PHOTON DYNAMICS INC - 10-K Annual Report

As of March 29, 2002, the aggregate market value of the voting stock held by non–affiliates of the registrant, computed by reference to the last sale price of such stock as of such date on the Nasdaq National Market, was approximately $799,795,484. Excludes an aggregate of 1,270,486 shares of common stock held by officers and directors and by each person known by the registrant to own 5% or more of the outstanding common stock as of March 29, 2002. Exclusion of shares held by any of these persons should not be construed to indicate that such person possesses the power, direct or indirect, to direct or cause the direction of the management or policies of the registrant, or that such person is controlled by or under common control with the registrant.

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual results could differ materially from those projected in the forward-looking statements as a result of a number of factors, risks and uncertainties, including the risk factors set forth under the caption “Factors Affecting Operating Results” in Part II Item 7 of this Form 10-K and elsewhere in this Form 10-K. Generally, the words “anticipate”, “expect”, “intend”, “believe” and similar expressions identify forward-looking statements. The information included in this Form 10-K 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.

Photon Dynamics, Inc. is a California corporation incorporated on March 1, 1983. We are a leading provider of yield management solutions to the flat panel display industry. Manufacturers in this industry use our solutions to collect data, analyze product quality and identify and repair product defects at critical steps in their manufacturing processes. Our customers use test, repair and inspection 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 also offer yield management solutions for the printed circuit board assembly industry and cathode ray tube display and high quality glass industries. Manufacturers in the printed circuit board assembly industry, also referred to as the surface mount technology industry, use our optical and X-ray inspection systems, which incorporate our proprietary image processing technology to detect and identify defects. We also leverage our core technologies to develop and sell products that locate and characterize defects in cathode ray tube displays, cathode ray tube glass and automotive glass panels.

We have recently acquired a number of complementary businesses and technologies. We acquired CR Technology, Inc. in November 1999, Photon Dynamics Canada Inc., formerly known as Image Processing Systems Inc. in December 2000, Intelligent Reasoning Systems, Inc. in July 2001, and Akcron Corporation, LTD. in September 2002. We also acquired certain assets and assumed certain liabilities from the Infrared Inspection Solutions Division of ART Advanced Research Technologies Inc. in July 2002, and from the Rapid Thermal Processing Division of Intevac, Inc. in October 2002.

Continuous innovations in microelectronics and materials science have enabled flat panel displays with sharper resolution, brighter pixels and faster imaging to be produced in varying sizes for differing applications. Similar innovations have led to the introduction of a broad array of electronic devices with increasing performance and decreasing size characteristics. Manufacturing these highly engineered products requires complex, multi-stage production processes, increasing the potential for defects and errors associated with equipment failures, contamination of materials, drift in process parameters, human error and other related factors. Manufacturing complexity also increases investment in work-in-progress inventories and lengthens production cycles. To better manage and enhance their yields, manufacturers are increasing their emphasis on automated testing, inspection and repair at various points in the manufacturing process. As production processes become more complex and reducing material and labor costs becomes increasingly important, we believe that ongoing yield management provides manufacturers with an important competitive advantage.

Growth in the mobile electronic devices market has driven the demand for flat panel displays, which offer reduced size, weight, power consumption and heat emission and better picture quality as compared to cathode ray tube displays, the current standard technology for stationary display devices. In addition to their dominance of high-performance mobile applications, flat panel displays offer similar advantages for stationary display applications even though they are currently more expensive than cathode ray tube displays with comparable viewing areas.

The active matrix liquid crystal display, the most prevalent and one of the highest performance flat panel displays available today, produces full color images and operates at much faster refresh rates than earlier passive monochrome liquid crystal displays. The color capability, resolution, speed and picture quality of active matrix liquid crystal displays currently make these displays the preferred choice for high-performance mobile applications, such as portable computers, multimedia and other applications requiring the display of video and graphics.

Manufacture of Active Matrix Liquid Crystal Displays. The manufacture of active matrix liquid crystal displays is an extremely complex process, which has been developed and refined for different panel sizes and resolutions through research and development, pre-production prototyping and commercial production. Manufacturing an active matrix liquid crystal display involves a series of three principal phases. The first phase of the process, array assembly, is the fabrication of an array of thin-film transistors, each of which is connected to a transparent sub-pixel, the smallest addressable unit in the display. Three sub-pixels are combined to produce a pixel, millions of which are fabricated, using semiconductor processes, on large glass plates. At the second phase, cell assembly, liquid crystal material and a color filter are applied to these glass plates. The third phase, module assembly, involves packaging the display and attaching the electronics and illumination, or backlight, which will allow the device to display the text, graphics and video images.

