory withholding requirements are not issued, but instead, become available for future grants. 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 (“ESPP”) 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 each option grant in the three and nine month periods ended June 30, 2008 and 2007 used the following weighted-average valuation assumptions:

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


	Three Months Ended						Nine Months Ended
	June 30,						June 30,
	2008			2007			2008			2007
Stock option plan:
Expected volatility		52	%		42	%		51	%		43	%
Risk free rate		2.4	%		4.5	%		2.5	%		4.6	%
Expected term (in years)		3.8			3.4			4.0			3.4
Expected dividends	None			None			None			None

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 determined the fair value of the offering period its ESPP in the three and nine months ended June 30, 2008 and 2007 using the following weighted-average valuation assumptions:


	Three Months Ended						Nine Months Ended
	June 30,						June 30,
	2008			2007			2008			2007
Stock purchase plan:
Expected volatility		53	%		42	%		53	%		43	%
Risk free rate		2.8	%		4.5	%		2.8	%		4.6	%
Expected term (in years)		0.5			0.5			0.5			0.5
Expected dividends	None			None			None			None

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.

Equity Incentive Plan

The following table summarizes the combined activity under the equity incentive plans for the indicated period:


	Awards						Weighted-		Weighted-Average		Aggregate
	Available			Options			Average		Remaining Contract		Intrinsic Value
	for Grant			Outstanding			Exercise Price		Term (in years)		(in thousands)
Balances at September 30, 2007		1,739,630			1,245,582		$	19.29
Plan shares expired (1)		(155,479	)		—			—
Restricted stock units granted (2)		(702,500	)		—			—
Restricted stock units cancelled (2)		78,415			—			—
Restricted stock units canceled or withheld for taxes (2)		27,379			—			—
Options granted		(160,750	)		160,750			9.63
Options canceled		293,179			(293,179	)		20.71
Options exercised		—			(17,018	)		9.44

Balances at June 30, 2008		1,119,874			1,096,135		$	17.64		5.63	$	2,259


Vested and expected to vest at June 30, 2008					921,266		$	18.75		5.53	$	1,616


Exercisable at June 30, 2008					688,017		$	21.22		5.18	$	677

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


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

(2)		Any restricted stock units granted under the 2005 Equity Incentive Plan or 2006 Non-Employee Directors’ Stock Incentive Plan shall be counted against the total number of shares issuable under the Plans. Additional detail of issued restricted stock units are shown below.

The aggregate intrinsic value in the table above represents the total pretax intrinsic value, based on the Company’s closing stock price of $15.08 as of June 30, 2008, 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 weighted average grant date fair value of options granted during the nine months ended June 30, 2008 and 2007 was $3.97 and $4.10 per share, respectively. The total intrinsic value of options exercised during the nine months ended June 30, 2008 and 2007 was approximately $27,000 and $37,000, respectively. The total cash received from employees as a result of stock option exercises during the nine months ended June 30, 2008 and 2007 was approximately $161,000 and $27,000 respectively. 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 June 30, 2008, the unrecognized stock-based compensation balance related to stock options was approximately $808,000 and will be recognized over an estimated remaining weighted-average amortization period of 1.6 years.

Restricted Stock Units

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


				Weighted-Average
	Number			Grant Date
	of Shares			Fair Value
Unvested restricted stock units at September 30, 2007		284,196		$	10.44
Restricted stock units granted		702,500		$	9.97
Restricted stock units released		(83,573	)	$	10.40
Unvested restricted stock units cancelled		(78,415	)	$	10.26

Unvested restricted stock units at June 30, 2008		824,708		$	10.06

As of June 30, 2008, the unrecognized stock-based compensation related to restricted stock units was approximately $3.7 million and will be recognized over an estimated remaining weighted-average amortization period of 2.0 years.

Employee Stock Purchase Plan

There were no shares purchased under the Employee Stock Purchase Plan during the nine months ended June 30, 2008. The Company began a new six-month Offering Period during the three months ended June 30, 2008.

As of June 30, 2008, the unrecognized stock-based compensation balance related to the Employee Stock Purchase Plan was approximately $167,000 and will be recognized over the remaining Offering Period, which ends on November 14, 2008.

The Plan shares are replenished through shareholder approval at the Annual Shareholder meeting. At June 30, 2008, a total of 829,915 shares were reserved and available for issuance under this Plan.

NOTE 8 — EARNINGS (LOSS) PER SHARE

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

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:


	Three Months Ended					Nine Months Ended
	June 30,					June 30,
	2008		2007			2008			2007
	(in thousands, except per share data)
Numerator:
Net income (loss)	$	3,886	$	(8,733	)	$	(483	)	$	(31,658	)


Denominator:
Weighted average shares outstanding, excluding unvested restricted stock, for basic net income (loss) per share		17,786		16,635			17,759			16,605
Effect of dilutive securities:
Employee stock options and restricted stock (1)		838		—			—			—

Weighted average shares for diluted net income (loss) per share		18,624		16,635			17,759			16,605


Earnings (loss) per share:
Basic	$	0.22	$	(0.52	)	$	(0.03	)	$	(1.91	)

Diluted	$	0.21	$	(0.52	)	$	(0.03	)	$	(1.91	)


Potentially anti-dilutive securities (2)		1,090		1,622			1,148			1,878


(1)		The effect of potentially dilutive securities to purchase 834,892 shares of common stock for the nine months ended June 30, 2008, and 318,823 and 320,321 shares of common stock for the three and nine months ended June 30, 2007, respectively, were not included in the computation of diluted net loss per share as the effect is anti-dilutive.

(2)		These securities are excluded from the computation of diluted earnings per share because the exercise price, including unamortized stock-based compensation net of tax benefits, was greater than the average market price of common shares for the periods presented. As a result, their effect would have been anti-dilutive.

NOTE 9 — 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 $50.7 million as of June 30, 2008 and $28.0 million as of September 30, 2007.

During the six months ended March 31, 2007, the Company incurred charges of approximately $635,000 to establish a reserve for costs associated with the cancellation of certain purchase orders. In the three months ended March 31, 2008, the company settled all claims for approximately $407,000 and recorded the reduction in expenses of approximately $228,000 to “Research and development” in the Condensed Consolidated Statement of Operations.

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Warranty Obligations

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

Changes in the Company’s product liability during the nine months ended June 30, 2008 and 2007 were as follows:


	Nine Months Ended
	June 30,
	2008			2007
	(in thousands)
Beginning balance	$	3,217		$	8,058
Estimated warranty cost of new shipments during the period		6,639			3,755
Warranty costs during the period		(4,351	)		(7,819	)
Changes in liability for pre-existing warranties, including expirations		318			697

Ending balance	$	5,823		$	4,691

The warranty liability at September 30, 2007 included 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.

Contingent Termination Fee Related to Merger with Orbotech

Under the terms of the Merger Agreement, the Company may be required to pay Orbotech a termination fee in the amount of $9,000,000 in certain circumstances. See Note 2 — Merger with Orbotech Ltd. for further discussion of the termination fee.

Legal Proceedings

Capital Partners v. Dr. Malcolm J. Thompson, et al. On July 25, 2008, Capital Partners, a purported stockholder of the Company, filed a complaint in California Superior Court, Santa Clara County, against the Company, each of the Company’s directors and Orbotech entitled Capital Partners v. Dr. Malcolm J. Thompson, et al. (Case No. 1-08-CV-118315). The complaint alleges, among other things, that the Company’s directors breached their fiduciary duties in connection with the merger, that the Company’s preliminary proxy statement relating to the merger omits material information and that Orbotech has aided and abetted the Company’s directors in their alleged breaches of fiduciary duties. The relief sought by the plaintiff includes a determination that the class action status is proper, an injunction barring the merger (or if the merger is consummated, a rescission of the merger), corrective disclosures and the payment of compensatory damages and other fees and costs.

On July 29, 2008, the complaint was formerly served on the Company and the individual defendants. On August 1, 2008, the Company and the individual defendants removed this case to the U.S. District Court for the Northern District of California. Also on August 1, 2008, Capital Partners filed an application in California Superior Court, Santa Clara County, seeking expedited discovery, a temporary restraining order that would bar the merger pending such discovery, and a hearing following such discovery on a preliminary injunction that would bar the merger pending a trial on the merits. The parties have not yet responded to the foregoing filings, nor have they been acted upon by any court; however, the Company and the individual defendants previously had agreed to provide expedited discovery. Although the ultimate outcome of this matter cannot be determined with certainty, the Company believes that the complaint is completely without merit and it and the other defendants intend to vigorously defend this lawsuit.

Amtower v. Photon Dynamics, Inc. 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

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

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. On April 9, 2008, the Supreme Court of California denied the plaintiff’s petition for review. As a result, the plaintiff has paid the Company approximately $718,000 in fees, costs and interest associated with the lawsuit. In addition, the Company settled its litigation with its insurance carriers related to the reimbursement of costs related to the litigation and received a payment of approximately $700,000.

Customs and Duties Liability. As of June 30, 2008, the Company has paid approximately $6.6 million, net of VAT amounts refundable, to foreign customs authorities in connection with its settlements regarding underpayment of customs duties for warranty parts and has accrued an additional $438,000 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 is continuing its 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.

Security and Exchange Commission Inquiry. During its second fiscal quarter, the Company responded to inquiries relating to its recent restatement from the SEC’s Enforcement Division. On July 3, 2008, the Company received notice that the Enforcement Division had terminated the investigation and that no enforcement action had been recommended to the Commission.

General Litigation. 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.

NOTE 10 — 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”).

From fiscal 2003 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 of each segment 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.

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

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 charges, 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 and nine months ended June 30, 2008 there was approximately $1,000 and $33,000 of inter-segment revenue, respectively, that has been adjusted for in the operating results reported below.

Segment information is summarized as follows:


	Three Months						Nine Months
	Ended						Ended
	June 30,						June 30,
	2008			2007			2008			2007
	(in thousands)
Revenue:
Flat panel display segment	$	44,470		$	14,430		$	103,544		$	49,793
High-performance digital imaging segment		1,651			—			3,846			—

Consolidated revenue	$	46,121		$	14,430		$	107,390		$	49,793


Operating income (loss):
Flat panel display segment	$	6,234		$	(8,455	)	$	4,491		$	(28,799	)
High-performance digital imaging segment		(1,456	)		—			(4,367	)		—

Total segment operating income (loss)	$	4,778		$	(8,455	)	$	124		$	(28,799	)

All of the Company’s Customer support and spare parts revenue was generated by the flat panel display segment.

Reconciliation of segment operating income (loss) to Photon Dynamics consolidated income (loss) from operations is as follows:


	Three Months						Nine Months
	Ended						Ended
	June 30,						June 30,
	2008			2007			2008			2007
	(in thousands)
Operating loss:
Total segment operating income (loss)	$	4,778		$	(8,455	)	$	124		$	(28,799	)
Unallocated costs		(1,060	)		(628	)		(1,983	)		(1,716	)
Restructuring costs (benefit)		—			95			—			(1,368	)
Impairment of property and equipment		—			—			—			(2,834	)
Gain on sale of property and equipment		—			—			49			—

Consolidated income (loss) from operations	$	3,718		$	(8,988	)	$	(1,810	)	$	(34,717	)

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

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


	Three Months				Nine Months
	Ended				Ended
	June 30,				June 30,
	2008		2007		2008		2007
	(in thousands)
Revenue:
South Korea	$	27,906	$	6,921	$	52,781	$	16,995
Taiwan		12,964		3,493		36,716		17,123
Japan		1,022		3,936		10,717		14,476
Germany		2,324		—		2,323		—
United States		1,651		—		3,846		—
China		254		80		1,007		1,199

Total	$	46,121	$	14,430	$	107,390	$	49,793

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


	Three Months						Nine Months
	Ended						Ended
	June 30,						June 30,
	2008			2007			2008			2007
Customer A		43	%		39	%		25	%		25	%
Customer B		14	%		*			23	%		*
Customer C		14	%		14	%		22	%		18	%
Customer D		13			*			11	%		13	%
Customer E		*			25	%		*			27	%


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

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:


	June 30,			September 30,
	2008			2007
Customer A		32	%		*
Customer B		22	%		28	%
Customer C		14	%		*
Customer D		12	%		*
Customer E		*			26	%
Customer F		*			19	%


*		Customer accounted for less than 10% of total accounts receivable.

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

Long-lived assets consist primarily of property, plant and equipment, goodwill and intangibles and are attributed to the geographic location in which they are located, as follows:


	June 30,		September 30,
	2008		2007
	(In thousands)
United States	$	24,365	$	27,518
South Korea		364		756
Other		201		189

Total	$	24,930	$	28,463

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 11 — 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 and nine months ended June 30, 2008, and in the three months ended June 30, 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 for accounting purposes under SFAS No. 133, and, as such, the Company records the changes in the fair value of these derivatives in “Interest income and other, net” in the Consolidated Statement of Operations. Total net gains from changes in fair values of all forward exchange contracts for both the three months ended June 30, 2008 and 2007 were immaterial. Total net losses from changes in fair values of all forward exchange contracts for the nine months ended June 30, 2008 were approximately $341,000, while total net losses from changes in fair value of all forward exchange contracts for the nine months ended June 30, 2007 were immaterial. All losses are include in “Interest income and other, net” in the Consolidated Statement of Operations. At June 30, 2008 and 2007, the Company had foreign exchange forward contracts outstanding to sell approximately $570,000 and $8.1 million, respectively, in Japanese Yen. The fair value of the open contracts at both June 30, 2008 and 2007 was immaterial and was included in “Other current liabilities” in the Consolidated Balance Sheet. The open contracts at June 30, 2008 will settle in the fourth quarter of fiscal 2008.

NOTE 12 — 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 held approximately 6% of the outstanding stock in the Company. The note bears interest at 5% per annum, which is payable quarterly. At June 30, 2008 approximately $5.4 million was outstanding, which included approximately $66,000 in interest. Approximately $2.7 million in principle related to this note is due in October 2008 and approximately $2.7 million in principle is due in January 2010.

NOTE 13 — INCOME TAXES

Tax Provision. For the three and nine months ended June 30, 2008, the Company recorded a provision for income taxes of approximately $255,000 and $559,000, respectively. The Company’s provision for income taxes is primarily due to foreign income taxes. The Company had a provision for income taxes despite a net loss position in the nine month period due primarily to foreign income taxes. The effective tax rates for both the three and nine month periods are different than the statutory rate due primarily to the

PHOTON DYNAMICS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

inability to recognize year-to-date domestic tax benefits under FIN 18 “Accounting for Income Taxes in Interim Periods — an interpretation of APB Opinion No. 28.”

For the three and nine months ended June 30, 2007, the Company recorded a provision for income taxes of approximately $72,000 and $278,000, 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 are different than the statutory rate due primarily to domestic losses that could not be benefited.

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 $366,000 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 and nine months ended June 30, 2008 and 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 complete the proposed acquisition by Orbotech; 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 I Item 1A. “Risk Factors” in our Annual Report on Form 10-K for our fiscal year ended September 30, 2007. 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.

MERGER WITH ORBOTECH, LTD.

On June 26, 2008, we entered into an Agreement and Plan of Merger and Reorganization dated as of June 26, 2008 (the “Merger Agreement”) among Orbotech Ltd. (“Orbotech”), PDI Acquisition, Inc., an indirect wholly-owned subsidiary of Orbotech (“Merger Sub”) and the Company. The Merger Agreement provides that, upon the terms and conditions set forth therein, Merger Sub will be merged with and into the Company (the “Merger”), with the Company surviving the Merger as an indirect wholly-owned subsidiary of Orbotech. Our board of directors has unanimously approved the Merger and the Merger Agreement. At the effective time and as a result of the Merger, each outstanding share of our common stock will be converted into the right to receive $15.60 in cash, without interest. Consummation of the Merger is subject to the conditions described in the Merger Agreement, including approval by the shareholders of our Company, antitrust and other regulatory approvals, and other customary closing conditions. Orbotech expects to finance the purchase price through a combination of the Company’s cash on hand at closing and debt financing. Consummation of the Merger is not subject to any financing condition. The transaction is expected to close during the second half of calendar year 2008.

Under the terms of the Merger Agreement, we may be required to pay Orbotech a termination fee of $9,000,000 in the following circumstances:

	•		Following the termination by the Company to accept a superior proposal (as defined in the Merger Agreement);

	•		Following the termination by Orbotech, if the Company’s Board of Directors changes its recommendation or recommends a competing proposal, or fails to reaffirm its recommendation following the public announcement of a competing proposal;

	•		Following the public announcement of a competing proposal that is not withdrawn prior to the special meeting, if (i) such termination results from a failure to obtain the required shareholder vote and (ii) within twelve months after such termination, the Company enters into a definitive agreement relating to an alternative acquisition or consummates an alternative acquisition; or

•

In addition, under the terms of the Merger Agreement, we have agreed to reimburse up to $2,000,000 of Orbotech’s reasonable out-of pocket expenses if the merger agreement is terminated as a result of the failure to obtain the required shareholder vote or as a result of our breach or material failure to perform any of its representations, warranties or covenants contained in the Merger Agreement; provided, however, that in the event that we pay the $9,000,000 termination fee to Orbotech, we will not be required to also reimburse its expenses.

In addition, under the terms of the Merger Agreement, Orbotech may be required to pay us a termination fee of $9,000,000 if the Merger Agreement is terminated because clearance by the Committee on Foreign Investment in the United States (“CFIUS”) has not been obtained and all other conditions to the completion of the merger have been met, and following three business days’ notice to Orbotech, Orbotech does not waive the CFIUS closing condition.

The foregoing description of the Merger and the Merger Agreement is qualified in its entirety by reference to the full text of the Merger Agreement, a copy of which has been filed as an exhibit to our Current Report on Form 8-K as filed with the Securities and Exchange Commission on June 26, 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 96% of our consolidated revenues during both the three and nine months ended June 30, 2008, and 99% of our consolidated revenues during the twelve months ended September 30, 2007.

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. During fiscal 2007, we 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, Germany 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. In addition, we have signed outsourcing agreements with third parties to begin limited manufacturing in both Taiwan and China. 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. However, 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 during that period panel prices stabilized 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 most of calendar year 2007 and strong demand for IT and television displays has created a capacity shortfall, particularly for larger-sized panels. For the past three quarters, flat panel display manufacturers have been 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.

As a result of the upswing in investment activity by flat panel display manufacturers, we experienced both higher levels of bookings and higher revenue in the nine months ended June 30, 2008 as compared to the same period in the prior fiscal year. However, while we expect that flat panel display manufacturers will continue 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 industry recovery will continue at the pace we expect or at all. Recently, there has been unease regarding current market conditions given the decline in panel prices, increases in inventories and the slowing end market demand, particularly in the greater than 40” television segment. A number of flat panel manufacturers are reducing capacity utilization in response to the slowing demand. Consumer demand patterns over the next several quarters will determine if the slowing demand is the result of typical seasonal demand trough or due to macroeconomic concerns. New manufacturing capacity investment for the second half of calendar 2008 and calendar 2009 will be strongly dependent on the supply/demand balance.

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, fluoroscopy and applications in the field of veterinary medicine.

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. Another industry focus for this segment’s products is the medical/scientific industry, specifically as it applies to X-ray in the veterinary industry. 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 June 30, 2008, our total backlog was approximately $202.2 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 gross margin over time can have a material impact on our consolidated revenue and consolidated gross margins 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, Europe 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.

Fair value of financial instruments

We determine the fair value of our financial instruments based on quoted market prices, where available, or on estimates using present values or other valuation techniques, as appropriate.

The cost and fair value of our available-for-sale investments are based on the specific identification method, using quoted market prices. In addition to the fair value, we periodically review our investment portfolios to determine if any investment is other-than-temporarily impaired due to changes in credit risk or other potential valuation concerns. We base our judgments of impairment on published ratings by established authorities.

The fair value for derivative instruments are obtained from quoted market prices and/or discounted cash flow models as appropriate. These contracts require management to exchange currencies at rates agreed upon at the contract’s inception and have terms designed to match the timing of payment from the foreign currency-denominated instrument being hedged. By their very nature, our estimates of anticipated transactions may fluctuate over time and may ultimately vary from actual transactions.

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 shorter or longer time period of estimated demand could result in increased or reduced inventory adjustment requirements, respectively. 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. 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.

While we were not engaged in any significant litigation matter as of June 30, 2008, on July 25, 2008, a purported stockholder of our Company filed a complaint entitled Capital Partners v. Dr. Malcolm J. Thompson, et al., in which they allege, among other things, certain breaches of fiduciary duties by our directors in connection with the merger with Orbotech. The relief sought by the plaintiff includes a determination that the class action status is proper, an injunction barring the merger (or if the merger is consummated, a rescission of the merger), corrective disclosures and the payment of compensatory damages and other fees and costs. This lawsuit is described in Part II, Item 1. “Legal Proceedings” in this Quarterly Report on Form 10-Q. Although the ultimate outcome of this matter cannot be determined with certainty, we believe that the complaint is completely without merit and both we and the other defendants intend to vigorously defend this lawsuit.

In addition, under the terms of the Merger Agreement, the Company may be required to pay Orbotech a termination fee in the amount of $9,000,000 in certain circumstances. See “Merger with Orbotech Ltd.” above for further discussion of the termination fee.

RESULTS OF OPERATIONS

Selected Financial Data

The percentage of net revenue represented by certain line items in our condensed consolidated statement of operations for the periods indicated are set forth in the table below.


	Three Months Ended						Nine Months Ended
	June 30,						June 30,
	2008			2007			2008			2007
Product revenue		90	%		79	%		88	%		79	%
Customer support and spare parts revenue		10			21			12			21

Total revenue		100			100			100			100


Product cost of revenue		50			70			54			73
Customer support and spare parts cost of revenue		4			8			5			9

Total cost of revenue		54			78			59			82


Gross Margin		46			22			41			18


Operating expenses:
Research and development		16			43			17			43
Selling, general and administrative		20			40			22			34
Restructuring charge (benefit)		—			(1	)		—			3
Impairment of property and equipment		—			—			—			6
Gain on sale of property and equipment		—			—			0			—
Amortization of intangible assets		2			2			3			2

Total operating expenses		38			84			42			88


Income (loss) from operations		8			(62	)		(2	)		(70	)
Interest income and other, net		1			2			2			7

Income (loss) before income taxes		9			(60	)		(0	)		(63	)
Provision for income taxes		1			1			1			1

Net income (loss)		8	%		(61	)%		(1	)%		(64	)%

Our total revenue increased 220% for the three months ended June 30, 2008 over the same period of the prior fiscal year and increased 1% sequentially from the three months ended March 31, 2008. Revenues from our Flat Panel Display segment constituted approximately 96% of our total revenues in both the three and nine months ended June 30, 2008 and 100% of the revenue in the three and nine months ended June 30, 2007.

This overall increase in revenues in the current fiscal year is primarily due to flat panel display manufacturers increasing their investments in new capacity in fiscal 2008, while in our fiscal 2007, the majority of flat panel display manufacturers had 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.

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


	Three Months Ended							Nine Months Ended
	June 30,							June 30,
	2008		Change			2007		2008		Change			2007
	(dollars in millions)
Korea	$	27.9		303	%	$	6.9	$	52.8		211	%	$	17.0
Taiwan		13.0		271	%		3.5		36.7		114	%		17.1
Japan		1.0		(74	)%		4.0		10.7		(26	)%		14.5
Germany		2.3		100	%		—		2.3		100	%		—
United States		1.7		100	%		—		3.8		100	%		—
China		0.3		217	%		0.1		1.0		(16	)%		1.2

Total Revenue	$	46.1		220	%	$	14.4	$	107.4		116	%	$	49.8

For each country, the changes in revenue from the three and nine months ended June 30, 2008 as compared to the same periods 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

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 can be found in Note 10 “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 charges, 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 and nine months ended June 30, 2008 and 2007 is as follows:


	Three Months Ended								Nine Months Ended
	June 30,								June 30,
	2008		Change			2007			2008		Change			2007
	(dollars in millions)
Revenues:
Product	$	39.7		250	%	$	11.4		$	91.0		131	%	$	39.5
Customer support and spare parts	$	4.7		54	%	$	3.1		$	12.5		21	%	$	10.3
Cost of revenue:
Product	$	21.9		120	%	$	10.0		$	55.4		54	%	$	36.1
Customer support and spare parts	$	1.8		54	%	$	1.2		$	5.4		20	%	$	4.5
Operating expenses:
Research and development	$	6.6		8	%	$	6.1		$	17.5		(17	)%	$	21.0
Selling, general and administrative	$	7.7		44	%	$	5.4		$	20.4		27	%	$	16.0
Amortization of intangible assets	$	0.2		(29	)%	$	0.3		$	0.5		(47	)%	$	1.0
Operating income (loss)	$	6.2				$	(8.5	)	$	4.5				$	(28.8	)

Revenue

Total revenue increased 208% and 108% for the three and nine months ended June 30, 2008, respectively, over the same periods of the prior fiscal year. As discussed above, flat panel display manufacturers have increased investments to add capacity, both in new factories and in upgrades to existing factories.

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:


	Three Months Ended						Nine Months Ended
	June 30,						June 30,
	2008			2007			2008			2007

Revenue by generation:
Generation 6 and earlier		57	%		17	%		45	%		16	%
Generation 7 and 8		32	%		42	%		43	%		52	%

Revenue by product:
ArrayChecker^TM		82	%		52	%		82	%		52	%
ArraySaver^TM		7	%		7	%		6	%		16	%

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 both the three and nine months ended June 30, 2008, we have seen a larger percentage of our revenues composed of earlier generation products, primarily Generation 6. 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.

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.

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 and nine months ended June 30, 2008 included a higher absolute dollar value of revenue related to the receipt of final customer acceptances following completed installation of our products compared to the same periods 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 11% and 12% of the Flat Panel Display segment revenue for the three and nine months ended June 30, 2008, respectively, as compared to approximately 41% and 31% of revenue for the three and nine months ended June 30, 2007, respectively. Revenues in the three and nine months ended June 30, 2008 were higher in absolute dollars than in the comparative prior year periods. Customer support and spare parts revenues generally increase as we increase the installed base of our products. Due to the more stable nature of our customer support and spare parts revenues, 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

Product gross margins as a percentage of revenue were approximately 45% and 40% in the three and nine months ended June 30, 2008, respectively, as compared to approximately 12% and 9% in the three and nine months ended June 30, 2007, respectively. Product gross margins, as a percentage of revenue, increased in the three and nine months ended June 30, 2008 as compared to the same periods in the prior fiscal year. This increase was due primarily to the relatively high mix of higher-margin ArrayChecker^TM

systems and savings from decreased headcount in the three and nine months ended June 30, 2008. In addition, during the three and nine months ended June 30, 2008, our margins benefited from the sale of approximately $1.1 million and $3.0 million, respectively, of inventory that had been previously fully reserved.

Customer support and spare parts gross margins as a percentage of revenue was approximately 61% in both the three months ended June 30, 2008 and 2007, respectively, and was approximately 57% in both the nine months ended June 30, 2008 and 2007, respectively. Customer support and spare parts gross margins, increased in absolute dollars in the three and nine months ended June 30, 2008 as compared to the same periods in the prior fiscal year, but as a percentage of revenue, remained relatively flat in the three and nine months ended June 30, 2008 as compared to the same periods in the prior fiscal year. The increase in absolute dollars was due to the increase in the installed base of our tools at customer fabs. Gross margin as a percentage of revenue is due primarily to the product mix of spare parts sold and to the mix between spare parts sold and service provided.

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 increased in the three months ended June 30, 2008 as compared to the same period in the prior fiscal year and decreased in the nine months ended June 30, 2008 as compared to the same period in the prior fiscal year. The decrease in the nine months ended June 30, 2008, as compared to the same period in the prior fiscal year is 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 10 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 and nine months ended June 30, 2008 as compared to the same periods in the prior fiscal year. The increase in the three months ended June 30, 2008, as compared to the same period in the prior fiscal year is due in part to approximately $1.6 million of direct merger-related expenses associated with the pending Merger with Orbotech, primarily comprised of legal fees. We have also incurred additional, non-material fees, such as board meetings, travel and other miscellaneous expenses in association with the pending Merger. In addition, the increase in the nine months ended June 30, 2008, as compared to the same period in the prior fiscal year includes additional legal, accounting and consulting 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 and nine months ended June 30, 2008 as compared to the same periods 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 June 30, 2008, and assuming no subsequent additions to, or impairment of the underlying assets, we expect our amortization to be approximately $5,000 in the remainder of fiscal 2008.

Operating Income/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 and assembly 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. As part of our acquisition of Salvador Imaging, we acquired Salvador Imaging’s existing product base of camera imaging systems. In addition, 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 and nine months ended June 30, 2008 is as follows:


	Three Months Ended			Nine Months Ended
	June 30, 2008			June 30, 2008
	(dollars in millions)
Revenue	$	1.7		$	3.9
Cost of revenue	$	1.1		$	2.8
Operating expenses:
Research and development	$	0.5		$	0.9
Selling, general and administrative	$	0.8		$	2.4
Amortization of intangible assets	$	0.7		$	2.2
Operating loss	$	(1.5	)	$	(4.4	)

There was no revenue from this segment in the corresponding periods of the prior year.

Revenue

Our revenue for the High-Performance Digital Imaging segment for the nine months ended June 30, 2008 includes approximately $711,000 of revenue from non-recurring engineering contracts. Our revenue from non-recurring engineering contracts is included in “Product revenue” in our condensed consolidated statements of operations.

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 31% and 27% in the three and nine months ended June 30, 2008. 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 costs include 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. As of June 30, 2008 all but one of the identified projects were complete and we expect to incur approximately $198,000 of additional costs to complete this last project. We anticipate the completion of this project in our fourth quarter.

Selling, General and Administrative

Our overall selling, general and administrative costs 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 June 30, 2008 were consistent with the prior quarter and relate to our July 2007 acquisition of Salvador Imaging.

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.

Restructuring Charge (Benefit)


	Three Months Ended									Nine Months Ended
	June 30,									June 30,
	2008			Change			2007			2008			Change			2007
	(dollars in millions)
Expense (benefit)	$	0.0			(100	)%	$	(1.0	)	$	0.0			(100	)%	$	1.4
Percent of Revenue		0	%					1	%		0	%					3	%

We have had no restructuring charges in our fiscal 2008. Our charges for restructuring in the three and nine months ended June 30, 2007, resulted from restructuring programs initiated by management in fiscal 2007 in response to the dynamics of the flat panel display market in fiscal 2007.

February 2007 Restructure

In February 2007, we recorded a restructuring charge of approximately $1.0 million associated with a Company-wide cost reduction plan designed to accelerate achieving the Company’s objective of consistent profitability. The charge was comprised of expenses for employee severance and related benefits as a result of planned termination of employees. In the three months ended June 30, 2007, the Company reversed approximately $95,000 of the initial charge for severance benefits not paid. These charges are reflected in “Restructuring charge (benefit)” in the Company’s Condensed Consolidated Statements of Operations.

Under this restructuring plan, we expected aggregate annual savings in salary and benefits costs of approximately $2.3 million to $2.7 million per fiscal year in both “Cost of revenue” and “Research and development,” while we expected annual savings in salary and benefits costs of approximately $1.0 million to $1.4 million in “Selling, general and administrative.” To date, our actual savings have approximated our expected savings.

November 2006 Restructure

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.

Under this restructuring plan, we expected aggregate annual savings in salary and benefits costs and depreciation of approximately $150,000 to $200,000 per fiscal year primarily in research and development. To date, our actual savings have approximated our expected savings.

Impairment of Property and Equipment


	Three Months Ended									Nine Months Ended
	June 30,									June 30
	2008			Change			2007			2008			Change			2007
	(dollars in millions)
Expense	$	0.0			0	%	$	0.0		$	0.0			(100	)%	$	2.8
Percent of Revenue		0	%					0	%		0	%					6	%

We recorded charges for impairment of property and equipment in the nine month period ended June 30, 2007 of approximately $2.8 million, as a result of management’s review of our Company’s global operations in light of the then-current and anticipated dynamics of the flat panel display market environment and to our commitment to transfer certain manufacturing to South Korea. As a result of this review and in conjunction with the Company’s restructuring, we determined that one of our U.S. manufacturing facilities was impaired, and we recorded an impairment charge of approximately $2.0 million based on the difference between the carrying amount of the asset over the asset’s appraised fair value. In addition, we recorded an impairment charge of approximately $834,000 related to the write-off of certain capital equipment that we determined had no additional future use.

Gain on Sale of Property and Equipment


	Three Months Ended									Nine Months Ended
	June 30,									June 30,
	2008			Change			2007			2008			Change			2007
	(dollars in thousands)
Gain (loss)	$	0.0			100	%	$	0.0		$	49			100	%	$	0.0
Percent of Revenue		0	%					0	%		0	%					0	%

During the nine months ended June 30, 2008, we recorded a net gain on the sale of miscellaneous assets.

Interest Income and Other, Net


	Three Months Ended									Nine Months Ended
	June 30,									June 30,
	2008			Change			2007			2008			Change			2007
	(dollars in millions)
Income	$	0.4			29	%	$	0.3		$	1.9			(43	)%	$	3.4
Percent of Revenue		1	%					2	%		2	%					7	%

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 and nine months ended June 30, 2008 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 regular and recurring changes in the effects of foreign currency transaction gains and losses. In addition, in the nine months ended June 30, 2007, the Company substantially liquidated its net investment in its Canadian subsidiary, Photon Dynamics Canada, Inc., for financial statement purposes. In accordance with the provisions of Statement of Financial Accounting Standards No. 52, “Foreign Currency Translation” we recorded a gain on our net investment in this subsidiary of approximately $928,000, composed of translation adjustment gains that had accumulated in “Accumulated other comprehensive income (loss)” on the Consolidated Balance Sheet.

Provision for Income Taxes


	Three Months Ended									Nine Months Ended
	June 30,									June 30,
	2008			Change			2007			2008			Change			2007
	(dollars in millions)
Expense	$	0.3			254	%	$	0.1		$	0.6			101	%	$	0.3
Percent of Revenue		1	%					1	%		1	%					1	%

The Company had a provision for income taxes in all periods presented primarily due to foreign income taxes. The Company had a provision for income taxes despite net loss positions in the nine months ended June 30, 2008 and in both the three and nine months ended June 30, 2007 due primarily to foreign income taxes. The effective tax rates for all periods presented are different than the statutory rate due primarily to domestic losses that could not be benefited.

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 and nine months ended June 30, 2008 and 2007 was as follows:


	Three Months Ended					Nine Months Ended
	June 30,					June 30,
	2008		2007			2008		2007
	(in thousands, except per share data)
Stock-based compensation expense included in continuing operations:
Cost of revenue	$	61	$	26		$	233	$	213
Research and development		242		125			411		324
Selling, general and administrative		757		274			1,338		976

Total stock-based compensation expense after income taxes (1)	$	1,060	$	425		$	1,982	$	1,513


Stock-based compensation expense by type of award:
Employee stock options	$	288	$	274		$	441	$	1,130
Employee stock purchase plan		56		74			56		281
Restricted stock awards		696		159			1,465		184
Amounts capitalized as inventory and deferred gross margin		20		(82	)		20		(82	)

Total stock-based compensation expense after income taxes (1)	$	1,060	$	425		$	1,982	$	1,513


(1)		The income tax benefit on stock-based compensation for all periods presented was not material.

As of June 30, 2008, the unrecorded stock-based compensation balance related to stock options was approximately $808,000 and will be recognized over an estimated remaining weighted average amortization period of 1.6 years. As of June 30, 2008, the unrecorded stock-based compensation balance related to restricted stock units was approximately $3.7 million and will be recognized over an estimated remaining weighted average amortization period of 2.0 years. As of June 30, 2008, the unrecognized stock-based compensation balance related to the Employee Stock Purchase Plan was approximately $167,000 and will be recognized over the remaining Offering Period, which ends on November 14, 2008.

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 approximately $90.1 million as of June 30, 2008, compared to approximately $88.6 million as of September 30, 2007. A major component of working capital is approximately $70.8 million of cash, cash equivalents and short-term investments as of June 30, 2008, compared to approximately $83.8 million as of September 30, 2007.

Operating Activities

Cash used in operating activities was approximately $10.8 million in the first nine months of fiscal 2008. Cash used in operating activities resulted from our net loss of approximately $483,000, adjusted for approximately $6.9 million of non-cash related items and for net cash of approximately $17.2 million used by changes in operating assets and liabilities. The primary source of the changes in our operating assets and liabilities was an increase in accounts receivable of approximately $25.0 million, and an increase in inventories of approximately $6.8 million, offset in part by an increase in accounts payable of approximately $17.9 million. Our accounts receivable balance increased primarily due to the timing of sales during the quarter, while our inventory increased due primarily to the timing of delivery of products in our backlog. Accounts payable increased due primarily to the timing of payments made on customs obligations.

Investing Activities

Cash provided by investing activities was approximately $30.1 million in the first nine months of fiscal 2008. Cash provided by investing activities was primarily the result of approximately $32.7 million of sales and maturities of short-term investments, net of purchases, offset in part by capital expenditures of approximately $2.8 million.

Financing Activities

Cash used in financing activities was approximately $81,000 in the first nine months of fiscal 2008 resulting from approximately $161,000 of sales of our common stock under our employee equity compensation plans, offset by approximately $80,000 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 June 30, 2008. Such obligations include both non-cancelable obligations and other obligations that are generally non-cancelable except under certain limited conditions.


	Payments Due by Fiscal Year
Contractual Obligations	Total		2008(1)		2009		2010		2011		2012		Thereafter
	(In thousands)
Purchase obligations	$	50,715	$	31,852	$	18,832	$	31	$	—	$	—	$	—
Operating lease obligations		7,285		851		2,881		2,830		723		—	$	—
Notes payable, including interest		5,500		—		2,800		2,700		—		—		—
Capital lease obligations		24		24		—		—		—		—		—

Total	$	63,524	$	32,727	$	24,513	$	5,561	$	723	$	—	$	—


(1)		Remaining three months

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 issued a note payable to a trust with a principle balance of approximately $5.3 million in July 2007, in connection with the purchase of Salvador Imaging. The note bears interest at 5% per annum, which is payable quarterly. The trustee, David W. Gardner, became an officer of the Company as a result of the acquisition.

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 March 2008, the Financial Accounting Standards Board (“FASB”) issued Statement of Accounting Standards No. 161, “Disclosures about Derivative Instruments and Hedging Activities — an amendment of SFAS No. 133” (“SFAS No. 161”). This statement changes the disclosure requirements for derivative instruments and hedging activities. SFAS No. 161 requires a Company to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities,” and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows. SFAS No. 161 will be effective for our interim periods beginning January 1, 2009. We are currently evaluating the impact of this statement on its results of operations, financial position and cash flows.

In February 2008, the FASB adopted FASB Staff Position Statement of Financial Accounting Standards No. 157-2, “Effective Date of FASB Statement No. 157” (“SFAS No. 157-2”). SFAS No. 157 “Fair Value Measurements” (“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. SFAS No. 157-2 delays the effective date of SFAS No.157 for one year for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). The provisions of SFAS No. 157 will be effective for our fiscal years beginning October 1, 2008, unless we elect the delayed adoption date for the portion of SFAS No. 157 impacted by SFAS No. 157-2. We are currently evaluating the impact of this statement on its results of operations, financial position and cash flows.

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141 (revised 2007) “Business Combinations” (“SFAS No. 141R”). SFAS No. 141R defines the acquirer as the entity that obtains control of one or more businesses in the business combination, establishes the acquisition date as the date that the acquirer achieves control and requires the acquirer to recognize the assets acquired, liabilities assumed and any noncontrolling interest at their fair values as of the acquisition date. In addition, SFAS No. 141R requires expensing of acquisition-related and restructure-related costs, remeasurement of earn-out provisions at fair value, measurement of equity securities issued for purchase at the date of close of the transaction and non-expensing of in-process research and development related intangibles. SFAS No. 141R will be effective for our fiscal years beginning October 1, 2009. We are currently 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 our fiscal years beginning October 1, 2008. We are currently evaluating the impact of this statement on its 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 nine months ended June 30, 2008, approximately $11.2 million of our revenue was denominated in currencies other than U.S. dollars, primarily in Japanese yen.

At June 30, 2008, approximately $4.3 million of our cash and cash equivalents and approximately $666,000 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 June 30, 2008 would decrease the fair value of our cash and cash equivalents by approximately $391,000 and our accounts receivable by approximately $61,000.

As of June 30, 2008, we had forward exchange contracts outstanding to sell approximately $570,000 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 11 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 nine months ended June 30, 2008. Our forward exchange contracts are 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 June 30, 2008 would decrease the fair value of the contract by approximately $64,000.

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 June 30, 2008, we had an investment portfolio of both fixed and variable rate securities of approximately $11.2 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; however, in an on-going effort to manage our risk, we have reduced our holdings in auction rate securities from approximately $16.2 million at September 30, 2007 to approximately $1.0 million at June 30, 2008. While we did not incur any material losses while holding these investments, management has implemented steps to rebalance our investment portfolio to better meet our investment objectives, including safety and preservation of capital.

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 June 30, 2008

During the first nine months of fiscal 2008, we have undertaken 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. In April 2008, we hired a new chief financial officer. We are also working to fill other finance positions as soon as practicable. Our ongoing efforts to find qualified candidates may be materially affected should our shareholders approve the proposed acquisition of the Company by Orbotech.

Although we have made significant progress during the first nine months of fiscal 2008 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 June 30, 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.

In light of this determination and as part of the work undertaken in connection with this report, we have applied compensating procedures and processes as necessary to ensure the reliability of our financial reporting. Accordingly, management believes, based on its knowledge, that (i) this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statement made, in light of the circumstances under which they were made, not misleading with respect to the periods covered by this report, and (ii) the financial statements, and other financial information included in this report, fairly present in all material respects our financial condition, results of operations and cash flows as of and for the periods presented in this report.

Changes in Control Over Financial Reporting in the Third Quarter of Fiscal 2008

During the period covered by this report, we have not implemented any significant changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting, other than the on-going remedial actions we are in the process of implementing with regards to our current material weaknesses, as discussed above.

Inherent Limitations of Disclosure Controls and Procedures and Internal Control Over Financial Reporting.

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

PART II. OTHER INFORMATION

ITEM 1. Legal Proceedings

Capital Partners v. Dr. Malcolm J. Thompson, et al. On July 25, 2008, Capital Partners, a purported stockholder of our Company, filed a complaint in California Superior Court, Santa Clara County, against the Company, each of our directors and Orbotech entitled Capital Partners v. Dr. Malcolm J. Thompson, et al. (Case No. 1-08-CV-118315). The complaint alleges, among other things, that our directors breached their fiduciary duties in connection with the merger, that our preliminary proxy statement relating to the merger omits material information and that Orbotech has aided and abetted our directors in their alleged breaches of fiduciary duties. The relief sought by the plaintiff includes a determination that the class action status is proper, an injunction barring the merger (or if the merger is consummated, a rescission of the merger), corrective disclosures and the payment of compensatory damages and other fees and costs.

On July 29, 2008, the complaint was formerly served on our Company and the individual defendants. On August 1, 2008, our Company and the individual defendants removed this case to the U.S. District Court for the Northern District of California. Also on August 1, 2008, Capital Partners filed an application in California Superior Court, Santa Clara County, seeking expedited discovery, a temporary restraining order that would bar the merger pending such discovery, and a hearing following such discovery on a preliminary injunction that would bar the merger pending a trial on the merits. The parties have not yet responded to the foregoing filings, nor have they been acted upon by any court; however, we and the individual defendants previously had agreed to provide expedited discovery. Although the ultimate outcome of this matter cannot be determined with certainty, we believe that the complaint is completely without merit and we and the other defendants intend to vigorously defend this lawsuit.

Amtower v. Photon Dynamics, Inc. Photon Dynamics and certain of our 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 our Company and our former officers. The plaintiff, a former officer of the Company, had asserted several causes of action arising out of alleged misrepresentations made to plaintiff regarding the existence and enforcement of our insider trading policy. The plaintiff had sought damages in excess of $6 million for defendants’ alleged refusal to allow plaintiff to sell shares of our stock in May of 2000, plus unspecified emotional distress and punitive damages. The plaintiff has the right to appeal the judgments. On June 30, 2006, the plaintiff filed a timely notice of appeal. On July 28, 2006, the Court awarded us 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. On April 9, 2008, the Supreme Court of California denied the plaintiff’s petition for review. As a result, the plaintiff paid us approximately $718,000 in fees, costs and interest associated with the lawsuit. In addition, we settled our litigation with our insurance carriers related to the reimbursement of costs related to the litigation and received a payment of approximately $700,000.

Customs and Duties Liability. As of March 31, 2008, we have paid approximately $6.6 million, net of VAT amounts refundable, to foreign customs authorities in connection with its settlements regarding underpayment of customs duties for warranty parts and we have accrued approximately $690,000 more to settle all known amounts with foreign customs authorities. We have 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, we are continuing our 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 our failure to comply with U.S. filing obligations may subject us to penalties and result in additional expenses, which could be material and the extent of which we are currently unable to estimate.

Security and Exchange Commission Inquiry. During our second fiscal quarter, we responded to inquiries relating to our recent restatement from the SEC’s Enforcement Division. On July 3, 2008, we received notice that the Enforcement Division had terminated the investigation and that no enforcement action had been recommended to the Commission.

General Litigation. From time to time, we are subject to certain other legal proceedings and claims that arise in the ordinary course of business. Additionally, in the ordinary course of business we may potentially be subject to future legal proceedings that could individually, or in the aggregate, have a material adverse effect on our 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.

ITEM 1A. Risk Factors

Our actual results could differ materially from those projected in the forward-looking statements included in this Quarterly Report on Form 10-Q as a result of a number of factors, risks and uncertainties, including the risk factors set forth below and elsewhere in this Quarterly Report on Form 10-Q. You should carefully consider the risks described below before investing in our securities. The risks described below are not the only ones facing us. Additional risks not currently known to us or that we currently believe are immaterial may also impair our business, results of operations, financial condition and liquidity.

We have organized our risks into the following categories:

	•		Risks Relating to the Proposed Acquisition by Orbotech

	•		Risks Relating to our Business

	•		Risks Relating to Owning our Common Stock

	•		Risks Relating to Our Restatements and Related Matters

RISKS RELATING TO THE PROPOSED ACQUISITION BY ORBOTECH

Our business and results of operations are likely to be affected by our announced acquisition by Orbotech.

On June 26, 2008, we agreed to be acquired by Orbotech. The announcement of the acquisition could have an adverse effect in the near term on our revenue and our High-Performance Digital Imaging Segment if current or prospective customers delay, defer or cancel purchases pending consummation of the planned acquisition, which in some cases has already occurred. While we are attempting to mitigate this risk through communications with our customers, current and prospective customers could be reluctant to purchase our products or services due to uncertainty about the direction of the combined company’s product offerings and its support and service of existing products. To the extent that our announcement of the acquisition creates uncertainty among customers such that one large customer, or a significant group of small customers, delays purchase decisions pending consummation of the planned acquisition, our results of operations could be negatively affected. Decreased revenue could have a variety of adverse effects, including negative consequences to our relationships with customers, suppliers, resellers and others. In addition, our quarterly operating results could be substantially below the expectations of market analysts, which could cause a decline in our stock price. Finally, activities relating to the acquisition and related uncertainties could divert our management’s and our employees’ attention from our day-to-day business, cause disruptions among our relationships with customers and business partners, and cause employees to seek alternative employment, all of which could detract from our ability to grow revenue and minimize costs.

If the conditions to the proposed acquisition by Orbotech set forth in the Merger Agreement are not met, the acquisition may not occur.

The proposed acquisition of the Company by Orbotech is subject to the conditions described in the Merger Agreement, including approval by the shareholders of the Company, antitrust and other regulatory approvals, and other customary closing conditions. These conditions are set forth in detail in the Merger Agreement. We can not assure you that each of the conditions will be satisfied. If the conditions are not satisfied or waived, the proposed merger will not occur or will be delayed. Shareholders are encouraged to review the section “The Merger Agreement—Conditions to Completion of the Merger” in the Definitive Proxy Statement on Schedule 14A filed by the Company with the Securities and Exchange Commission on August 4, 2008 for more information.

Failure to complete the proposed acquisition by Orbotech would negatively impact our future business and operations.

If the proposed acquisition of the Company by Orbotech is not completed, we could suffer a number of consequences that may adversely affect our business, results of operations and stock price, including the following:

	•		Activities relating to the acquisition and related uncertainties may lead to a loss of revenue and market position, including with respect to our High-Performance Digital Imaging Segment, that we may not be able to regain if the acquisition does not occur;

	•		The market price of our common stock could decline following an announcement that the acquisition has been abandoned;

	•		We could be required to pay Orbotech a termination fee and provide reimbursement to Orbotech for costs incurred in connection with the acquisition;

	•		We would remain liable for our costs related to the acquisition, such as legal and accounting fees and a portion of our investment banking fees;

	•		We may not be able to take advantage of alternative business opportunities or effectively respond to competitive pressures; and

	•		We may not be able to retain key employees.

In certain instances, the Merger Agreement requires us to pay a termination fee of $9 million to Orbotech, a payment which could affect the decisions of a third party considering making an alternative acquisition proposal to the proposed acquisition of the Company by Orbotech.

Under the terms of the Merger Agreement, the Company may be required to pay to Orbotech a termination fee of $9 million if the Merger Agreement is terminated under certain circumstances. This payment could affect the structure, pricing and terms proposed by a third party seeking to acquire or merge with us and could deter such third party from making a competing acquisition proposal. Shareholders are encouraged to review the section “The Merger Agreement—Termination of the Merger Agreement” and “The Merger Agreement—Termination Fees and Expenses” in the Definitive Proxy Statement on Schedule 14A filed by the Company with the Securities and Exchange Commission on August 4, 2008 for more information.

