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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

_____________________

FORM 10-Q

For the quarterly period ended December 31, 2002

OR

Commission file number: 0-27234

_____________________

PHOTON DYNAMICS, INC.

17 Great Oaks Blvd.
San Jose, California 95119
(Address of principal executive offices including zip code)
(408) 360-3550
(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, as amended 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 x   No o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934, as amended). Yes x   No o

          As of January 31, 2003 there were 15,917,800 shares outstanding of the Registrant’s Common Stock, no par value.

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INDEX

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PART I. FINANCIAL INFORMATION

ITEM 1. Financial Statements

PHOTON DYNAMICS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to condensed consolidated financial statements.

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PHOTON DYNAMICS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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PHOTON DYNAMICS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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PHOTON DYNAMICS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE 1—Basis of Presentation

          The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted 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, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three-month period ended December 31, 2002 are not necessarily indicative of the results that may be expected for the year ending September 30, 2003. This financial information should be read in conjunction with the financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2002.

          The condensed consolidated balance sheet as of September 30, 2002 is derived from the Company’s audited consolidated financial statements as of September 30, 2002, included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission, but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

Revenue Recognition.

          The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the selling price is fixed or determinable and collectibility is reasonably assured.

          The Company accounts for certain of its product sales, including sales to a value added reseller, in its flat panel display and cathode ray tube display and high quality glass inspection product segments 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 Company has met defined customer acceptance experience levels for the delivered items, and the fair value of undelivered items, such as installation and system upgrade rights, can be reliably determined. The Company allocates revenue to the delivered items based on the amount due and billable upon shipment, with the remaining amount recognized after installation and acceptance when the final amount becomes due. The Company recognizes all other product sales upon customer acceptance. The Company recognizes revenue from the sale of spare parts upon shipment. The Company generally recognizes revenue from the sale of its printed circuit board assembly inspection products upon shipment, as such product sales are not subject to customer acceptance provisions.

          The Company records a provision for estimated sales returns in the same period as the related revenue is recorded, which is netted against revenue. These estimates are based on historical sales returns and other known factors. If the historical data the Company uses to calculate these estimates does not properly reflect future returns, additional provisions may be required.

Recent Accounting Pronouncements

          In December 2002, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 148 “Accounting for Stock-Based Compensation – Transition and Disclosure” (“FAS 148”), which provides for alternative methods to transition to the fair value method of accounting for stock options in accordance with the provisions of FASB Statement No. 123 “Accounting for Stock Based Compensation”. In addition, FAS 148 requires disclosure of the effects of an entity’s accounting policy with respect to stock-based compensation on reported net income and earnings per share in annual and interim financial statements. As permitted by FAS 148, the Company is adopting the disclosure provisions of FAS 148 beginning with the second quarter of fiscal 2003.

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NOTE 2—Inventories

          Inventories are stated at the lower of cost (on a first-in, first-out basis) or market. The components of inventories were as follows:

NOTE 3—Other Current Liabilities

          The components of other current liabilities were as follows:

NOTE 4—Acquisitions

          In November 2002, the Company acquired certain assets relating to rapid thermal processing technology (the “RTP Assets”) from Intevac, Inc. (“Intevac”). The acquired technology is used to activate low temperature poly-silicon films during the manufacturing process for flat panel displays and expands the Company’s product offerings to its current customer base into process equipment. As such, this acquisition is being included in our flat panel display segment. The purchase price was $20.0 million of cash, of which $18.0 million was paid to Intevac at closing and an additional $2.0 million was placed into escrow, which can be released either to the Company or to Intevac depending on the occurrence of certain future events during the escrow period as follows; $1.2 million related to the attainment of a certain level of sales by Photon of equipment included in the RTP Assets acquired from Intevac, $500,000 related to the re-issuance of a former rapid thermal processing patent in Japan for certain acquired technology and $300,000 for indemnification and reimbursement should Intevac breach any representations and warranties under the acquisition agreement. The Company’s preliminary allocation of the purchase consideration (see below) excludes the contingent consideration of $2.0 million and accordingly, amounts allocated to goodwill may increase based on the outcome of these events. In addition, the Company assumed approximately $350,000 of liabilities and incurred approximately $500,000 in acquisition related expenses, consisting primarily of consulting, legal and accounting fees. The identifiable assets acquired primarily included accounts receivable, inventory and fixed assets. The funds used to purchase the RTP Assets came out of the Company’s working capital.