At various points in this 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. In addition, test and inspection systems can provide qualitative feedback to the flat panel display manufacturer and enable the manufacturer to address yield problems and to optimize the manufacturing process.

Challenges Faced by Flat Panel Display Manufacturers. The ability of flat panel display manufacturers to improve yields of active matrix liquid crystal displays and other flat panel displays depends, in large part, on their ability to test, repair and inspect displays during the manufacturing process and to use the resulting data to refine the manufacturing process. The ability to test, repair and inspect helps manufacturers address a number of challenges, including:

The printed circuit board assembly industry, also known as the surface mount technology industry, is also driving to achieve smaller sizes and greater densities in response to their customers’ demand for smaller, lighter and more sophisticated products. To remain competitive, manufacturers of these products must continue to improve their manufacturing productivity, which is facilitated by better quality control through the use of improved inspection equipment.

Just as the growing demand for increasingly sophisticated mobile and interconnected electronic devices is driving the market for new display technologies, this demand has caused manufacturers to seek to reduce the size, power consumption and cost of the other components contained in these devices. Additionally, as the functionality and sophistication of mobile electronic devices have increased, so has the complexity of their electronic components. These factors are driving the development of smaller, denser and more complex printed circuit boards upon which semiconductors and other electronic components are attached and interconnected.

As semiconductors continue to shrink and become more complex, an increasing number of wire connectors, or leads, must be attached to the semiconductor package. Ball grid array semiconductor packaging technology was developed to address the problems associated with greater lead counts required for advanced semiconductors. Because the leads in ball grid array semiconductor packages are located under the package and, therefore, are not visible after the package has been mounted on the surface of a printed circuit board, the inspection of these solder joints requires the use of X-ray inspection or ultrasound technologies as a replacement for visual inspection technologies. Furthermore, as the number of leads on semiconductor packages continues to increase, inspection technology must become more sophisticated and precise.

At the same time, electronic device original equipment manufacturers are increasing their focus on core competencies and outsourcing the manufacture of many components incorporated into their products. This trend has resulted in the rapid expansion of the contract manufacturing industry. Increased competition is causing contract manufacturers to focus on reducing costs while differentiating themselves through improved quality. One way in which contract manufacturers may reduce manufacturing costs is through yield improvements and increased throughput, which may be achieved through increased and more sophisticated inspection. Contract manufacturers are moving towards 100% inspection standards and adopting new inspection technologies as they seek to provide high quality products while reducing costs. Also, the contract manufacturing industry is characterized by shorter product life cycles, a greater variety of products manufactured in smaller lot sizes and high employee turnover rates. These factors require contract manufacturers to adopt a flexible approach to manufacturing with inspection equipment that is intuitive, easy to use and easily configured.

Each cathode ray tube television and computer monitor must be inspected, adjusted and aligned to ensure that its picture is focused, has the specified size and color quality, and is properly positioned on the screen. The glass must undergo numerous inspections steps to ensure structural integrity and the absence of visible defects on the faceplate. Historically, inspection and adjustment have been performed manually, using hand-held instruments and special templates. Manual inspections and adjustments are a time-consuming and error-prone part of the cathode ray tube display manufacturing process and require skilled operators and technicians. Issues associated with operator fatigue, inconsistency and cost have driven manufacturers to look for automated inspection solutions.

Increased consumer demand for higher quality in automobiles and increased competition in the automotive market have resulted in automobile manufacturers insisting on more stringent quality specifications for automotive glass. Automotive glass manufacturers must reduce the acceptable parts per million defect rate and are imposing large financial penalties on glass manufacturers that do not meet quality standards. Currently, the primary method of inspection is by the human eye. However, human inspection is inconsistent, expensive and unable to collect precise data to trace the cause of defects and correct the process. In order to meet the quality demands of the automobile manufacturers, the automotive glass manufacturers have begun to adopt automated inspection methods.

Our flat panel display yield management products include test and repair equipment. Our test equipment can identify and characterize defects at early stages of the manufacturing process so that the panels may be repaired before the next stage or, if necessary, discarded, minimizing the loss of time and materials. Our test and repair systems use similar software-based controls, processing and graphical user interfaces. Products can be networked together so that defect data can be stored, analyzed and used throughout the manufacturing process. Our systems are also compatible with a variety of material handling automation systems.

Flat Panel Display Test Systems. Our ArrayChecker test systems detect, locate, quantify and characterize electrical, contamination and other defects in active matrix liquid crystal displays after array fabrication. These systems use our proprietary non-contact Voltage Imaging technology to provide a high-resolution voltage map of the entire display and our proprietary image analysis software converts this voltage map into complete pixel defect data. The ArrayChecker test systems determine whether individual pixels or lines of pixels are functional and also find more subtle defects such as variations in individual pixel voltage. These defect data files are then used for repair and statistical process control. Our software driven ArrayChecker test systems can be configured rapidly for testing different panel sizes relative to traditional systems that require a different probe card for each panel size.

Flat Panel Display Repair Systems. Our ArraySaver repair systems utilize multiple wavelength laser technology to repair defects in flat panel displays during and after array fabrication. Our systems can use defect data files downloaded from our array test systems or other test and inspection systems to automatically position the panel for repair, thereby eliminating the time spent by operators locating defects.

Flat Panel Display Inspection Systems. Our PanelMaster inspection systems use our proprietary MuraLook image analysis algorithms and N-Aliasing technology to inspect flat panel displays for visual defects after cell assembly and also during and after module assembly. The system uses a high-resolution camera and a computer workstation to quantitatively measure visual characteristics such as contrast, luminance and color balance and to precisely locate and characterize line, cluster, pixel and blemish defects. Inspection data generated by the system is displayed on a video monitor for immediate interpretation and can be stored or sent to a repair system to effect repairs. Our inspection system offers different levels of resolution, functionality and flexibility to suit customers’ needs. The system is available either as a stand-alone unit or as a modular unit that can be integrated with manufacturers’ material handling equipment.

We offer a broad line of X-ray, optical and infrared systems for non-destructive inspection of products for the printed circuit board assembly industry. Customers can use these systems to detect and identify defects on printed circuit board assemblies and within advanced semiconductor packaging. Our X-ray, optical and infrared inspection product lines are based on our proprietary image processing technology and are integrated with a graphical user interface designed for ease of use on the production line. Our user-friendly, flexible configuration interface is a critical feature for many of our customers whose manufacturing operations must cope with fast turnaround, short production runs and workforces with limited skills and high turnover rates. These products use a common Windows-based computing platform and can be networked together to provide factory and enterprise-wide access to product defect data. We offer fully automated systems for use in high volume production lines and also offer lower cost systems for use off the production line.

Optical Inspection Systems. Our SV series automated optical inspection systems inspect printed circuit board assemblies for defects either before or after the soldering step in the manufacturing process. Many of the defects detected by our systems cannot be detected electrically. Our family of systems inspect for component presence, correct component, orientation, polarity, skew, solder integrity and other defects. Our systems feature integrated cameras and lighting heads, which pass over the surface of the printed circuit board, collecting images of each component. Our software can then analyze these images to identify errors and defects.

X-ray Inspection Systems. Our SX series X-ray inspection systems provide an effective, non-destructive means of verifying hidden solder connections such as under ball grid array packages. These systems also verify connections such as die attachments and wire bonds inside semiconductor packaging. Customers use the sharp, high magnification images provided by these SX systems to analyze failures that cannot be detected by optical means. We offer a variety of SX configurations to meet customer requirements for handler size, resolution, magnification, power, pricing and other factors. Printed circuit board assembly manufacturers use our systems to inspect the hidden solder connections between printed circuit boards and ball grid array devices.

Automated Optical and X-ray Inspection Systems. Our SVX series combined automated optical and X-ray inspection system shares the same easy-to-use software as our automated optical inspection systems, and leverages our X-ray capabilities to reduce handling, speed throughput and save floor space by simultaneously inspecting both visible and hidden features of printed circuit board assemblies.

Cathode Ray Tube Display Inspection Systems. Our optical inspection systems inspect cathode ray tube displays for defects after module assembly. Our family of systems uses high-resolution cameras and a computer workstation to quantitatively measure visual characteristics such as contrast, luminance and color balance and to precisely locate and characterize defects. Our systems can perform the same inspections and adjustments more quickly and more accurately than traditional manual methods and can automatically direct operators of our systems (who require minimal training and no special computer skills) through the inspection and alignment process, resulting in increased inspection accuracy, improved speed of production lines and reduced costs and higher productivity in manufacturing. Simple interactive graphics alert operators of our systems when products do not meet required specifications. All results can be recorded for management reporting, quality control analysis and product traceability and can be fully integrated with a manufacturer’s management information system.

Cathode Ray Tube Glass Inspection Systems. Our optical inspection systems inspect cathode ray tube glass faceplate panels in a variety of sizes early in the manufacturing process, detecting and measuring most glass defects, including scratches, pits, blisters, bubbles and stones in polished cathode ray tube faceplates. This fully-automated, non-contact, high-speed inspection system is designed to deliver improved product quality, reduced costs, increased throughput and data for process improvement. All results can be recorded for management reporting, quality control analysis and product traceability and can be fully integrated with a manufacturer’s management information system.

Automotive Glass Inspection Systems. Our optical inspection systems inspect either flat or curved automotive glass panels in a variety of different shapes and sizes. Our systems detect and measure a wide variety of glass defects including scratches, pits, bubbles and stones. This integrated, turnkey solution, including a precision conveyor, provides a yield management solution to increase productivity and results in data for process improvement. Our systems combine imaging devices, along with advanced image analysis, to provide for the automated inspection of automotive glass with greater inspection accuracy, throughput and data collection than obtained by traditional human inspection.

We sell our products to manufacturers in the flat panel display, printed circuit board assembly and cathode ray tube display and high quality glass industries. Most of our flat panel display customers are located in Korea, Taiwan and Japan, where flat panel display production is concentrated. The majority of our printed circuit board assembly customers are located in the United States. The majority of our cathode ray tube display customers are in China, Taiwan, Korea and Japan. The majority of our cathode ray tube glass and automotive glass customers are in Europe and the United States.

respectively. During fiscal year 2002, sales to LG Philips LCD Co., Ltd. accounted for 39% of our total revenue. See Note 11 of our Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for further information regarding sales to our major customers. Sales of our flat panel display products represented $49.3 million, $38.3 million and $64.2 million, or 71%, 54% and 68% of revenue, in fiscal 2002, 2001 and 2000, respectively. Sales of our printed circuit board assembly products represented $12.4 million, $18.1 million and $18.0 million, or 18%, 25% and 19% of revenue, in fiscal 2002, 2001 and 2000, respectively. Sales of our cathode ray tube display and high quality glass products represented $7.5 million, $14.7 million and $12.5 million, or 11%, 21% and 13% of our revenue, in fiscal 2002, 2001 and 2000, respectively. A significant portion of our revenue is derived from sales to companies located outside the United States, which exposes us to risks that we do not experience with domestic sales, such as export license restrictions, political instability, trade restrictions and fluctuations in the United States dollar. These and other risks relating to our business are detailed under the caption “Factors Affecting Operating Results” in Part II Item 7 of this Form 10-K. See Note 11 of our Notes to Consolidated Financial Statements included in “Item 8. Financial Statements and Supplementary Data” for a description of revenue from external customers, profit and loss and total assets of our three reportable segments (flat panel display products, printed circuit board assembly products, and cathode ray tube display and high quality glass inspection products) during the last three years, as well as revenue from external customers attributable to geographic areas.

We sell our products for the flat panel display industry directly to our customers in Korea and Taiwan, and through Ishikawajima-Harima Heavy Industries Co., Ltd., or IHI, our distributor, in Japan. We sell our products for the cathode ray tube display and high quality glass industries directly, except in Japan, where we use a sales representative. We sell our products for the printed circuit board assembly market primarily through sales representatives and distributors. We service our products worldwide directly, except in Japan, where IHI services our flat panel display products.

For our flat panel display and cathode ray tube display and high quality glass product customers, our terms are typically 80% to 90% of payment due upon shipment with the remaining amount due after installation and upon final acceptance. For our printed circuit board assembly customers, payments are generally due 30 days after shipment. We typically provide a limited warranty on our products for a period of one year. Our field service personnel provide customers with repair and maintenance services. As of September 30, 2002, we had 78 sales and service personnel, who were located as follows: 55 in Asia, 19 in North America and 4 in Europe.

In the flat panel display, cathode ray tube display and high quality glass markets, our sales and marketing strategy is to provide our customers with increased manufacturing yields and throughput, improved quality and greater overall efficiency in their manufacturing process. In the printed circuit board assembly industry, we focus on high-end applications where our high-resolution, advanced image processing and optical inspection technologies and products provide our customers with product quality assurance capabilities. Our sales and marketing strategy is also to focus on the rapidly expanding contract manufacturing industry. Operating on narrow margins, contract manufacturers compete by reducing costs and improving quality, as well as promoting their advanced capabilities. These customers require flexible systems that are easy to set up and cost-efficient.

The market for integrated yield management systems is characterized by rapid and continuous technological development and product innovation. We believe that it is necessary to maintain our competitive position through continued and timely development of new products and enhancements to existing products. Accordingly, we devote a significant portion of our personnel and financial resources to research and development. Our research and development expenses, consisting primarily of personnel, consultants and prototype materials, were $18.8 million, $17.1 million and $14.2 million, or 27%, 24% and 15% of our revenue, in fiscal 2002, 2001 and 2000, respectively.

We are focusing our current research and development for the flat panel display market on increasing the performance of our array test, repair and inspection systems. Our current research and development for the printed circuit board assembly industry is focused on increasing the performance, reliability and functionality of our inspection systems, expanding the application of our inspection systems for use in related markets and developing new optical and infrared inspection products. Our current research and development for the cathode ray tube display and high quality glass markets is focused on increasing the performance, reliability and functionality of our inspection systems.

Our flat panel display products and our printed circuit board assembly products are primarily manufactured in San Jose, California, and our cathode ray tube display and high quality glass products are manufactured in Markham, Ontario, Canada. Our manufacturing activities consist primarily of final assembly and test of components and subassemblies, which are purchased from third party vendors.

We have operated our manufacturing processes with suppliers of fully or partially assembled and tested subsystems for many years. In December 2001, we entered into a three-year manufacturing outsourcing agreement with Sanmina-SCI Corporation. Under this and related agreements, Sanmina-SCI provides a significant portion of the procurement of raw materials, manufacturing, assembly and test operations for our flat panel display and printed circuit board assembly products. We continue to manufacture some of the proprietary and more complex pieces of our equipment, such as our modulators. Under the terms of this agreement, Sanmina-SCI leases 15,000 square feet of our San Jose facility, leases and operates the equipment required to manufacture a significant number of our flat panel display and printed circuit board assembly products, expanded our San Jose clean room, and purchased a substantial portion of our existing raw materials inventory for our flat panel display and printed circuit board assembly products.

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 16 weeks for our flat panel display, cathode ray tube glass and automotive glass products, and within eight weeks for our printed circuit board assembly and cathode ray tube display products. We maintain quality control through inspection of components, in-process inspection during equipment assembly and final inspection and operation of all manufactured equipment prior to shipment. Although we assemble some components and final test our systems under limited clean room conditions, most of our manufacturing occurs in standard manufacturing space.

Under the terms of our relationship with IHI, we have retained the exclusive right to manufacture some critical components based on technology not shared with IHI and to sell these components to IHI at prices that are mutually established from time to time. IHI has the right to manufacture, assemble and sell array test systems incorporating these components. To date, we have manufactured all array test systems sold by IHI. Furthermore, IHI has sold products only in its capacity as our distributor in Japan.

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, ultra high-resolution cameras and high-speed image processing systems for our flat panel display products from single source suppliers. We also currently obtain X-ray equipment for our printed circuit board assembly products from limited source suppliers. Although we seek to reduce dependence on our single source and limited group suppliers, alternative sources of supply for certain pieces of equipment may not be available or may be available on unfavorable terms. The partial or complete loss of a single source or limited group of suppliers or any delay in shipment from a single source or limited group of suppliers could at least temporarily 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 could harm

We protect our proprietary technology through various methods such as patents and patent applications, trademarks, non-disclosure agreements and trade secrets. We have filed and obtained a number of patents in the United States and abroad and have also jointly filed patent applications in Japan with IHI. As of November 15, 2002, we have been issued 55 patents in the United States that are in force. The normal expiration dates of these patents range from 2006 to 2021. As of November 15, 2002, there are 20 pending patent applications in the United States. As of November 15, 2002, we have been issued 21 non-U.S. patents that are in force and there are 31 non-U.S. pending patent applications.

Our backlog consists of orders for which we have accepted purchase orders and assigned shipment dates within the next twelve months. All orders are subject to delay or cancellation with limited or no penalty to the customer. Because of possible changes in product delivery schedules and cancellation of product orders, among other factors, our backlog may vary significantly and, at any particular date, is not necessarily indicative of actual sales for any succeeding period. Our backlog as of September 30, 2002 and 2001 was approximately $54.0 million and $32.0 million, respectively.

The worldwide market for integrated yield management systems is highly competitive. We face substantial competition in each of our operating segments from established companies, many of which have greater financial, engineering and manufacturing resources and have larger service organizations and long-standing customer relationships with key existing and potential customers. We may also face future competition from new market entrants from other overseas and domestic sources or if IHI elects to begin competing with us.

In the flat panel display industry, our competitors primarily include Micronics Japan Corporation, Applied Komatsu Technology and Shimadzu Corporation in array testing, NEC Corporation, NTN Corporation and Hoya Continuum Corporation in array repair and several competitors in the cell and module inspection market. The printed circuit board assembly market is divided into X-ray inspection and optical inspection. In the X-ray inspection market, our competitors include The Dage Group, Teradyne, Inc., phoenix | x-ray Systems + Services GmbH and FeinFocus Röntgen-Systeme GmbH. In the optical inspection market, our competitors include

We expect our competitors to continue to improve the design and performance of their products and to introduce new products with competitive price and performance characteristics. Our customers may choose to develop proprietary technology that may obviate or lessen their need to purchase our products. Moreover, increased competitive pressure may necessitate price based competition, which could harm our business, financial condition and results of operations.

We believe that we can compete effectively with our competitors by building on our substantial installed customer base, providing technologically superior, competitively priced products and continuing to emphasize our easy-to-use user interfaces and customer support. However, realizing and maintaining such advantages will require a continued high level of investment by us in engineering, research and development, marketing and customer service and support. We may not have sufficient resources to continue to make such investments. Even if sufficient funds are available, we may not be able to make the technological advances necessary to maintain such competitive advantages.

In October 2002, we purchased certain assets from Intevac, Inc. related to Intevac’s Rapid Thermal Processing Division. The rapid thermal processing systems use a patented technology designed to activate low temperature poly-silicon films utilizing a precise heating process critical to the manufacture of advanced active matrix, thin film transistor liquid crystal displays and organic light emitting diodes. This acquisition has expanded our flat panel display product offering.

In July 2002 we purchased certain assets from ART Advanced Research Technologies Inc. related to ART’s Infrared Screening and Inspection Solutions Division. The primary assets acquired utilize an infrared imaging technology for off-line inspection and failure analysis of powered printed wiring assemblies. This acquisition has expanded our yield management capabilities for original equipment manufacturers and electronic services companies in the electronics industry.

Name	Age	Position
Vincent F. Sollitto, Jr.	54	Chief Executive Officer, President and Director
Richard L. Dissly	58	Chief Financial Officer and Secretary
Jon R. Hopper	40	Senior Vice President, Sales and Support Organization
Bernard T. Clark	58	Vice President and President, Flat Panel Display Division
Bruce P. Delmore	41	Vice President and President, Electronics Division
Jeffrey A. Hawthorne	45	Vice President and President, Image Processing Systems Division

Vincent F. Sollitto has been our President and Chief Executive Officer since June 1996 and has been a member of our board of directors since July 1996. From August 1993 to 1996, he was the General Manager of Business Unit Operations for Fujitsu Microelectronics Inc., a semiconductor and electronics company. From April 1991 to August 1993, he was the Executive Vice President of Technical Operations at Supercomputer Systems, Incorporated. Prior to joining Supercomputer Systems, Incorporated, Mr. Sollitto spent twenty-one years in various management positions at International Business Machines Corporation, an information technology service company, including Director of Technology and Process. Mr. Sollitto serves as a director of Irvine Sensors Corp., a compact packages technology company, Applied Films Corporation, a thin film deposition equipment company, Ultratech Stepper, Inc., a photolithography equipment company and US Display Consortium, a research & development non-profit organization. Mr. Sollitto holds a B.S. degree in Electrical Engineering from Tufts College.

Richard L. Dissly has been our Chief Financial Officer since November 1998 and our Secretary since October 1999. He was Chief Financial Officer of Semaphore Communications, a network equipment provider, from January 1997 until October 1998 and Chief Financial Officer of CrossCheck Technology, an electronics design automation company, from July 1992 until December 1996. He currently serves on the board of directors of Nextest Systems, Inc. Mr. Dissly holds a MBA degree from Santa Clara University and is a licensed CPA.

Jon R. Hopper has been Senior Vice President of Sales and Support Organization since July 2001. From October 1998 to July 2001, Mr. Hopper was Chief Executive Officer of Intelligent Reasoning Systems, Inc., a supplier of capital equipment to the electronics manufacturing industry. From July 1997 to October 1998, he served as Group Vice President for Electro Scientific Industries (“ESI”), a supplier of capital equipment to the semiconductor and electronics manufacturing industries. From January 1995 to July 1997, he served as Chief Executive Officer of Dynamotion Corp. until Dynamotion was acquired by ESI. Mr. Hopper received a B.A. degree in German Literature from Heidelberg University and a B.S. degree in Engineering from the University of Arizona.

Bernard T. Clark has been our Vice President and President, Flat Panel Display Division since February 2001. From May 2000 to February 2001 he was our Vice President, Manufacturing and Field Operations. From 1995 until 2000, Mr. Clark was the Director of Process and Product Assurance for IBM Storage Systems Division, an information technology service company. Mr. Clark received a Bachelor of Engineering degree from New York University.

Bruce P. Delmore has been our Vice President and President, Electronics Division since August 2001. From August 1999 to August 2001 he was our Vice President of Marketing, Strategy and Business Development. He was President of Strategos Group, a strategy consulting firm, from 1997 until 1999. From 1994 until 1997, Mr. Delmore held several executive positions including Director of EDA and Strategic ASIC Development at Fujitsu Microelectronics, a semiconductor and electronics company. Mr. Delmore received a B.S. degree in Mechanical Engineering from the University Wisconsin-Madison.

Jeffrey A. Hawthorne has been our Vice President and President, Image Processing Systems Division since November 2001. Mr. Hawthorne joined us in 1991 and has held a series of other management positions including Vice President, Development from September 1994 to November 2001. Mr. Hawthorne received a B.S. degree in Engineering Physics from the University of Colorado and an M.S. degree in Optical Engineering from the University of Rochester.

Our corporate headquarters are located in San Jose, California and consist of a 22,000 square foot owned facility for sales, marketing and administration. Flat panel display product manufacturing, research and development, marketing, service and administration is also located in San Jose, California in a 52,000 square foot leased facility, of which Sanmina-SCI subleases 15,000 square feet from us. We lease 19,700 square feet in Aliso Viejo, California and 35,200 square feet in Austin, Texas for printed circuit board assembly product research and development, sales, marketing, service and administration. We lease 50,000 square feet in Markham, Ontario, Canada for cathode ray tube and high quality glass product manufacturing, research and development, sales, marketing, service and administration. We lease 5,200 square feet in Daejon, Korea for flat panel display automated optical inspection product manufacturing, research and development, sales,marketing, service and administration. In addition, we lease office space for our sales and service operations in Tokyo, Japan; Hsinchu, Taiwan; Seoul, Korea; Surrey, England; Eindhoven, Netherlands and Beijing and Shanghai, China.

We have been named as defendant in a lawsuit captioned Thomason v. Photon Dynamics, Inc., No. 02CC03568, filed on February 28, 2002 in the Superior Court of the State of California, County of Orange. The plaintiff in this action has purported to assert that he was wrongly not allowed to exercise certain stock options and is seeking damages of approximately $900,000. On March 29, 2002, we responded to the lawsuit and filed a counterclaim against the plaintiff for breach of a general release agreement. While we intend to vigorously contest the action, we cannot predict the outcome of this litigation. We believe that an adverse determination in this litigation would not have a material adverse effect on our financial condition or results of operations.

We, and certain of our directors and officers have been 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 plaintiff, a former officer of Photon, has asserted several causes of action arising out of alleged misrepresentations made to plaintiff regarding the existence and enforcement of our insider trading policy. Plaintiff seeks damages of approximately $17.7 million for our alleged refusal to allow plaintiff to sell Photon stock in May of 2000, plus unspecified emotional distress and punitive damages. On December 6, 2001, the court granted our motion to dismiss the complaint for failure to allege facts sufficient to state a cause of action, with leave to file an amended complaint. On January 17, 2002, plaintiff filed his amended complaint and we again moved to dismiss the action. On June 27, 2002, the court issued an order granting in part and denying in part the motion, and further granted plaintiff an opportunity to restate certain claims. On October 1, 2002, plaintiff filed his Second Amended Complaint. Our motion to dismiss is pending and scheduled to be heard in January of 2003. We believe plaintiff’s case is without merit and intend to defend this action vigorously. Although we cannot predict the outcome of this litigation, we believe that any adverse judgment in this litigation would not have a material adverse effect on our financial condition or results of operations.