RISKS RELATING TO OUR BUSINESS

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

We reported a net loss for the nine months ended June 30, 2008. In addition, although we reported net income for the fiscal years ended September 30, 2006 and 2004, we reported a net loss for each of the fiscal years ended September 30, 2007, 2005, 2003 and 2002. In the future our revenue may decline, remain flat or grow at a rate slower than expected.

Our ability to achieve and maintain profitability is dependent in part on the success of our efforts to increase revenues and to reduce operating expenses as a percentage of revenue through our ongoing cost-cutting measures, gross margin improvement programs and outsourcing of manufacturing to Asia. If demand for our products is not sustained and we do not react quickly to reduce discretionary and variable spending, this would impair our ability to achieve profitability on a going-forward basis. For all of these reasons, there is no assurance that we will be successful in achieving or maintaining increased revenue, reduced operating expenses, positive cash flows or profitability and we may incur losses going forward.

Our customers may cancel or defer their purchases at any time and on short notice, which could harm our operating results.

Our flat panel display business is substantially dependent on orders we receive and fill on a short-term basis. We do not have contracts with our customers that provide any assurance of future sales, and sales are typically made pursuant to individual purchase orders, often with short lead times. Accordingly, our customers:

	•		May stop purchasing our products or defer their purchases at any time without penalty;

	•		Are free to purchase products from our competitors;

	•		Are not required to make minimum purchases; and

	•		Have cancelled, and may in the future cancel, purchase orders that they place with us without reimbursing us for any costs incurred.

As a result, we cannot rely on orders in backlog as a reliable and consistent source of future revenue. Sales to any single customer may and do vary significantly from quarter to quarter. Our flat panel display customers generally do not place purchase orders more

than twelve months in advance. In addition, our customers’ purchase orders have varied significantly from quarter to quarter. This means that customers who account for a significant portion of our revenues in one quarter may not and often do not place orders at the same level as the current quarter in the succeeding quarter, which makes it difficult to forecast our revenues in future periods. Moreover, our expense levels are based in part on our expectations of future revenue, and we may be unable to adjust costs in a timely manner in response to further revenue shortfalls. In addition, because certain parts used in our manufacturing process require longer lead times, if a customer cancels an order, we may be required to record additional inventory write-offs, which would have a negative impact on our gross margin. In addition, a small number of our flat panel display products are built without any advance customer commitment. All of these factors can result in significant quarterly fluctuations in our operating results.

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

We have experienced, and expect to continue to experience, significant fluctuations in our quarterly and annual results. Consequently, past financial results may not be indicative of future financial results. A substantial percentage of our revenue is derived from the sale of a small number of flat panel yield enhancement systems that ranged in price from approximately $450,000 to $3.4 million in fiscal 2007. Therefore, the timing of, and recognition of revenue from, the sale of a single system could have a significant impact on our quarterly and annual results. After we ship our products, customers may reject or delay acceptance, which would adversely impact our revenues and our stock price. Moreover, customers may cancel or reschedule shipments, and production difficulties could delay shipments.

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

	•		The result of competitive pricing pressures;

	•		The timing of the receipt of orders from major customers;

	•		The result of sudden, unanticipated changes in customer requirements;

	•		The cancellation or postponement of firm orders by a customer without compensation;

	•		The receipt of final acceptance on new products;

	•		The product mix that makes up our revenue;

	•		The incurrence of warranty expenses;

	•		Our 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;

	•		The ability to obtain components from our single or limited source suppliers in a timely manner;

	•		The ability to effectively implement our strategy of migrating or outsourcing manufacturing offshore;

	•		The ability of our offshore manufacturing operations to timely produce and deliver products in the quantity and of the quality our customers require;

	•		The costs of operations in the global markets in which we do business;

	•		The effects of changing international economic conditions;

	•		The effects of currency exchange rate fluctuations;

	•		The outcome of current litigation;

	•		The effects of worldwide political instability;

	•		The ability to design, manufacture and introduce new products on a cost-effective and timely basis;

	•		The delay between expenses to further develop marketing and service capabilities and the realization of benefits from those improved capabilities; and

	•		The introduction of new products by our competitors.

Due to the factors noted above and other risks discussed in this section, we believe that quarter-to-quarter comparisons of our operating results may not be meaningful. In addition, as a result of these or other factors, our operating results could be significantly and adversely affected and our stock price could decline. In addition, it is possible that in some future quarter our operating results may be below the expectations of public market analysts and investors, which could cause our stock price to fall.

We have experienced multiple material weaknesses in our internal controls and procedures during each of our 2003 through 2007 fiscal years, including three material weaknesses identified during our 2007 fiscal year that have not yet been remediated. If we are unable to implement our remediation plan effectively or if other material weaknesses or control deficiencies develop that we are unable to address, the material weaknesses in our internal controls could have a significant adverse effect on our business, financial condition and results of operations, result in our failure to meet reporting obligations and adversely affect our stock price.

We have experienced one or more material weaknesses in our internal control over financial reporting during each of our 2003 through 2007 fiscal years. A material weakness is a deficiency, or combination of deficiencies, in internal controls over financial reporting such that there is a reasonable probability that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. As described in more detail in Part I, Item 4, “Controls and Procedures,” our internal review of customs practices and the resulting restatement of our consolidated financial statements led to the identification of three material weaknesses in internal control over financial reporting during our fiscal 2007, which have not yet been successfully remediated. Our inability to maintain effective internal controls has strained our resources, caused us to delay filing periodic reports with the SEC and subjected us to potential delisting. In addition, we have experienced significant turnover in key financial positions, including three different chief financial officers in the last three years. This turnover has increased the difficulty of improving our financial controls. In order to remediate our material weaknesses effectively, we are devoting significant resources to building a new finance team. Although we are committing significant resources to rebuilding our finance team and remediating these material weaknesses, there can be no assurances that we will be successful in doing so, or that our revised internal controls and procedures will be effective in remediating our existing material weaknesses and preventing additional material weaknesses from occurring in the future. If we are unable to implement our remediation plan effectively or if other material weaknesses or control deficiencies develop, the material weaknesses in our internal controls could have a significant adverse effect on our business, financial condition and results of operations, result in our failure to meet reporting obligations and adversely affect our stock price. In addition, we have been required to hire additional employees to implement our remediation plan and improve our control environment, which could result in higher than anticipated operating expenses during the implementation of these changes and thereafter.

We have experienced significant employee turnover, including in several key financial positions. If we are unable to attract and retain key employees, it may disrupt our ability to improve our financial controls, meet our reporting obligations and effectively manage our business.

We depend on our employees and on our ability to attract and retain key employees. We have recently experienced higher employee attrition, particularly in key financial positions. Our employee turnover in fiscal 2007 was 33% in total, including the voluntary resignation of 15% of our employees. We generally do not have employment contracts with our employees and do not maintain key person life insurance on any of our employees. There can be no assurance that we will be able to retain our existing employees or attract additional qualified personnel in the future. If we are unable retain qualified employees and hire additional key employees, including additional finance staff, it may adversely affect relationships with key customers, disrupt our ability to improve our financial controls, meet our reporting obligations and effectively manage our business.

We have exposure to various foreign and domestic regulatory risks. Our failure to comply with governmental regulations could subject us to liability and additional expense.

We have exposure to various risks related to new, existing and sometimes inconsistent laws, rules and regulations that have been or may in the future be enacted by legislative bodies or regulatory agencies in the countries in which we operate and with which we must comply.

We are subject to a variety of laws of the United States and other countries related to the import and export of our products and technology, including shipments to South Korea, Taiwan, Japan, Germany and China. A failure to comply with these laws could subject us to additional expense and to civil and criminal liability. For example, as a result of our review of the our methodology for calculating certain customs duties in connection with the cross-border movements of warranty parts, we have paid approximately $6.6 million, net of VAT amounts refundable to foreign customs authorities in connection with the settlements regarding the underpayment of customs duties for warranty parts and we have accrued an additional $438,000 as of June 30, 2008 to settle all known amounts with foreign customs authorities. In addition, in fiscal 2007, we paid approximately $1.6 million of one-time costs associated with the internal investigation by our audit committee and the resulting restatement of our consolidated financial statements. We have 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. We have not concluded any settlement with U.S. authorities with respect to our failure to make certain filings in connection with the export of warranty parts. We have 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 our 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 our failure to comply with U.S. filing obligations may subject us to penalties and result in additional expenses, which could be material and the extent of which we are currently unable to estimate.

In addition, from time to time we enter into transfer pricing arrangements with our subsidiaries to establish sales prices for internal distributions of goods that have the effect of allocating taxes between the parent corporation and our subsidiaries. In general, these transfer prices have not been approved by any governmental entity and, therefore, may be challenged by the applicable tax authorities.

We employ a number of foreign nationals in our U.S. operations and, as a result, we are subject to various laws related to the status of those employees. We also send our U.S. employees to foreign countries from time to time and for varying durations of time to assist with our foreign operations. Depending on the durations of such arrangements, we may be required to withhold and pay personal income taxes in respect of the affected U.S. employees directly to the foreign tax authorities, and the affected U.S. employees may be required to register with various foreign governmental authorities. Our failure to comply with the foregoing laws and regulations or any other applicable laws and regulations could subject us to liability or the unfavorable treatment of our employees by immigration authorities.

If our flat panel display products experience performance, reliability or quality problems, our customers may reduce their orders.

We believe that future orders of our flat panel display products will depend in part on our ability to satisfy the performance, reliability and quality standards required by our customers. Particularly as customers seek increased yields, greater throughput and higher-quality end products, we must continually redesign our products to meet the needs of our customers. As with the introduction of any new product, our products may experience design and reliability issues. For example, our original Generation 7 ArrayChecker^tm and ArraySaver^tm systems required longer than anticipated time periods to bring them to full production due to design and reliability issues experienced by some of our customers. If our products have performance, reliability or quality problems, then we may experience:

	•		Delays in receiving final acceptance from our customers, which in turn delays recognition of the associated revenue;

	•		Cancellation of orders by customers;

	•		Assessment of penalties by customers;

	•		Delayed payment by customers;

	•		Renegotiation of our prices by customers;

	•		Reduced orders from our customers;

	•		Additional warranty and service expenses; and

	•		Higher manufacturing costs.