          The acquisition of the RTP Assets was accounted for under the purchase method of accounting. The purchase price was allocated by management to the assets acquired and liabilities assumed taking into account an independent appraisal of their fair values. To determine the value of the developed and core technologies, the expected future cash flows attributed to all existing technology were discounted, taking into account risks related to the characteristics and application of the technology, existing and future markets and assessments of the life cycle stage of the technology. The value attributed to backlog is related to purchase orders that had been received prior to the close of the acquisition, determined as the expected discounted cash flow resulting from the revenue related to the shipment of such orders, less normal profit margins.

          The value of in-process research and development was determined based on the expected cash flow attributed to the in-process projects, taking into account revenue that is attributable to previously developed technology, the level of effort to date in the in-process research and development, the percentage of completion of the project and the level of risk associated with the in-process

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technology. The projects identified as in-process are those that were underway as of the acquisition date and that will, after the applicable closing date, require additional effort in order to establish technological feasibility and have no alternative future uses. These projects have identifiable technological risk factors that indicate that even though successful completion is expected, it is not assured. The value of in-process research and development has been included in the Company’s results of operations.

          The Company applied discount factors to the projected cash flows of the technology in order to determine the present value, based on discount rates with inherent risk and expected growth of the developed, core and in-process technologies. The discount rates used were 15%, 20% and 25% for the developed, core and in-process technologies, respectively.

          A summary of the preliminary allocation of the purchase price is as follows:

          The acquired core technology and acquired developed technology are being amortized over a five-year life. Backlog is amortized to cost of sales at the time revenue is recognized for the related customer order.

NOTE 5–Impairment of Goodwill and Other Long-Lived Assets

          In accordance with FAS 142, the Company is required to review goodwill for impairment of value, at least annually, and in certain circumstances between annual tests if there are indicators of impairment. The goodwill impairment test involves a two-step process. Step one consists of a comparison of the fair value of a reporting unit with its carrying amount, including the goodwill allocated to the reporting unit. If the carrying amount is in excess of the fair value, step two requires the comparison of the implied fair value of the reporting unit goodwill with the carrying amount of the reporting unit goodwill. Any excess of the carrying value of the reporting unit goodwill over the implied fair value of the reporting unit goodwill will be recorded as an impairment loss. In the first quarter of fiscal 2003, based on further deterioration of business conditions from the fourth quarter of fiscal 2002 when the Company recorded impairment of goodwill, the Company performed an interim analysis of the fair value of the printed circuit board assembly reporting unit. As a result of this analysis, the Company determined that the remaining goodwill was impaired and recorded an impairment charge of $15.1 million in the quarter ended December 31, 2002. The valuation was done as of December 31, 2002, using established valuation techniques, specifically, the income and market approaches.

          Changes in the carrying amount of goodwill for the three months ended December 31, 2002 by reportable segment, are as follows:

           In accordance with Statement of Financial Accounting Standards No. 144, “Impairment of Long-Lived Assets,” (“FAS 144”) the Company performs tests for impairment of its long-lived assets, including intangible assets whenever events or circumstances suggest that such assets may be impaired. FAS 144 requires the Company to assess whether the carrying value is recoverable from undiscounted future cash flows. If the assets are not recoverable, the impairment is calculated by the difference between the carrying value of the assets and their fair value which is generally determined based on discounted future cash flows. Accordingly, in the first quarter of fiscal 2003, based on certain indicators of impairment in the printed circuit board assembly inspection division, the Company performed an impairment analysis of purchased intangible assets and certain other long-lived assets associated with the printed circuit board assembly inspection reporting unit. As a result, the Company recorded impairment charges of approximately $2.9 million related to the unamortized portion of the acquired developed and core technology intangible assets and approximately $2.9 million related to certain other long-lived assets to reduce the carrying values of purchased intangible assets and other long-lived assets to their respective estimated values.

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          Information regarding the Company’s other acquisition related intangible assets is as follows: