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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-KSB
[X] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended September 30, 1997
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File Number: 0-27234
PHOTON DYNAMICS, INC.
(Exact name of small business issuer as specified in its charter)
CALIFORNIA 94-3007502
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
6325 SAN IGNACIO
SAN JOSE, CA 95119
(Address of principal executive offices)
(408) 226 9900
(Issuer's telephone number)
Securities registered under Section 12(b) of the Exchange Act:
NONE
Securities registered under Section 12(g) of the Exchange Act:
COMMON STOCK
Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the last 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. YES X NO
--- ---
Check if there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B contained in this form, and no disclosure will be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-KSB or any
amendment to this Form 10-KSB. [ ]
Revenue for the year ended September 30, 1997 was $24,507,000.
The aggregate market value of the voting stock held by non-affiliates of the
Registrant, based on the closing price of the Common Stock on December 22, 1997,
as reported on the Nasdaq National Market, was approximately $17,165,000.
Shares of Common Stock held by each officer and director and by each person who
owns 5% or more of the outstanding Common Stock have been excluded from this
computation in that such persons may be deemed to be affiliates. This
determination of affiliate status is not necessarily a conclusive determination
for other purposes.
As of December 22, 1997 the Registrant had outstanding 7,157,169 shares of
Common Stock.
Transitional small business Disclosure Format (check one) Yes ; No X
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DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's Proxy Statement for its 1998 Annual Meeting of
Shareholders and the Registrants Annual Report to Shareholders for its fiscal
year ended September 30, 1997 are incorporated by reference in Part I, II and
III of this Form 10-KSB report.
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The statements contained in this report on Form 10-KSB that are not purely
historical are forward looking statements within the meaning of Section 27A of
the Securities Act of 1933 and Section 21E of the Securities Exchange Act of
1934, including statements regarding the Company's expectations, hopes,
intentions or strategies regarding the future. All forward looking statements
included in this document are based on information available to the Company on
the date hereof, and the Company assumes no obligation to update any such
forward looking statements. It is important to note that the Company's actual
results could differ materially from those in such forward looking statements.
You should consult the risk factors listed from time to time in the Company's
reports on Form 10-QSB, and annual reports to shareholders. Among the factors
that could cause actual results to differ materially are those discussed under
"Factors That May Affect Future Results" and elsewhere in this Form 10-KSB.
PART I
ITEM 1: DESCRIPTION OF BUSINESS
THE COMPANY
Photon Dynamics, Inc. ("Photon Dynamics" or the "Company") is a leading
worldwide supplier of array test, inspection and repair systems for the flat
panel display ("FPD") industry. The Company's systems are used to control,
monitor and refine the manufacturing process to increase the yield of FPDs, to
reduce materials loss, to transition new FPD designs from research and
development to commercial production and to assist in the rapid start-up of new
FPD manufacturing facilities. While certain aspects of the manufacturing
processes for FPDs are similar to manufacturing processes for semiconductor
devices, materials costs represent a substantially higher percentage of the cost
of an FPD as compared with semiconductor devices. As a result, the need for
array test and inspection of FPDs goes beyond the need to improve yields as FPD
manufacturers seek to identify defects early in the manufacturing process to
either avoid investment of further materials cost or to repair the defect before
further manufacturing steps make it less accessible. The Company believes that
more of its systems have been used by manufacturers of active matrix liquid
crystal displays ("AMLCDs") and other advanced FPDs to array test, inspect and
repair more VGA and other higher resolution FPDs than any other currently
available competitive system. The Company believes that the experience it has
acquired from the wide use of its systems has enabled it to become a leading
technical innovator of array test, inspection and repair equipment for advanced
FPD manufacturers.
Photon Dynamics offers a suite of products to inspect almost all current types
of commercially produced FPDs and to address all key areas of AMLCD test,
inspection and repair throughout all major stages of the manufacturing life
cycle, from research and development through commercial production. The
Company's array test products include test systems that locate, count and
characterize electrical array faults, contamination and other defects on
partially completed flat panel display substrates. Its inspection products
perform flat panel cell and module inspection to detect and locate optical
defects in FPDs. The Company's repair product performs array laser cut and weld
repair functions based upon information generated by its array test and
inspection products. All of the Company's product lines interface with one
another through software systems used to store data and generate reports and
other information used by FPD manufacturers to increase their yields.
The Company's products incorporate proprietary technologies that enable FPD
manufacturers to obtain information critical to yield improvement and management
of manufacturing processes that had not previously been readily available to FPD
manufacturers. The Company's proprietary Voltage Imaging(TM) and N-Aliasing(TM)
technologies, in conjunction with its proprietary software programs, permit non-
contact, full characterization and image evaluation of almost all commercially
produced FPD displays, regardless of panel size or the FPD technology employed.
All of the Company's product lines are currently being used with VGA, SVGA, XGA
and SXGA displays and are designed for use with next generation UXGA displays.
INDUSTRY BACKGROUND
Overview of Flat Panel Display Market
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The market for FPDs has grown significantly in recent years as the result
of the increasing popularity of portable computers and other electronic devices
that display textual or graphical information. The weight and thin form factor
of FPDs enable new display applications not supported by the previously
predominant monitor technology, cathode ray tubes ("CRTs"). Laptop and notebook
computers, personal digital assistants, portable video games, digital phones and
a variety of devices for the automotive, technical, medical and military markets
are examples of electronic products in fast growing markets which cannot be
served by CRT technology.
Different applications for FPDs have varying cost, size and performance
requirements, and alternative FPD technologies have been developed to address
these different applications. Different types of FPDs that are currently being
produced to address certain segments in the broader FPD market include liquid
crystal ("LCD"), plasma ("PDP"), electroluminescent ("EL") and field emissive
("FED") displays and digital micro-mirror devices ("DMDs"). Currently the most
common type of FPD is the LCD, which first emerged in the form of watch and
calculator displays in the 1970s. The most advanced form of LCD available today
is the thin-film transistor ("TFT") AMLCD which utilizes three individual
emissive transistors at each pixel, enabling the AMLCD both to produce full
color images and to operate at much faster refresh rates than earlier passive
monochrome LCDs. The color capability, resolution, speed and picture quality of
AMLCDs currently make these displays a preferred choice for high performance
portable computer, multimedia and other applications requiring the display of
video and graphics. The trend toward higher resolution video and graphic
displays has been reflected in the evolution from VGA displays (640 x 480 lines
of resolution) to SVGA displays (800 x 600 lines of resolution) to XGA displays
(1,024 x 768 lines of resolution) which in turn are being replaced by next-
generation SXGA displays (1,280 x 1,024 lines of resolution) and soon UXGA
displays (1,600 x 1,200 lines of resolution). To achieve higher resolution
display capability and enhanced picture quality, the number of pixels integrated
in AMLCDs is increased, which in turn increases the complexity of the
manufacturing process.
The AMLCD Flat Panel Display Manufacturing Process
The manufacture of AMLCDs is an extremely complex process which is
developed and refined for different panel sizes and resolutions through research
and development, pre-production prototyping and commercial production.
Manufacturing an AMLCD involves a series of three principal steps. The first
step is to build an active array of thin-film transistors on a substrate through
a photolithography process, which is essentially the same step used to create
electronic circuitry on a semiconductor device. In an SVGA-quality color AMLCD,
there are three transistors (red, green and blue) at each pixel and typically
1,440,000 transistors in total with geometric line widths for each transistor of
between three and five microns. The next step involves attaching a color filter
to the transistor-embedded substrate and injecting liquid crystal material
between the color filter and the transistor array. The color filter enables the
display to attain color capability by selectively filtering out the light
emissions from each multi-color pixel array to produce the desired color mix in
the displayed image. At this second step, the "cell" for each pixel is created
through the combination of transistors and a color filter. The last step in the
process is to package the display and attach the necessary "driver" electronics
that will interpret and convert the electronic signals directed by the computer
or other electronic system to the AMLCD and cause it to display the desired
text, graphics and video images. This step also involves sealing the FPD and
installing the interface electronics. Current Yield and Cost Problems
Experienced by FPD Manufacturers While there are many similarities between the
techniques used to manufacture semiconductor devices and FPDs such as AMLCDs,
the manufacture of FPDs is different in a number of ways that expose the FPD
manufacturer to potentially greater risk from yield loss throughout the
manufacturing process. The cost structure for the manufacture of FPDs is very
different from semiconductor devices in that materials costs represent a much
larger percentage of the total product cost to the FPD manufacturer than the
semiconductor manufacturer. Second, the manufacture of FPDs combines both
electrical manufacturing techniques as well as a number of complex non-
electrical manufacturing steps, such as the manufacture and alignment of the
color filter at exacting physical tolerances, injection of the liquid crystal,
sealing of the FPD and assembly of the driver electronics and circuitry. Third,
because of the visual function performed by FPDs, an FPD must satisfy certain
visual criteria and have consistent resolution, color and quality to be
acceptable to the end user. Certain types of visual deficiencies, such as
variations in screen brightness or color or blurred resolution, are unrelated to
electrical defects and can cause substantial yield losses. These defects, some
types of which are referred to as "mura", cannot be detected by traditional
automated
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semiconductor array test equipment and are not relevant to the manufacture of
semiconductor devices and other electronic components where minor defects not
affecting the electrical performance of the product do not result in yield loss.
Due to these factors, the AMLCD industry continues to experience substantial
yield losses and to incur significant materials costs in the manufacture of
FPDs.
The ability of FPD manufacturers to improve yields of AMLCDs and other FPDs
depends in large part on their ability to array test and inspect displays during
the manufacturing process and to use array test and inspection data to refine
the manufacturing process. Through inspection, the FPD manufacturer seeks to
identify defects at an early stage in the process to permit repair or to avoid
wasting costly materials on continued manufacturing of a defective product. The
Company estimates that 80% of the overall cost of manufacturing a typical full
color AMLCD is incurred in later stage manufacturing steps after the primary
transistor array has been developed on the glass substrate. Material costs can
be reduced through in-process array testing if yield defects in the
manufacturing process can be properly detected at earlier stages. In addition,
systematized inspection provides qualitative feedback to the FPD manufacturer
and enables it to address yield problems and enhance the manufacturing process.
Because of this critical role of yield in reducing FPD manufacturing costs, the
FPD industry is now generally recognizing the need for automated FPD array test,
inspection and repair equipment and seeking yield enhancing solutions at all
stages of the FPD manufacturing process. This need has become much more acute
recently as AMLCDs have become increasingly more complex and the market has
evolved from existing VGA and SVGA standard displays to the higher resolution
XGA and SXGA displays.
PRODUCTS
Photon Dynamics offers a suite of products to inspect almost all
commercially produced FPDs. All of the Company's systems use similar software
based controls, processing and graphical user interfaces. Products can be
networked together so that FPD defect data can be stored, analyzed and used
throughout the manufacturing process. All of the Company's systems are capable
of providing fully automated functionality through robotics purchased from third
party vendors.
Array Test Systems (Test Systems)
The Company's array test systems use the Company's proprietary Voltage
Imaging(TM) technology to detect, locate, quantify and characterize electrical,
contamination and other defects in AMLCD arrays after the completion of the
first major step of production, the construction of the transistor array on the
glass substrate. The systems incorporate a computer workstation and proprietary
image processing software to display pixel images and information which not only
allows manufacturers to determine whether individual pixels or lines of pixels
are functional, but also allows them to find more subtle defects such as
individual pixel voltage variations early in the production process. In
addition, these systems generate point and line defect data files specifying the
exact location of each defect, which data can then be used for statistical
process control or downloaded to the Company's repair systems to effect repairs.
The systems also perform key procedures involved in the array testing process,
including running test sequences and loading, unloading and sorting substrates.
The array test systems can be adapted to test different panel sizes in less than
three hours, as compared with systems using probe card technology which the
Company estimates can require up to 16 hours. The currently available
ArrayChecker system is an enhanced version of earlier array test systems that
uses optimized processing software, graphical user interface and materials
transport features. These features have been designed to enable the ArrayChecker
system to achieve throughput rates that are closer to conventional probe card
based systems while providing the same functionality, flexibility and cost-
efficient features of the earlier array test systems.
Flat Panel Inspection Systems (FIS or Inspection Systems)
The Company's Flat Panel Inspection (FIS) systems use the Company's
proprietary N-Aliasing(TM) technology to inspect almost any type and size of
commercially available FPD panel for optical defects after the completion of the
second major stage of production. FIS systems are also designed to perform
inspection after final module assembly of FPD panels. The systems use a single
high-resolution camera and workstation driven by the Company's N-Aliasing(TM)
software to quantitatively measure critical optical qualities such as contrast,
luminance and color balance and to precisely locate mura, line, cluster and
individual pixel defects. Test data generated by the systems is displayed on a
video monitor to permit immediate visual interpretation and can be stored or
sent to a repair system to effect repairs. Inspection systems comprise a family
of products that offer different levels of resolution, functionality and
flexibility to suit customers' needs. Currently available systems include the
FIS250, PanelMaster 300, UltraFIS and SpotLite. Each system can currently be
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configured to perform as many as 100 individual array tests and are adaptable to
panel sizes ranging from 0.75 to 15 inches. The systems are available either as
stand-alone units or as modular systems designed to be integrated with
manufacturers' material handling equipment.
Array Repair System (Repair System)
The Company's repair systems use a laser to repair opens and shorts in
AMLCD and passive LCD panels. These repair systems can use defect files
downloaded from the Company's array test or inspection systems to automatically
locate the defects in the panel so that the operator can decide whether or not
to repair them. This capability saves operator time searching for the defects
among the hundreds of thousands of pixels on a display. The repair systems
repair shorts by cutting away excess material and opens by welding a new
connection to a recovery ring. The latest repair systems feature unique
BeamBlender laser technology. The feature allows manufacturers to blend two
laser frequencies in certain ratios for cutting or welding.
INTELLECTUAL PROPERTY
The Company has been issued over 28 U.S. patents with respect to its FPD
array test, inspection and repair technologies and has certain U.S. and foreign
applications pending. The Company has a number of U.S. patents related to its
Voltage Imaging(TM) technology and has applied for U.S., Japanese and Korean
patents related to this technology as well as its N-Aliasing(TM) technology. No
patents are scheduled to expire before 2010, subject to payment of applicable
maintenance fees. In addition, Photon Dynamics and Ishikawajima-Harima Heavy
Industries Co., Ltd. ("IHI"), have jointly filed patent applications in Japan
relating to certain aspects of the array test systems.
The Company frequently reviews its inventions and attempts to determine
which inventions will provide substantial differentiation between the Company's
products and those of its competitors. In certain cases, the Company may also
choose to keep an invention or a process as a trade secret. Trade secrets are
routinely employed in the Company's manufacturing processes. The Company has
entered into non-disclosure agreements to protect its proprietary technology
with its employees and consultants, and in some instances with its suppliers,
its customers and IHI. Because of rapid technological developments in the
electronics and FPD industries and the broad and rapidly developing patent
coverage in such industries, the patent position of any manufacturer, including
the Company, is subject to uncertainties and may involve complex legal and
factual issues. Consequently, although the Company holds certain patents and is
currently prosecuting additional patent applications, there can be no assurance
that patents will issue from any pending applications or that claims allowed by
any existing or future patents will issue from any pending applications or that
claims allowed by any existing or future patents issued to the Company will not
be challenged, invalidated, or circumvented, or that any rights granted
thereunder will provide adequate protection to the Company. Furthermore, there
can be no assurance that others will not develop technologies that are similar
or superior to the Company's technology, duplicate the Company's technology or
design around the patents owned by the Company. In addition, effective copyright
and trade secret protection may be unavailable or limited in certain foreign
countries. There can be no assurance that the steps taken by the Company will
prevent misappropriation of its technology. In addition, litigation may be
necessary in the future to enforce the Company's patents and other intellectual
property rights, to protect the Company's trade secrets, to determine the
validity and scope of the proprietary rights of others or to defend against
claims of infringement or invalidity. Such litigation could result in
substantial costs and diversion of resources and could have a material adverse
effect on the Company's results of operations or financial condition. Moreover,
the Company may be required to participate in interference proceedings to
determine the priority of inventions, which also could result in substantial
cost to the Company. See "Factors That May Affect Future Results - Patents and
Proprietary Rights"
RESEARCH AND DEVELOPMENT
The market for FPD array test, inspection and repair systems is
characterized by rapid and continuous technological development and product
innovation. The Company believes that continued and timely development of new
products and enhancements to existing products is necessary to maintain its
competitive position. Accordingly, the Company devotes a significant portion of
its personnel and financial resources to research and development programs and
seeks to maintain close relationships with customers to remain responsive to
their product needs. Photon Dynamics' current research and development efforts
are directed to increasing the performance of its flat panel inspection and
array test systems and expanding the application of its inspection systems for
use in other related markets. Because the software incorporated by
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the Company into its products represents a significant portion of the value
added by these products, over one-third of the Company's research and
development personnel are focused on software development.
The Company's research and development expenses were $7.8 million and $4.0
million in fiscal 1997 and fiscal 1996, respectively, or 31.7% and 16.1% of
revenue, respectively. Research and development expenses consist primarily of
salaries, project materials and other costs associated with the Company's
ongoing efforts to improve and enhance the Company's products.
The Company has obtained substantial development funding from IHI with
respect to the Company's array test systems. IHI has provided funding for
initial feasibility studies and development of the first prototypes of array
test systems, and since 1990 IHI has provided to the Company in excess of $7.8
million in research and development funding with respect to the array test
systems. In exchange for this funding IHI has been granted certain licenses and
joint ownership rights to the developed technology. See "Factors That May Affect
Future Results - Relationship with IHI"
The Company has entered into contracts with the U.S. government and private
companies including IHI, to develop products which Photon Dynamics is then able
to sell with certain restrictions. Photon Dynamics generally owns all of the
intellectual property developed under these contracts. However the Company has
licensed certain rights to its array test technology to the U.S. government
which may transfer its license to a third party for use in products sold to U.S.
customers in the event the Company becomes unable to delivery array test systems
to U.S. customers.
CUSTOMERS, SALES AND SERVICE
The Company sells its products to leading FPD manufacturers. Sales to LG
Electronics, Inc represented 26% and 19% of revenue in fiscal 1997 and fiscal
1996. Overall, the Company's top four customers contributed 83% of revenue in
fiscal 1997. International sales accounted for 98% and 88% of revenue in fiscal
1997 and 1996, respectively. See "Factors That May Affect Future Results -
Dependence on Principal Customers" and "International Operations".
Photon's revenue is obtained primarily through a direct sales force and to
a lesser extent through value added resellers in Japan and Korea. During fiscal
1997 the Company entered into an agreement with a Korean company to be the
exclusive value added reseller of the Company's inspection products in Korea.
The Company has also entered into a new memorandum of understanding with IHI,
under which it is intended that IHI will sell and service all three of the
Company's product lines in Japan. Previously the Company marketed its inspection
and repair systems directly through its subsidiary, KKPD. In the quarter ended
June 30, 1997, the Company shipped its first inspection and repair systems to
IHI. The final agreement is expected to be signed during the next six months.
See "Factors That May Affect Future Results - Relationship with IHI".
In the U.S., the Company maintains its sales and service office at its
headquarters in San Jose, California. In Asia, the Company has subsidiaries in
Tokyo, Japan and Seoul, Korea that provide direct sales and service support.
The Asian sales and service operations are staffed by direct marketing, sales
and service personnel located in Japan and Korea. In addition, in Japan the
Company's array test systems are serviced by IHI.
The Company generally sells its products on net 30-day terms to its
customers, with a small portion held back until final acceptance. However, a
substantial portion of its customers, primarily foreign, remit payments on
significantly longer terms. The Company generally warrants its products for a
period of one year from final acceptance by customers. Installation is generally
included in the price of the product. The Company's field engineers provide
customers with repair and maintenance services. Customers may enter into repair
and maintenance service contracts covering the Company's products. The Company
provides customer training for a fee to enable its customers to perform routine
service and provides telephone consultation services generally free of charge.
The Company does not consider its business to be seasonal in nature, but it may
become cyclical with respect to the capital equipment procurement practices of
major FPD manufacturers.
MANUFACTURING AND SUPPLIERS
The Company's principal manufacturing activities take place in San Jose,
California and consist primarily of assembling and testing components and
subassemblies which are acquired from third party vendors and then integrated
into Photon Dynamics' finished products. Certain of the components and
subassemblies included in the Company's systems are obtained from a single
source or a limited group of suppliers. For example, the Company has obtained
all of
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the high speed image processing systems, materials handling platforms and
ultra-high resolution cameras used in its products from single source suppliers,
including Kodak Corporation and Dover Corporation. The Company has not entered
into any formal agreements with such suppliers, other than long term purchase
orders and, in some cases, volume pricing agreements. The partial or complete
loss of such suppliers could increase the Company's manufacturing costs or delay
product shipments while the Company qualifies a new supplier, could require
redesigning the Company's products and could therefore have an adverse effect on
the Company's results of operations and damage customer relationships. Further,
a significant increase in the price of one or more of the components supplied by
such suppliers could adversely affect the Company's results of operations.
The Company schedules production based upon firm customer commitments and
anticipated orders during the planning cycle. The Company generally expects to
be able to accept a customer order, build the required machinery and ship to the
customer within 16 weeks. Quality control is maintained through incoming
inspection of components, in-process inspection during equipment assembly and
final inspection and operation of all manufactured equipment prior to shipment.
The Company works in close collaboration with its employees, customers and
suppliers and trains all of its employees in basic quality. Although the
Company conducts final testing of its systems and assembles certain components
under limited clean room conditions, most manufacturing occurs in standard
manufacturing space. Therefore the Company believes that additional
manufacturing space to respond to higher demand is readily available.
The Company has granted certain exclusive rights to IHI to manufacture
array test systems, developed prior to June 1997, for Japan, Korea and the rest
of the IHI territory. Under the terms of the Company's agreements with IHI,
Photon Dynamics retains the right to manufacture certain critical components for
the array test systems and to sell these components to IHI at prices that are
established annually, and IHI has the right to manufacture and assemble the
balance of the array test systems to be sold in its territories. To date, IHI
has allowed Photon Dynamics to manufacture all array test systems for IHI, which
has acted as a distributor in Japan and performed customization of the array
test systems for the Japanese market and its individual customers in that
market. To the extent IHI determines in the future to exercise fully its
contractual right to manufacture and sell these systems for the IHI territory,
such action would reduce revenue of the Company attributable to these IHI
manufactured array test systems and may have a material adverse effect on the
Company's results of operations. See "Factors That May Affect Future Results -
Relationship with IHI".
BACKLOG
As of September 30, 1997, the Company's backlog was approximately $12.4
million as compared to approximately $4.9 million as of September 30, 1996. In
addition, approximately 90% of the Company's backlog at fiscal 1997 year-end was
comprised of orders from three customers. The Company's backlog consists of
those customer orders for which it has accepted purchase orders and assigned
shipment dates within the next 12 months. All orders are subject to delay or
cancellation with limited or no penalty. Because of possible changes in product
delivery schedules and cancellation of product orders, because orders received
by the Company in any particular quarter may vary significantly and because the
Company's sales will often reflect orders shipped in the same quarter they are
received, the Company's backlog may vary significantly and at any particular
date is not necessarily indicative of actual sales for any succeeding period.
COMPETITION
The FPD equipment industry is highly competitive. The Company faces the
prospect of substantial future competition from established companies, some of
which are expected to be larger companies, some of which are expected to have
greater financial, engineering and manufacturing resources than the Company and
some of which are expected to have larger service organizations and long-
standing customer relationships with major FPD manufacturers. In the event that
the Company's current negotiations with IHI are not successful, IHI may compete
with the Company selling the Company's array test systems in Japan, Korea and
the rest of the IHI territory. See "Relationship with IHI". The Company also
expects it may face additional competition from new entrants into the FPD
equipment industry and from competitors utilizing new technologies. The
Company's competitors can be expected to continue to improve the design and
performance of their products and to introduce new products with competitive
price/performance characteristics. In addition, the Company's customers may
choose to develop proprietary technology and FPD equipment which may obviate or
lessen their need to purchase the Company's products. The Company's customers
may also use multiple technologies and solutions, including competitors'
products, to replicate the functionality of the Company's systems. Competitive
pressures may necessitate price reductions which could adversely affect the
Company's results of operations. Although the Company believes that it has
certain technological and other advantages over its competitors, realizing and
maintaining such advantages will require a continued high level of investment by
the Company in engineering, research and development, marketing and customer
service and support. There can be no assurance that the Company will have
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sufficient resources to continue to make such investments or that even if
sufficient funds are available, the Company will be able to make the
technological advances necessary to maintain such competitive advantages.
EMPLOYEES
As of September 30, 1997, the Company employed 112 persons, all full time.
Many of the Company's employees are highly skilled, and the Company's success
will depend in part upon its ability to retain such employees and attract new
qualified employees, who are in great demand. The Company has never had a work
stoppage or strike and no employees are represented by a labor union or covered
by a collective bargaining agreement. The Company considers its employee
relations to be good. See "Factors That May Affect Future Results - Dependence
on Key Employees".
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FACTORS THAT MAY AFFECT FUTURE RESULTS
VARIABILITY OF QUARTERLY RESULTS OF OPERATIONS; LIMITED HISTORY OF PROFITABILITY
The Company has experienced and expects to continue to experience
significant fluctuations in its quarterly results of operations. The Company
derives substantially all of its revenue from the sale of a relatively small
number of systems, which typically range in price from $400,000 to $1.5 million.
As a result, the timing of the sale of a single system could have a significant
impact on the Company's quarterly revenue and results of operations. The failure
to receive anticipated orders or delays in shipments in a particular quarter,
due, for example, to unanticipated shipment reschedulings, cancellations by
customers or unexpected manufacturing difficulties, may cause revenue for that
quarter to fall significantly below the Company's expectations, which would have
a material adverse effect on the Company's results of operations for such
quarter. The Company's backlog at the beginning of each quarter is not
necessarily indicative of actual sales for any succeeding period. All orders are
subject to delay or cancellation with limited or no penalty. The Company's sales
will often reflect orders shipped in the same quarter that they are received.
Other factors which may have an influence on the Company's results of operations
in a particular quarter include the volume, mix and timing of the receipt of
orders from major customers, competitive pricing pressures, costs of components
and subsystems, the Company's ability to design, manufacture and introduce new
products on a cost effective and timely basis, the delay between incurrence of
expenses to further develop marketing and service capabilities and realization
of benefits from such improved capabilities, fluctuations in foreign exchange
rates, the timing of recognition of revenue under development contracts, the
introduction and announcement of new products by the Company's competitors and
changing conditions in the FPD market worldwide. In particular, due to
substantial differences in gross margin for the Company's products, changes in
the mix of products sold could result in substantial fluctuations in the
Company's gross margin. Accordingly, the Company's results of operations are
subject to significant variability from quarter to quarter.
DEPENDENCE ON RECENTLY INTRODUCED AND NEW PRODUCTS
The markets for the Company's products are characterized by rapidly
changing technologies, extensive research and new product introductions. The
Company believes that its future success will depend in part upon its ability to
continue to enhance its existing products and to develop and manufacture new
products. As a result, the Company expects to continue to make a significant
investment in engineering, research and development. There can be no assurance
that the Company will be successful in the introduction, marketing and cost
effective manufacture of any of its new or recently introduced products or that
the Company will be able to develop and introduce new products or enhancements
to its existing products and processes in a timely manner which satisfy customer
needs, achieve market acceptance or address technological changes in the FPD
industry. In order to develop new products successfully, the Company is
dependent upon close relationships with its customers and the willingness of
those customers to share information with the Company. The failure to develop
products and introduce them successfully and in a timely manner could adversely
affect the Company's competitive position and results of operations. The
Company's future results of operations are highly dependent on the continuing
market introduction, marketing and cost-effective manufacture of the Company's
array test product line, of which a new version, the ArrayChecker, first shipped
in September 1997. The Company continues to perform research and development
work with respect to the array test systems to attain additional performance
specifications, including increased throughput levels and detection sensitivity.
The Company has experienced delays in the development of performance
specifications required by new and existing customers. No assurance can be given
that development efforts related to other performance parameters will be
successful. The Company believes that future orders of array test systems will
be dependent on its ability to attain requested throughput levels and other
performance parameters. The Company has experienced delays in obtaining final
acceptance and final payment on some products. If products have performance,
reliability or quality problems or shortcomings, then the Company may experience
reduced orders, higher manufacturing costs, delays in collecting accounts
receivable and additional warranty and service expenses which may have an
adverse effect on the Company's results of operations. In addition, future
growth in sales of the Company's products will depend upon the acceptance of the
Company's array test or inspection technologies by a broader group of customers.
Such Customers include additional international customers and FPD manufacturers
which currently do not perform the type of FPD array test or inspection offered
by the Company's products or which utilize alternative technologies for, or
methods of, inspection, such as "open/short" array testing and human visual
inspection. Because of the large capital commitment involved in the construction
and operation of an FPD manufacturing facility, the decision by an FPD
manufacturer to purchase the Company's array test or inspection systems involves
a significant technological and financial commitment as compared to current
alternatives such as human inspection and open/short array testers There can be
no assurance that the Company will be successful in obtaining broader acceptance
of its array test or inspection technologies. Failure to achieve broader
acceptance would have an adverse effect on the Company's results of operations.
8
<PAGE>
INTERNATIONAL OPERATIONS
Approximately 98% of the Company's total revenue for fiscal 1997 was
attributable to sales outside the U.S. The Company expects that international
sales and in particular sales to Asia will continue to represent a significant
portion of its total sales. Sales to customers outside the U.S. are subject to
risks, including the imposition of governmental controls, the need to comply
with a wide variety of foreign and U.S. export laws, political and economic
instability, trade restrictions, changes in tariffs and taxes, longer payment
cycles typically associated with international sales, and the greater difficulty
of administering business overseas as well as general economic conditions.
Although substantially all of the Company's direct international sales are
denominated in U.S. dollars, both direct sales by the Company and sales through
IHI may be affected by changes in demand resulting from fluctuations in interest
and currency exchange rates. To the extent the Company's sales are denominated
in foreign currency, the Company's revenue and results of operations may also be
directly affected by fluctuations in foreign currency exchange rates.
Furthermore, although the Company endeavors to meet technical standards
established by foreign regulatory bodies, there can be no assurance that the
Company will be able to comply with changes in foreign standards in the future.
The inability of the Company to design products to comply with foreign standards
could have a material adverse effect on the Company. In addition, the laws of
certain foreign countries may not protect the Company's intellectual property to
the same extent as do the laws of the U.S.
DEPENDENCE ON PRINCIPAL CUSTOMERS
The FPD industry is extremely concentrated, with almost all major FPD
manufacturers and many of the Company's principal customers located in Asia.
Although the composition of the Company's largest customers has changed from
year to year, direct sales to the Company's top four end user customers in
fiscal 1997 and top six in fiscal 1996 accounted for approximately 83% and 78%,
respectively, of the Company's total revenue. The Company currently has no
long-term purchase commitments with any of its customers, and sales are
generally made pursuant to purchase orders. All orders are subject to delay or
cancellation with limited or no penalty. A reduction, delay, or cancellation of
orders from one or more of its significant customers, or the loss of one or more
of such customers, could have a material adverse effect on the Company's results
of operations.
DEPENDENCE ON THE JAPANESE AND KOREAN MARKETS
The future performance of the Company will depend, in part, upon its
ability to continue to compete successfully in the Japanese and Korean markets,
the two largest markets for FPD array test, inspection and repair equipment. The
Company's ability to compete in such markets in the future is dependent upon
continuing free trade between Korea, Japan and the U.S., the continuing ability
of the Company to develop products in a timely manner that meet the technical
requirements of its Japanese and Korean customers and the continuing ability of
the Company to maintain satisfactory relationships with leading companies in the
Japanese and Korean FPD industry. The Company believes that the Japanese and
Korean companies with which it competes may have a competitive advantage in
Japan and Korea because of the preference of some customers for local equipment
suppliers because such customers may have longer standing or closer business
relationships with such competitors. The Company's sales to Japan and Korea and
results of operations will also be affected by the overall health of the
Japanese and Korean economies, including the effects of currency exchange rate
fluctuations on the global competitiveness of Japanese and Korean FPD
manufacturers. The Company believes that the current economic conditions in East
Asia and specifically Korea could have a negative impact on the Company's
results of operations if the Korean Won continues to fall against the US dollar.
This could result in lower average sales prices for the Company's products in
Korea, cancellation of orders or failure to place new orders for the Company's
equipment.
RELATIONSHIP WITH IHI
The Company has granted certain exclusive manufacturing and sales rights to
IHI with respect to its array test systems developed prior to June 1997, for
Japan, Korea, a number of other Asian countries, Saudi Arabia, Australia, New
Zealand, India and Sri Lanka (the "IHI Territory"). Under the terms of this
relationship the Company reserves the rights to manufacture certain critical
components and to sell the components to IHI for inclusion in array test systems
to be sold by IHI in its territory. The agreements between IHI and the Company
provided for the Company to assist IHI in its sales efforts in these countries
in exchange for a commission. This relationship continued on an exclusive basis
for the IHI territory until June 1997, since which IHI has had non-exclusive
manufacturing and sales rights in its territory. In exchange for these rights,
IHI has provided significant funding for development of the array test systems,
which funding substantially enhanced the Company's ability to complete
development of these systems in a timely fashion. To date, IHI has allowed
Photon Dynamics to manufacture all array test systems sold by IHI in the IHI
territory. IHI had agreed to
9
<PAGE>
allow Photon Dynamics to sell directly all array test systems outside Japan
through June 1997. Since June 1997, IHI and the Company have been operating
under a memorandum of understanding whereby IHI continues to sell array test
systems in Japan and the Company sells directly outside Japan in the IHI
territory. IHI and the Company are currently in negotiations for IHI to be the
exclusive reseller of all of the Company's products in Japan. IHI would continue
to perform all support and service for system units in Japan, while Photon would
provide support and service in the remainder of the IHI territory. There can be
no guarantee that the Company and IHI will successfully complete these
negotiations on favorable terms to the Company.
To the extent IHI determines to exercise its contractual rights to
manufacture and sell the Company's systems in the IHI territory, such action
could reduce revenue of the Company attributable to these IHI manufactured array
test systems and may have a material adverse effect on the Company's results of
operations. Given the concentration of FPD manufacturers in the IHI territory,
the Company is highly dependent on IHI and the success of the Company's
relationship with IHI to market and sell the array test systems in these
critical markets. In the event IHI should determine to reduce its internal
budgets, staffing levels, research and development funding or other allocations
of its resources for the development, manufacture, sale and support of array
test systems in Japan, such action by IHI could have a material adverse effect
on the Company's ability to compete in this market and on the Company's results
of operations. While the Company believes that both it and IHI have obtained
significant mutual benefit from their continuing relationship, no assurance can
be given that the IHI relationship will continue to provide such benefits to the
Company or that the Company's results of operations will not be adversely
impacted in the future based on its dependency on IHI for the sales and support
of array test systems in Japan.
DEPENDENCE ON SINGLE OR LIMITED SUPPLIERS
Certain of the components and subassemblies included in the Company's
systems are obtained from a single source or a limited group of suppliers. For
example, the Company has obtained all of the high speed image processing
systems, materials handling platforms and ultra-high resolution cameras used in
its products from single source suppliers, including Kodak Corporation and Dover
Corporation. The Company has not entered into any formal agreements with such
suppliers, other than long term purchase orders and, in some cases, volume
pricing agreements. The partial or complete loss of such suppliers could
increase the Company's manufacturing costs or delay product shipments while the
Company qualifies a new supplier, could require redesigning the Company's
products and could therefore have an adverse effect on the Company's results of
operations and damage customer relationships. Further, a significant increase in
the price of one or more of the components supplied by such suppliers could
adversely affect the Company's results of operations.
10
<PAGE>
RAPID AND FUNDAMENTAL TECHNOLOGICAL CHANGE
The FPD industry is an evolving industry characterized by extensive
research and development which has and is expected to continue to lead to rapid
technological change. The development by others of new or improved products or
technologies may make the Company's current or proposed products obsolete or
less competitive. Although the Company devotes significant efforts and
financial resources to further develop and enhance its existing products, there
can be no assurance that advances in other or alternative technologies will not
make the Company's products obsolete or less competitive. Currently, the
predominant technology used in the FPD industry is LCD technology. Although the
Company has installed its products or has entered into discussions with
manufacturers utilizing virtually all of the alternative FPD technologies which
the Company believes are commercially viable FPD technologies, its revenue is
derived primarily from sales of products related to a variant of LCD technology
used in a substantial portion of all FPDs, AMLCD technology. An industry shift
away from AMLCD technology or the emergence of new competing technologies could
have a material adverse effect on the Company's business and results of
operations.
COMPETITION
The FPD equipment industry is highly competitive. The Company faces the
prospect of substantial future competition from established companies, some of
which are expected to be larger companies, some of which are expected to have
greater financial, engineering and manufacturing resources than the Company and
some of which are expected to have larger service organizations and long-
standing customer relationships with major FPD manufacturers. In the event that
the Company's current negotiations with IHI are not successful, IHI may compete
with the Company selling the Company's array test systems in Japan, Korea and
the rest of the IHI territory. See "Relationship with IHI". The Company also
expects it may face additional competition from new entrants into the FPD
equipment industry and from competitors utilizing new technologies. The
Company's competitors can be expected to continue to improve the design and
performance of their products and to introduce new products with competitive
price/performance characteristics. In addition, the Company's customers may
choose to develop proprietary technology and FPD equipment which may obviate or
lessen their need to purchase the Company's products. The Company's customers
may also use multiple technologies and solutions, including competitors'
products, to replicate the functionality of the Company's systems. Competitive
pressures may necessitate price reductions which could adversely affect the
Company's results of operations. Although the Company believes that it has
certain technological and other advantages over its competitors, realizing and
maintaining such advantages will require a continued high level of investment by
the Company in engineering, research and development, marketing and customer
service and support. There can be no assurance that the Company will have
sufficient resources to continue to make such investments or that even if
sufficient funds are available, the Company will be able to make the
technological advances necessary to maintain such competitive advantages.
FLAT PANEL DISPLAY INDUSTRY DOWNTURNS OR SLOWDOWNS
The Company's business depends in large part upon the capital equipment
expenditures of FPD manufacturers, which in turn depend on the current and
anticipated market demand for FPDs and products utilizing FPDs. For example,
the Company believes that historical shortages of supplies of semiconductor
components may have temporarily limited the quantities of laptop computers that
were manufactured, which in turn may have reduced demand from laptop computer
manufacturers for certain FPDs. If these conditions had continued for an
extended period, the resulting reduced long-term demand for FPDs suitable for
laptop computers could have affected adversely the level of capital expenditure
by FPD manufacturers. The FPD industry may, like the semiconductor industry,
become highly cyclical and experience periodic downturns or slowdowns in growth,
which may have a material adverse effect on capital equipment expenditures by
FPD manufacturers and in turn adversely affect the Company's results of
operations. No assurance can be given that the Company's results of operations
would not be adversely affected if such downturns or slowdowns in the FPD
industry were to occur in the future. In addition, the need for continued
investment in engineering, research and development and marketing required to
penetrate targeted foreign markets and maintenance of extensive worldwide
customer service and support capabilities will limit the Company's ability to
reduce expenses during downturns or slowdowns in growth in the FPD industry.
PATENTS AND PROPRIETARY RIGHTS
The Company's future success and competitive position are dependent in part
upon its proprietary technology, and the Company relies on patent, trade secret,
trademark and copyright law to protect its intellectual property. There can be
no assurance that any patent owned or licensed by the Company will not be
invalidated, circumvented, challenged or licensed
11
<PAGE>
to others, that the rights granted thereunder will provide competitive
advantages to the Company or that any of the Company's pending or future patent
applications will be issued with the scope of the claims sought by the Company,
if at all. Furthermore, there can be no assurance that others will not develop
technologies that are similar or superior to the Company's technology, duplicate
the Company's technology or design around the patents owned by the Company. In
addition, effective copyright and trade secret protection may be unavailable or
limited in certain foreign countries. There can be no assurance that the steps
taken by the Company will prevent misappropriation of its technology. In
addition, litigation may be necessary in the future to enforce the Company's
patents and other intellectual property rights, to protect the Company's trade
secrets, to determine the validity and scope of the proprietary rights of others
or to defend against claims of infringement or invalidity. Such litigation could
result in substantial costs and diversion of resources and could have a material
adverse effect on the Company's results of operations.
Competitors in both the U.S. and foreign countries, many of which have
substantially greater resources and have made substantial investments in
competing technologies, may have applied for or obtained, or may in the future
apply for and obtain, patents that will prevent, limit or interfere with the
Company's ability to manufacture and sell its products. The Company has not
conducted an independent review of patents issued to third parties. There can be
no assurance that other third parties will not assert infringement claims
against the Company or that such claims will not be successful. Even successful
defense of patent suits are both costly and time-consuming. An adverse outcome
in the defense of a patent suit could subject the Company to significant
liabilities to third parties, require disputed rights to be licensed from third
parties or require the Company to cease selling its products.
DEPENDENCE ON KEY EMPLOYEES
The future success of the Company is dependent, in part, on its ability to
retain certain key personnel. The Company also needs to attract additional
skilled personnel in all areas of its business to continue to grow. While many
of the Company's current employees have many years of service with the Company,
there can be no assurance that the Company will be able to retain its existing
personnel or attract additional qualified employees in the future.
POSSIBLE VOLATILITY OF COMMON STOCK PRICE
Many factors such as, but not limited to, announcements of technological
innovations or new products by the Company, its competitors or third parties, as
well as quarterly variations in the Company's actual or anticipated results of
operations, may cause the market price of the Company's Common Stock to
fluctuate significantly. Furthermore, the stock market has experienced extreme
price and volume fluctuations, which have particularly affected the market
prices of many high technology companies and which have often been unrelated to
the operating performance of such companies. These broad market fluctuations
may adversely affect the market price of the Company's Common Stock.
ITEM 2: DESCRIPTION OF PROPERTY.
The Company's main headquarters, located in San Jose, California consists
of a 50,000 square foot facility. The current monthly base rental under the
lease for the facility is approximately $49,000. The lease expires in 2002. The
Company also leases office space for its sales and service operations in Seoul,
Korea and Tokyo, Japan.
ITEM 3: LEGAL PROCEEDINGS.
The Company is not a party to any material litigation.
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
No matters were submitted to a vote of security holders during the quarter
ended September 30, 1997.
12
<PAGE>
PART II
ITEM 5: MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The information required by this Item is incorporated by reference from
page 22 to 23 of the Company's 1997 Annual Report to Shareholders.
ITEM 6: MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION.
The information required by this Item is incorporated by reference from
pages 8 to 11 of the Company's 1997 Annual Report to Shareholders.
ITEM 7: FINANCIAL STATEMENTS.
The information required by this Item is incorporated by reference from
pages 12 to 21 of the Company's 1997 Annual Report to Shareholders.
ITEM 8: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
Not applicable
13
<PAGE>
PART III
Certain information required by Part III is omitted from this Report in
that the Registrant will file a definitive proxy statement within 120 days after
the end of its fiscal year pursuant to Regulation 14A (the "Proxy Statement")
for its 1998 Annual Meeting of Stockholders to be held January 27, 1998 and the
information included therein is incorporated herein by reference.
ITEM 9: DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE
WITH SECTION 16(a) OF THE EXCHANGE ACT.
With the exception of the table below, the information required by this
Item is incorporated by reference from the Company's Proxy Statement for the
1998 Annual Meeting of Stockholders.
The following table sets forth certain information concerning the executive
officers of the Company.
<TABLE>
<CAPTION>
NAME AGE POSITION(S)
<S> <C> <C>
Howard Bailey 51 Chief Financial Officer, Secretary
Jeffrey Hawthorne 40 Vice President, Development
Alan Nolet 40 Senior Vice President, Sales
Donald Jerome 60 Vice President, Operations
Carl Merrill 37 Vice President, Sales and Marketing
Dr. William Pratt 60 Chief Technical Officer - Software
</TABLE>
MR. BAILEY joined the Company in May 1994 as a consultant and was
appointed to the position of Chief Financial Officer and Secretary in August
1994. From 1992 to 1994, Mr. Bailey was a partner in the Financial Services
Division of David Powell, Inc., where he provided high-level financial support
services for such companies as Sierra Semiconductor, Syquest, WSI, Alien Sport
and Cubic Memory. In connection with the filing by Alameda of a petition under
Title 11 of the United States Code in April 1993, Mr. Bailey, who was employed
by David Powell, Inc. as a consultant to Alameda was appointed Chief Financial
Officer and debtor in possession of Alameda. From 1989 to 1991, Mr. Bailey was
the Chief Financial Officer at Plus Logic Corporation (currently part of
Xilinx). Mr. Bailey has held various other financial management positions
including Chief Financial Officer at Telmos, Controller at Intel and Financial
Planning Manager at SP Communications (currently Sprint). Mr. Bailey received a
B.S. in economics from the University of Maryland in 1969 and an M.B.A. in
finance from the University of Utah in 1974.
MR. HAWTHORNE joined the Company in November 1991 as Senior
Applications Engineer, FIS Products. He was promoted to Project Manager FIS
Products and then General Manager and Vice President Inspection Division in
August 1992 and in September 1994, respectively. From June 1990 to November
1991, he was a consultant with Display Tech, which provided consulting services
in the area of liquid crystal displays. He received a B.S. in engineering
physics from the University of Colorado in 1987 and an M.S. in optical
engineering from the University of Rochester in 1990.
MR. NOLET became the Senior Vice President, Sales in May 1996. He
joined the Company in September 1992 as Vice President of Sales and Marketing
Communications and was appointed Vice President of U.S. Sales and then Vice
President Worldwide Sales in May 1993 and June 1994, respectively. From 1987 to
1992, Mr. Nolet was a Vice President responsible for worldwide sales, field
operations, service and marketing at LAM Research Corporation. He currently
serves on the Executive Committee for SEMI's FPD Division. Mr. Nolet received a
B.S. in chemical engineering from Clarkson University in 1978. Effective
September 21, 1997 Alan Nolet resigned his position at the Company.
MR. JEROME joined the Company in June 1995 as Vice President,
Manufacturing. From April 1995 to June 1995, Mr. Jerome was a consultant with
Bell Microproducts. From May 1994 to April 1995, Mr. Jerome was Director of
Manufacturing at Creative Insight, Inc. From July 1992 to April 1994, he was
Director of Materials at Pacific Pay Video, Ltd. From March 1989 to July 1992,
he was Director of Materials at Plus Logic Corporation. Mr. Jerome received an
A.A. from Foothill College in 1967 and an M.A. from CSU San Francisco in 1973.
Effective October 1, 1997 Mr. Jerome became Director of Materials and is no
longer considered an officer of the Company.
MR. MEURELL joined the Company in May of 1996. From April 1995 to May
1996, he served as a director of Teradyne's Low Cost Logic Tester Line for the
Megatest division of Teradyne. From October 1993 to April 1995, Mr.
14
<PAGE>
Meurell was with Catapult Software Training Centers, an IBM company, for which
he served as General Manager in the New York Metropolitan region. From December
1980 to October 1993, he held various sales management positions at the Megatest
Corporation. Mr. Meurell received a B.S. in electrical engineering from the
University of Massachusetts and an M.B.A. degree from Union College.
DR. PRATT joined the Company in October 1996 as Chief Technical
Officer for Software. From 1988 through 1994 he was Director of Multimedia and
Imaging Technology at Sun Microsystems, Inc. In 1993, he founded Pixelsoft,
Inc., a start-up image processing software development company. Dr. Pratt
received a B.S. degree in electrical engineering from Bradley University and an
M.S. and a Ph.D. in electrical engineering the University of Southern
California. Dr. Pratt holds five patents and is the author of several books on
image processing.
ITEM 10: EXECUTIVE COMPENSATION.
The information required by this Item is incorporated by reference from the
Company's Proxy Statement for the 1998 Annual Meeting of Stockholders under the
heading "Management"
ITEM 11: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required by this Item is incorporated by reference from the
Company's Proxy Statement for the 1998 Annual Meeting of Stockholders under the
heading "Security Ownership Of Certain Beneficial Owners And Management"
ITEM 12: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by this Item is incorporated by reference from the
Company's Proxy Statement for the 1998 Annual Meeting of Stockholders under the
heading "Certain Relationships And Related Transactions"
ITEM 13: EXHIBITS AND REPORTS ON FORM 8-K.
(a) The following documents are filed as part of this Form 10-KSB Report:
(1) Financial Statements
(2) Exhibits: See Index to Exhibits. The Exhibits listed in the
accompanying Index to Exhibits are incorporated by reference as part of this
report.
(b) Reports on Form 8-K. No reports on Form 8-K were filed during the
quarter ended September 30, 1997.
15
<PAGE>
SIGNATURES
In accordance with Section 13 or 15(d) of the Securities and Exchange Act of
1932 as amended (the "Exchange Act"), the registrant caused this report to be
signed on its behalf by the undersigned, thereunto duly authorized.
<TABLE>
<CAPTION>
<S> <C>
PHOTON DYNAMICS, INC.
Date: December 24, 1997 /s/ VINCENT SOLLITTO
--------------------------------
Vincent Sollitto
Chief Executive Officer and Director
(Principal Executive Officer)
</TABLE>
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Vincent F. Sollitto Jr. and Howard M.
Bailey, and each of them, acting individually, as his or her attorney-in-fact,
each with full power of substitution and resubstitution, for him and in his
name, place and stead, in any and all capacities, to sign any and all amendments
to this Annual Report on Form 10-KSB, and to file the same, with all exhibits
thereto, and other documents in connection therewith, with the Securities and
Exchange Commission, granting unto said attorneys-in-fact and agents, and each
of them, full power and authority to do and perform each and every act and thing
requisite and necessary to be done in connection therewith and about the
premises, as fully to all intents and purposes as he might or could do in
person, hereby ratifying and confirming all that said attorneys-in-fact and
agents, or any of them, or their or his substitute or substitutes, may lawfully
do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Act of 1933, this
Annual Report on Form 10-KSB has been signed by the following persons in the
capacities and on the dates indicated:
<TABLE>
<CAPTION>
<S> <C> <C>
December 24, 1997 Chief Executive Officer and Director /s/ VINCENT SOLLITTO
(Principal Executive Officer) ----------------------------------
Vincent Sollitto
December 24, 1997 Chief Financial Officer and Secretary
(Principal Financial and Accounting /s/ HOWARD BAILEY
Officer) ----------------------------------
Howard Bailey
/s/ E. FLOYD KVAMME
December 24, 1997 Chairman of the Board ----------------------------------
E. Floyd Kvamme
/s/ FRANCOIS HENLEY
December 24, 1997 Director ----------------------------------
Francois Henley
/s/ BARRY COX
December 24, 1997 Director ----------------------------------
Barry Cox
/s/ MICHAEL KIM
December 24, 1997 Director ----------------------------------
Michael Kim
/s/ DR. MALCOLM J. THOMPSON
December 24, 1997 Director ----------------------------------
Dr. Malcolm J. Thompson
/s/ STEVE KRAUSZ
December 24, 1997 Director ----------------------------------
Steve Krausz
</TABLE>
16
<PAGE>
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
NUMBER EXHIBIT REFERENCE
- ---------------- ----------------------------- ---------------
<C> <S> <C>
3.1 Form of Amended and Restated Articles of Incorporation of the Registrant. A
3.2 Bylaws of the Registrant and amendments thereto. A
4.1 Reference is made to Exhibits 3.1 and 3.2. A
10.1 First Amended and Restated Investor Rights Agreement between Registrant and the A
shareholders set forth therein dated May 11, 1994.
l0.2 Fourth Amended Shareholders Agreement for Photon Dynamics, Inc. between the A
Registrant and the shareholders set forth therein dated May 11, 1994.
10.3 Form of Indemnification Agreement between the Registrant and each of its executive A
officers and directors.
10.4 1987 Stock Option Plan and Form of Stock Option Agreement. A,B
10.5 1995 Stock Option Plan and Forms of Stock Option Agreements. A,B
10.6 1995 Employee Stock Purchase Plan. A,B
10.7 Lease agreement between Berg & Berg Developers and Photon Dynamics, Inc. dated C
August 6, 1996.
10.8 Sales Agent Agreement between the Registrant, K.K. Photon Dynamics and A
Ishikawajima-Harima Heavy Industries Co., Ltd. dated June 1, 1992, the amendment
thereto dated November 17, 1993 and the modification agreement related thereto dated
January 1, 1995.
10.9 License Agreement between the Registrant and Ishikawajima-Harima Heavy Industries A
Co., Ltd. dated June 1, 1992 and the addendum thereto dated November 11, 1993.
10.10 Commercialization Agreement between the Registrant and Ishikawajima-Harima Heavy A
Industries Co., Ltd. dated June 1, 1992 and the amendment thereto dated November 17,
1993.
10.13 Form of Amendment to First Amended and Restated Investor Rights Agreement. A
10.14 Agreement Regarding Change of Control between the Registrant and Vincent Sollitto C
dated July 1, 1996.
11.1 Statement re: computation of earnings per share.
13.1 Registrants Annual Report to Shareholders for the year ended September 30, 1997 (only
such portions as necessary to satisfy Form 10-KSB requirements).
21.1 Subsidiaries of the Registrant.
23.1 Consent of Ernst & Young LLP, Independent Auditors
27.1 Financial Data Schedule
Key to Exhibits:
(A) Incorporated by reference to Registrants' Registration Statement on Form SB-2 filed with the Securities
and Exchange Commission on November 15, 1995
(B) Management contract or compensatory plan or arrangements required to be filed as an exhibit to this report
on Form 10-KSB pursuant to Item 13(a) of this report.
(C) Filed as the same exhibit number as set forth herein to Registrant's Form 10-KSB for the year ended
September 30, 1996
</TABLE>
<PAGE>
EXHIBIT 11.1
PHOTON DYNAMICS, INC.
STATEMENT RE COMPUTATION OF EARNINGS PER SHARE
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Primary and Fully Diluted Earnings Per Share
- --------------------------------------------
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
------------------------
1997 1996
------- ------
<S> <C> <C>
Net income (loss) $(2,481) $ 854
Computation of weighted average common and common
equivalent shares outstanding:
Common stock 7,049 6,548
Options and warrants - 839
------- ------
Total weighted average common and common equivalent
shares outstanding 7,049 7,387
------- ------
Net income (loss) per share $ (0.35) $ 0.12
======= ======
</TABLE>
<PAGE>
EXHIBIT 13.1
The Board of Directors
Photon Dynamics, Inc.
We have audited the accompanying consolidated balance sheets of Photon Dynamics,
Inc. as of September 30, 1997 and 1996, and the related consolidated statements
of operations, shareholders' equity, and cash flows for the years then ended.
These consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Photon
Dynamics, Inc. as of September 30, 1997 and 1996, and the consolidated results
of its operations and its cash flows for the years then ended in conformity with
generally accepted accounting principles.