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

In addition, we typically provide a limited warranty on our flat panel display products for a period of 12 months from final acceptance by our customers. Actual warranty claims may, at times, exceed the estimated cost of warranty coverage we record in our warranty provision. For example, in the fourth quarter of fiscal 2006, we agreed to replace two of the four original Generation 7 ArrayChecker^tm test systems purchased by one customer with a newer version of our Generation 7 test systems under our warranty coverage of the purchased systems. Even though all four original Generation 7 systems were in full production, reliability and uptime issues had impacted the production capability of the fabrication lines in which they operated. The expected replacement of these systems resulted in additional warranty charges of approximately $3.0 million in the quarter ended September 30, 2006. Approximately $2.7 million of warranty liability associated with this exchange was satisfied during fiscal 2007 when the machines were replaced. Although we believe the problems associated with the two array test systems that were replaced were fixed in subsequent versions of our Generation 7 test systems, we may experience additional warranty costs on other products that are in excess of our estimated warranty costs. In the future, we may incur substantial warranty claim expenses on our products and actual warranty claims may exceed recorded provisions, resulting in harm to our business.

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

Our flat panel display business depends in large part on capital expenditures by manufacturers of flat panel display products, which in turn depends on the current and anticipated market demand for the end products in that industry. The capital equipment procurement practices of flat panel display manufacturers has been highly cyclical. At the end of the first half of calendar year 2006, we saw an oversupply in the consumer market, causing manufacturers to respond by scaling back factory utilization rates and dropping panel average selling prices, which eroded the manufacturers’ profits. The majority of manufacturers scaled back their investment plans for calendar year 2007 as they evaluated television manufacturing costs, holiday season demand and consumer electronics market issues such as brand strength and high-definition programming formats and availability. And although manufacturers increased investment orders in the first half of calendar year 2008, recently, there has been unease regarding current market conditions given the decline in panel prices, increases in inventories and the slowing end market demand, particularly in the greater than 40” television segment. A number of flat panel manufacturers are reducing capacity utilization in response to the slowing demand. Consumer demand patterns over the next several quarters will determine if the slowing demand is the result of typical seasonal demand trough or due to macroeconomic concerns. New manufacturing capacity investment for the second half of calendar 2008 and calendar 2009 will be strongly dependent on the supply/demand balance

When cyclical fluctuations result in lower than expected revenue levels, operating results may be adversely affected and cost reduction measures may be necessary in order for us to remain competitive and financially sound. During a down cycle, we must be in a position to rapidly adjust our costs and expense structure to prevailing market conditions and to continue to motivate and retain our key employees. Adjusting to a downcycle may cause us to reduce or realign our manufacturing capacity, which may result in asset impairment charges in our manufacturing facilities. In addition, during periods of rapid growth, we must be able to increase manufacturing capacity and personnel to meet customer demand. We can provide no assurance that these objectives can be met in a timely manner in response to industry cycles. In addition, our need to invest in the engineering, research and development, and marketing required to penetrate targeted foreign markets and maintain extensive service and support capabilities limits our ability to reduce expenses during downturns.

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

The flat panel display industry is extremely concentrated with a small number of manufacturers producing the majority of the world’s glass panels for flat panel displays. If one or more of our major customers ceased or significantly curtailed their purchases, our revenue could drop significantly. We may be unable to replace sales to these customers. Sales to our greater than 10% customers has been as follows: four 10% customers accounted for 81% of our revenue in the nine months ended June 30, 2008, four 10% customers accounted for 77% of our revenue in fiscal 2007; and three 10% customers accounted for 76% of our revenue in fiscal 2006. None of our customers has entered into a long-term purchase agreement that would require the customer to purchase our products

We rely upon sales of a limited range of flat panel display products, and if demand for one product decreases for any reason it could cause our revenue to decline significantly.

The substantial majority of our revenue is expected to come from a limited range of products for the flat panel display industry. Although we are seeking to diversify our market base through the acquisition of Salvador Imaging, we currently expect revenue from the sales of our flat panel display product line to continue to constitute a majority of our revenue in the near future. As a result, we are highly reliant on the flat panel display industry. Any decline in demand for, or failure to achieve continued market acceptance of, our primary products or any new version of these products could harm our business. Continued market acceptance of our array test and array repair products is critical to our success.

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

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

We expect to continue to incur significant research and development costs. There can be no assurance that we will be successful in the introduction, marketing and cost-effective manufacture of any of our new products, that we will be able to timely develop and introduce new products and enhance our existing products and processes to satisfy customer needs or achieve market acceptance, or that the new markets for which we are developing new products or expect to sell current products will develop sufficiently.

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

If we are not able to receive sufficient parts to meet our production requirements, we may experience significant delays in producing our products, which could decrease our revenue for an extended period of time.

We use a wide range of materials in the production of our products, including custom electronic and mechanical components, and we use numerous suppliers to supply these materials. We generally do not have guaranteed supply arrangements with our suppliers. Because of the variability and uniqueness of customers’ orders, we do not maintain an extensive inventory of material for manufacturing. Significant delays in receiving required materials could delay our shipments, subject us to penalties from our customers for late delivery of customer orders, harm our results of operations and damage customer relationships. In addition, we obtain some equipment for our systems from a single source or a limited group of suppliers. For example, we currently obtain material handling platforms, PCI boards, certain laser assemblies and certain pellicle products from single source suppliers. Although we seek to reduce dependence on sole and limited source suppliers, alternative sources of supply for this equipment remain unavailable or may only be available on unfavorable terms. In addition, a sole or Limited source supplier could determine that laws or regulations prohibit it from shipping certain components to us. The partial or complete loss of our sole and limited source suppliers could significantly delay our shipments or otherwise harm our results of operations and damage customer relationships. Further, a significant increase in the price of one or more of these pieces of equipment by a single or limited source supplier could harm our results of operations.

Substantially all of our revenue from flat panel display products is derived from sales to companies located outside the United States, which exposes us to risks that we would not experience with domestic sales.

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

	•		Political instability and the possibility of hostilities, terrorist attacks, or war;

	•		Imposition of governmental controls;

	•		Fluctuations in interest and currency exchange rates;

	•		Customs and export and import license requirements;

	•		Restrictions on the export of technology;

	•		Limited foreign protection of intellectual property rights;

	•		Periodic local or international downturns;

	•		Decreases in productivity, temporary plant shutdowns or infrastructure service disruptions resulting from widespread health alerts including Severe Acute Respiratory Syndrome (“SARS”) and warnings of an avian flu pandemic;

	•		Changes in tariffs; and

	•		Difficulties in staffing and managing international operations.

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

Our customer qualification and sales cycle is lengthy and unpredictable and requires us to incur substantial costs to make a sale, and if we fail to make a sale, our increased expenses may lead to lower profit margins.

Our flat panel display customers typically expend significant time and effort evaluating and qualifying our products and manufacturing process prior to placing an order. This evaluation and qualification process frequently results in a lengthy sales cycle, typically ranging from nine to twelve months and sometimes longer. 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, 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. We expect that our High-Performance Digital Imaging segment will also be characterized by lengthy sales cycles as we anticipate that customers in the defense, security and medical industries will also generally expend significant time and effort evaluating our products and processes prior to placing an order.

In addition, our customers’ purchases of our products are frequently subject to unplanned delays and rescheduling, particularly with respect to larger customers for which our products represent a very small percentage of their overall purchase activity. Unplanned delays in the purchase or installation of our products have occurred in the past, and may continue to occur, as a result of delays in the installation of other manufacturers’ equipment at a customer’s facilities. Long sales cycles may cause our revenues and operating results to vary significantly and unexpectedly from quarter to quarter, which could cause volatility in our stock price.

Our ability to efficiently and effectively implement our strategy of using both domestic and outsourced offshore manufacturing may impact our profitability.

Our ability to successfully compete in our current flat panel display markets may be determined in part by our ability to efficiently and effectively implement our strategy of using both domestic and offshore manufacturing. Our offshore manufacturing facilities may at times create excess capacity in our domestic manufacturing facilities which may in turn cause an increase in costs due to the under-utilization of our San Jose facilities. Based on the success of our offshore manufacturing strategy to date, we are increasing our offshore capacity and are outsourcing and moving additional manufacturing offshore. This new offshore strategy contributed to an approximately $2.8 million impairment charge we recorded in the quarter ended March 31, 2007 as a result of excess capacity in one of our remaining domestic manufacturing facilities. If we continue to be successful in executing our offshore manufacturing strategy, it may result in additional asset impairment charges by creating excess capacity in our domestic manufacturing facilities.

In addition, a number of factors may adversely affect our existing international manufacturing operations and ability to execute our offshore manufacturing strategy, including:

	•		Political instability and the possibility of hostilities, terrorist attacks, or war;

	•		Imposition of governmental controls;

	•		Fluctuations in interest and currency exchange rates;

	•		Limited foreign protection of intellectual property rights;

	•		Trade restrictions;

	•		Periodic or local international downturns;

	•		Decreases in productivity, temporary plant shutdowns or infrastructure service disruptions resulting from widespread health alerts such as those relating to SARS and avian flu outbreaks; and

	•		Difficulties in staffing and managing international manufacturing.

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

Any failure of, or other problems at or with, our third party manufacturers could delay shipments of our products, harm our relationships with our customers or otherwise negatively impact our business.

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

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

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

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

While our technology is applicable to other flat panel display technologies, our experience has been focused on applications for active matrix liquid crystal displays, the most prevalent and one of the highest performance flat panel displays available today. We derive a substantial majority of our revenue from flat panel display products, substantially all of which are based on the active matrix liquid crystal display technology. An industry shift away from active matrix liquid crystal display technology to existing or new competing technologies could reduce the demand for our existing products and require significant expenditures to develop new products, each of which could harm our business. For example, if the AMLCD television market has a significant shift to plasma technology, it would negatively affect LCD manufacturers’ fab planning and our business would be negatively impacted.

We may have difficulty integrating businesses or assets that we have acquired or developed in new ventures and may acquire or develop in the future, and we may not realize the benefits that we expect from these acquisitions and new ventures.