We filed a lawsuit captioned Photon Dynamics, Inc. vs. PanelVision Technology and Guillermo Tora-Lira, No. CO202563PJH filed on May 28, 2002 in the U.S. District Court for the Northern District of California, County of Santa Clara. We are alleging infringement of a U.S. Patent owned by us and seeking full compensatory damages and an injunction against the defendants. On July 17, 2002, the defendants answered our complaint and asserted a counterclaim alleging damages of at least $6.0 million in compensatory damages for loss of business. We believe that the counterclaims are without merit and intend to vigorously contest the counterclaims. Although we cannot predict the outcome of this litigation, we believe that any adverse determination in this litigation would not have a material adverse effect on our financial condition or results of operations.

From time to time we are subject to legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the outcome of these proceedings and claims cannot be predicted with certainty, management does not believe that the outcome of any of these legal matters will have a material adverse effect on our results of operations or financial condition.

Our common stock commenced trading on the Nasdaq National Market on November 15, 1995 under the symbol “PHTN.” The closing price for our common stock as reported by the Nasdaq National Market on November 30, 2002 was $35.25 per share. As of November 30, 2002, there were approximately 184 shareholders of record of our common stock. The following table sets forth the high and low sales prices of our common stock as traded on the Nasdaq National Market for the periods indicated.

Fiscal 2002 Quarter ended	December 31, 2001	March 31, 2002	June 30, 2002	September 30, 2002
High	$45.650	$53.870	$51.350	$28.020
Low	$22.200	$35.930	$28.680	$18.060

Fiscal 2001 Quarter ended	December 31, 2000	March 31, 2001	June 30, 2001	September 30, 2001
High	$43.063	$27.625	$33.300	$39.970
Low	$19.938	$16.875	$18.063	$22.010

In August 2002, our Board of Directors approved a stock repurchase program authorizing us to repurchase up to an aggregate of $25.0 million of our common stock. The repurchases are made from time to time on the open market at prevailing prices, in negotiated transactions off the market or pursuant to a 10b5-1 plan adopted by us. The 10b5-1 plan, allows us to repurchase our shares during a period in which we are in possession of material non-public information, provided that we communicated share repurchase instructions to the broker at a time when we were not in possession of such material non-public information. As of November 30, 2002, we had repurchased 1,049,300 shares for an aggregate repurchase price of approximately $20.3 million.

The following selected consolidated financial data should be read in conjunction with the Company’s Consolidated Financial Statements and Notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, which are included elsewhere in this report. The consolidated statement of operations data for the years ended September 30, 2002, 2001 and 2000 and the consolidated balance sheet data as of September 30, 2002 and 2001 are derived from the consolidated financial statements included elsewhere in this report. The consolidated statement of operations data for the years ended September 30, 1999 and 1998 and the consolidated balance sheet data as of September 30, 2000, 1999 and 1998 are derived from audited consolidated financial statements not included in this report.

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

		Page

PART I		1

Item 1.	Business	1

Item 2.	Properties	12

Item 3.	Legal Proceedings	12

Item 4.	Submission of Matters to a Vote of Security Holders	13

PART II		14

Item 5.	Market for the Registrant’s Common Equity and Related Stockholder Matters	14

Item 6.	Selected Financial Data	15

Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16

Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	35

Item 8.	Financial Statements and Supplementary Data	35

	REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS	36

	ARTHUR ANDERSEN LLP AUDITORS’ REPORT	37

	CONSOLIDATED BALANCE SHEETS	38

	CONSOLIDATED STATEMENTS OF OPERATIONS	39

	CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY	40

	CONSOLIDATED STATEMENTS OF CASH FLOWS	41

	NOTES TO CONSOLIDATED FINANCIAL STATEMENTS	42

Item 9.	Changes in and Disagreements With Accountants on Accounting and Financial Disclosure	65

PART III		66

Item 10.	Directors and Executive Officers of the Registrant	66

Item 11.	Executive Compensation	66

Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	66

Item 13.	Certain Relationships and Related Transactions	66

Item 14.	Controls and Procedures	66

PART IV		67

Item 15.	Exhibits, Financial Statement Schedules, and Reports on Form 8-K	69

Signatures		72

Certifications		73

	Patents in Force
	U.S.	Non-U.S.
Flat Panel Display Products	39	19
Printed Circuit Board Assembly Products	9	1
Cathode Ray Tube Display and High Quality Glass Products	4	0
Other	3	1

Total	55	21

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