In addition to our efforts to develop new technologies from internal sources, we also may seek to acquire new technologies from external sources or partner with other companies to develop new technologies. As a part of this effort, we may make additional acquisitions of, or significant investments in, businesses with complementary products, services and/or technologies. For example, in the fourth quarter of our fiscal 2007 we purchased Salvador Imaging, through which we are developing highly sensitive color and monochrome cameras that can be used to provide daytime and nighttime surveillance capabilities for the military and security markets, and unique inspection capabilities in industrial applications.

Integrating a business can be a complex, time-consuming and expensive process. If we are not able to do so effectively, we will not be able to realize the benefits that we expect to receive from either our past or future acquisitions and new ventures. For each acquisition or new venture, we must integrate separate technologies, product lines, business cultures and practices, employees and systems. Acquisitions and new ventures are subject to numerous risks, including:

	•		Difficulty in the assimilation of the technologies and products;

	•		Entering markets in which we have no or limited direct prior experience;

	•		Loss of key customers;

	•		Diversion of management resources;

	•		Incompatibility of business cultures or practices;

	•		Loss of key employees;

	•		Costs and delays in implementing common systems and procedures;

	•		Potential inefficiencies in delivering services to customers; and

	•		Assumption of unknown or undisclosed liabilities.

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

In addition, we may also elect to change our strategic direction and may no longer have need for the acquired businesses or new technologies. For example, in fiscal 2007 we stopped funding NB Digital, which we acquired in November 2002 and which subsequently went into bankruptcy and ceased operations. Future acquisitions may also result in potentially dilutive issuances of equity securities, incurrence of debt and contingent liabilities and amortization expenses related to acquired intangible assets, which could harm our profitability.

We may never achieve or sustain profitability in our High-Performance Digital Imaging business segment.

We commenced operations in our High-Performance Digital Imaging segment with our acquisition of Salvador Imaging in July 2007. Because we have limited experience in this market segment, it is difficult for us to predict our operating results and the ultimate size of the market for our products. There can be no assurance that we will be successful in the introduction, marketing and cost-effective manufacture of any new products, that we will be able to develop and introduce new products on a timely basis, that we will be able to scale our operations from the current low volumes to more substantial commercial volumes, or that we will be able to enhance our existing products to satisfy customer needs. We expect operating expenses for this segment to increase over the next several years as we hire additional sales and marketing personnel and develop our technology and new products. In future periods, revenues could decline and, accordingly, we may not be able to achieve profitability in this segment. Even if we do achieve profitability in this segment, we may not be able to sustain or increase profitability on a consistent basis.

If the products developed within our High-Performance Digital Imaging segment become successful, we may derive a significant portion of our revenue from customers that receive their funding for our products from U.S. government contracts, which are subject to unique risks.

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 the 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. In addition to normal business risks, contracts involving the U.S. government are subject to unique risks, including the following, which may be beyond our control.

The funding of U.S. government programs is subject to congressional appropriations. Many of the U.S. government programs in which we or our customers may participate could extend for several years; however, these programs are normally funded annually. Long-term government contracts and related orders are subject to cancellation if appropriations for subsequent performance periods are not made. If we or our customers are successful in participating in a U.S. government program, the termination of funding for that U.S. government program would result in a loss of anticipated future revenues attributable to that program.

The U.S. government would have the ability to modify, curtail or terminate contracts. The U.S. government may modify, curtail or terminate its contracts and subcontracts without prior notice at its convenience upon payment for work done and commitments made at the time of termination. Because our customers will likely depend on contracts with the U.S. government, modification, curtailment or termination of their contracts with the U.S. government could have an adverse effect on our results of operations and financial condition.

Our contract costs would be subject to audits by U.S. government agencies. U.S. government representatives could have the right to audit the costs that we incur in connection with work performed as a subcontractor under a U.S. government contract, including allocated indirect costs. If an audit were to uncover improper or illegal activities, we could be subject to civil and criminal penalties and administrative sanctions.

Our business could be subject to potential U.S. government inquiries and investigations. If we are successful in participating directly or indirectly in a U.S. government program, we would be subject to U.S. government inquiries and investigations of our business practices upon any findings of potential improprieties due to our participation in government contracts. Any such inquiry or investigation could potentially result in an adverse effect on our results of operations and financial condition.

Contracts with the U.S. government would be subject to specific procurement regulations and other requirements affecting us or our customers. These requirements, although customary in U.S. government contracts, may increase our performance and compliance costs, which could have a negative effect on our financial condition. Our ability to do business with government contractors would be dependent on complying with various registration and licensing requirements, such as the International Traffic in Arms Regulations (ITAR) certification that we recently received for our High-Performance Digital Imaging business. Certain of our high-performance digital imaging cameras are subject to other restrictions and requirements under U.S. laws and regulations. Failure to comply with these regulations and requirements could cause our licenses or permits to be revoked or suspended, or lead to suspension or debarment, for cause, from U.S. government contracting or subcontracting.

Certain U.S. government programs are subject to security classification restrictions on information. We may participate in programs that are subject to security classification restrictions (“restricted business”), which could limit our ability to discuss details about these programs, their risks or any disputes or claims relating to such programs. As a result, investors might have less insight into our restricted business than other businesses of the company or could experience less ability to evaluate fully the risks, disputes or claims associated with such restricted business.

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

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

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

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

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

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

Our corporate offices and manufacturing facilities and our customers’ manufacturing facilities may be subject to disruption from natural disasters.

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

Operations at our customers’ manufacturing facilities are subject to the same disruptions that may affect our facilities. Any such disruption could result in the delay of scheduled delivery dates for products ordered by affected customers, the cancellation of existing orders, and the delay of future orders, all of which could seriously harm our business.

We rely upon certain critical information systems for our daily business operation. Our inability to use or access these information systems at critical points in time could unfavorably impact the timeliness and efficiency of our business operation.

Our global operations are linked by information systems, including telecommunications, the internet, our corporate intranet, network communications, email and various computer hardware and software applications. Despite our network security measures, our products, tools and servers are vulnerable to computer viruses, break-ins, and similar disruptions from unauthorized tampering with our computer systems and with our products at customer sites. Any such event could have an adverse effect on our business, operating results, and financial condition.

We may experience difficulties with our enterprise resource planning (“ERP”) system and other IT systems. System failure or malfunctioning may result in disruption of operations and the inability to process transactions, and this could adversely affect our financial results.

System failure or malfunctioning could disrupt our ability to timely and accurately process and report key components of the results of our consolidated operations, our financial position and cash flows. Any disruptions or difficulties that may occur in connection with our ERP system or other systems could also adversely affect our ability to complete important business processes such as the evaluation of our internal controls and attestation activities pursuant to Section 404 of the Sarbanes-Oxley Act of 2002. If we encounter unforeseen problems with regard to our ERP system or other systems, our business could be adversely affected.

RISKS RELATING TO OWNING OUR COMMON STOCK

Our stock price may fluctuate significantly.

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

	•		The need to restate our consolidated financial statements;

	•		Announcements of technological innovations or new products by us or by our competitors;

	•		Failure to comply with government regulations;

	•		Developments in patent or other property rights; and

	•		Developments in our relationships with our customers.

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

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

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

We do not anticipate paying cash dividends.

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

RISKS RELATING TO OUR RESTATEMENTS AND RELATED MATTERS

Our recent restatement of our consolidated financial statements and related events, as well as possible future restatements, may have a material adverse effect on our business.

As described in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Part II, Item 9A. “Controls and Procedures” of our Annual Report on Form 10-K, we restated our financial results for the fiscal years ended September 30, 2003 through 2006. As long as we continue to have one or more unremediated material weaknesses in our internal control over financial reporting, we may in the future identify additional reasons to restate our financial results. Furthermore, the threshold for causing us to restate financial information in the future is potentially very low in the current regulatory environment due in part to the fact that we currently, and in the near future, expect to operate at close to break-even levels of earnings or loss. If, as a result of any of the matters described above, we are required to amend or restate certain of our financial information; it may have a material adverse effect on our business and results of operations.

ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

ITEM 3. Defaults Upon Senior Securities

None.

ITEM 4. Submission of Matters to a Vote of Security Holders

None.

ITEM 5. Other Information

None.

ITEM 6. Exhibits

Exhibits

See the Exhibit Index which follows the signature page of this Quarterly Report on Form 10-Q, which is incorporated herein by reference.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


	PHOTON DYNAMICS, INC.
	By:	/s/ James P. Moniz
		James P. Moniz
		Chief Financial Officer (Duly authorized and principal financial officer)

Dated: August 11, 2008

Exhibit Index


Number		Exhibit

3.1(1)		Amended and Restated Articles of Incorporation of the Registrant.

3.2(1)		Certificate of Amendment to Articles of Incorporation of the Registrant.

3.3(2)		Bylaws of the Registrant.

4.1		Reference is made to Exhibits 3.1, 3.2 and 3.3.

10.59(3)		Agreement and Plan of Merger and Reorganization dated as of June 26, 2008 among Orbotech Ltd., PDI Acquisition, Inc. and Photon Dynamics, Inc.

10.60		Amended Change in Control Agreement between the Registrant and Jeffrey Hawthorne dated March 31, 2008.

10.61		Amended Change in Control Agreement between the Registrant and Wendell Blonigan dated March 31, 2008.

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

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

32.1**		Certifications required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. §1350).

Key to Exhibits:


(1)		Previously filed as the like-numbered exhibit to the Registrant’s Registration Statement on Form S-1 (Commission File No. 333-76650) as filed with the Securities and Exchange Commission on January 14, 2002, as amended, and incorporated herein by reference.

(2)		Previously filed as the like-described exhibit to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended December 31, 2005 as filed with the Securities and Exchange Commission on February 9, 2006, and incorporated herein by reference.

(3)		Previously filed as the like-described exhibit to the Registrant’s Current Report on Form 8-K as filed with the Securities and Exchange Commission on June 26, 2008, and incorporated herein by reference.

**		The certification attached as Exhibit 32.1 accompanies the Quarterly Report on Form 10-Q pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed “filed” by the Company for purposes of Section 18 of the Securities Exchange Act of 1934, as amended.

PHOTON DYNAMICS INC 10-Q