San Jose, California
October 24, 1997
<PAGE>
SELECTED CONSOLIDATED FINANCIAL DATA
<TABLE>
<CAPTION>
YEARS ENDED SEPTEMBER 30,
-----------------------------
(IN THOUSANDS EXCEPT PER SHARE DATA) 1997 1996 1995 1994 1993
-------- ------- ------- -------- --------
<S> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENT OF OPERATIONS
Revenue $24,507 $24,763 $18,447 $10,587 $10,312
Gross margin 10,718 11,507 6,756 3,902 3,066
Operating income (loss) (2,695) 563 710 (2,048) (3,109)
Net income (loss) $(2,481) $ 854 $ 377 $(2,105) $(3,070)
Net income (loss) per share (pro forma for $ (0.35) $ 0.12 $ 0.07
1995)
Shares used in computing net
income (loss) per share 7,049 7,387 5,425
SEPTEMBER 30,
------------
1997 1996 1995 1994 1993
------- ------- ------- ------- -------
(IN THOUSANDS)
CONSOLIDATED BALANCE SHEET DATA
Working capital (deficit) $14,769 $17,290 $ 709 $ 408 $ (857)
Total assets 23,203 24,958 10,519 6,567 4,948
Total shareholders' equity 17,762 19,770 1,857 1,435 132
UNAUDITED QUARTERLY CONSOLIDATED FINANCIAL DATA
<CAPTION>
(In thousands) FISCAL QUARTERS ENDED,
DECEMBER 31, 1996 MARCH 31, 1997 JUNE 30, 1997 SEPTEMBER 30, 1997
<S> <C> <C> <C> <C>
Revenue (2) $6,246 $5,085 $6,821 $ 6,355
Gross margin 3,073 2,271 3,366 2,008
Net income (loss) 52 (973) 27 (1,587)
<CAPTION>
(In thousands) FISCAL QUARTERS ENDED,
DECEMBER 31, 1995 MARCH 31, 1996 JUNE 30, 1996 SEPTEMBER 30, 1996
<S> <C> <C> <C> <C>
Revenue $6,205 $6,308 $7,709 $ 4,541
Gross margin 2,804 2,975 3,599 2,129
Net income (loss) (1) 563 751 825 (1,285)
</TABLE>
(1)Net loss for the fourth quarter of fiscal 1996 includes a $844,000 charge for
the write down of assets related to a product line disposal, see Note 3 to the
consolidated financial statements.
(2) Revenue in the first quarter of fiscal 1997 includes a $1 million initial
fee paid by a Korean company to be the exclusive value added reseller of the
Company's inspection products in Korea.
<PAGE>
Management's Discussion & Analysis of Results of Operations and Financial
Conditions
The following table sets forth certain operating data as a percentage of total
revenue.
<TABLE>
<CAPTION>
Years Ended
September 30,
-----------------
1997 1996
------ ------
<S> <C> <C>
Revenue
Product sales 94.5% 94.4%
Non product 5.5 5.6
----------------
100.0 100.0
----------------
Cost of revenue
Product sales 56.3 49.6
Non product 0.0 3.9
----------------
56.3 53.5
----------------
Gross margin 43.7 46.5
----------------
Operating expenses
Research and development 31.7 16.1
Selling, general and administrative 23.0 24.7
Asset write-off related to product line disposal 0.0 3.4
----------------
Total operating expenses 54.7 44.2
Operating income (loss) (11.0) 2.3
Other income, net 1.0 1.3
----------------
Income (loss) before provision for income taxes (10.0) 3.6
Provision for income taxes 0.1 0.2
Net income (loss) (10.1)% 3.4%
================
</TABLE>
This Annual Report contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. To the extent that this annual report discusses financial
projections, information or expectations about products or markets of Photon
Dynamics, Inc. all such forward-looking statements are based on information
available to the Company on the date hereof, and the Company assumes no
obligation to update any such forward-looking statements. It is important to
note that the Company's actual results could differ materially from those in
such forward-looking statements. The Company's results will be affected,
particularly when measured on a quarterly basis, by the volume, composition and
timing of orders for capital equipment by FPD manufacturers. Other
uncertainties include, acceptance of new products, timing of orders received,
costs associated with new product introductions and managing growth, as well as
the factors discussed in "Other Factors Affecting Company Results" below. For a
further discussion of the Company's business, please refer to the Company's 1997
Annual Report on Form 10-KSB.
Overview
Photon Dynamics develops, manufactures and markets on a worldwide basis a suite
of products to inspect virtually all types of FPDs and to address all key areas
of AMLCD test, inspection and repair throughout all major stages of the
manufacturing life cycle, from research and development through commercial
production.
Photon dynamics' revenue is obtained primarily through a direct sales force, and
to a lesser extent, value added resellers in Japan and Korea. During fiscal
1997, the Company entered into an agreement with a Korean company to be the
exclusive value added reseller of the Company's inspection products in Korea.
The Company has also entered into a new memorandum of understanding with IHI,
under which it is intended that IHI will sell and service all three of the
Company's product lines in Japan. Previously the Company marketed its
inspection and repair systems directly through its subsidiary, KKPD. In the
quarter ended June 30, 1997 the Company shipped its first inspection and repair
systems to IHI. The Company is in the process of negotiating the final
agreement with IHI.
<PAGE>
The Company derives substantially all of its revenue from international sales in
Asia, primarily Japan and Korea, where the majority of volume flat panel
production currently resides. At present all sales to Korea whether direct or
to value added resellers are made in US dollars. Sales to IHI of the Company's
test systems are made in US dollars. Sales of inspection and repair systems
made directly through the Company's Japanese subsidiary are made in Yen.
The Company's revenue is derived primarily from the sale of products. The
Company does not expect that service revenue for continuing maintenance of its
products will be a significant part of its revenue in the near term.
Results of Operations
Revenue. Revenue decreased 1% from $24.8 million in fiscal 1996 to $24.5
million in fiscal 1997. Revenue from product sales decreased by $0.2 million
from $23.4 million to $23.2 million over the same period. Revenue, although
essentially flat year on year, was below the Company's expectations. The
Company is in the process of announcing and shipping new products which have
significant improvements in throughput and testing specifications over our
current generation of products, decreasing demand for the Company's existing
systems. The Company experienced delays in shipping some of these new products
in the fourth quarter of fiscal 1997. Because the Company derives substantially
all of its revenue from the sale of a relatively small number of systems, which
typically range in price from $400,000 to $1.5 million, the timing of the sale
of a single system could have and has had a significant impact on the Company's
revenue in any particular period.
International sales accounted for $24.0 million and $21.6 million of revenue in
fiscal 1997 and 1996, respectively. Sales to Japan decreased to $7.2 million in
fiscal 1997 from $9.3 million in fiscal 1996, and sales in Korea increased to
$14.7 million in fiscal 1997 from $10.6 million in fiscal 1996.
Gross Margin. Gross margin as a percent of revenue decreased to 43.7% in fiscal
1997 from 46.5% in 1996. The gross margin for product sales decreased to 40.5%
in fiscal 1997 from 47.4% in fiscal 1996. The decrease was the result of a less
favorable product mix year to year as well as an investment by the Company in
customer service. Overall product gross margins will fluctuate on a quarterly
basis as the Company's product mix fluctuates. The decrease in product gross
margins was offset by an increase in non product gross margins due to a $1
million initial fee paid by a Korean company to be the exclusive value added
reseller of the Company's inspection products in Korea.
Research and Development. The Company increased its research and development
expenses to $7.8 million in fiscal 1997, or 31.7% of revenue, from $4.0 million
in fiscal 1996, or 16.1% of revenue. The increase in research and development
spending primarily reflects the increased costs of hiring and retaining
experienced engineers to increase the level of new product development. The
Company has identified and announced a number of product enhancements that it
believes will improve its ability to sell to volume production environments. As
a result, the Company increased its level of research and development spending
and does not expect this level to decline significantly on an absolute dollar
basis in fiscal 1998.
Selling, General and Administrative. Selling, general and administrative
expenses decreased to $5.6 million, or 23% of revenue, in fiscal 1997 from $6.1
million, or 24.7% of revenue, in fiscal 1996. In fiscal 1997, the Company
established a Korean subsidiary and terminated an agreement with a
representative, who had previously sold all products in Korea. This resulted in
a net decrease in selling expenses related to Korea. Selling, general and
administrative expenses may increase in absolute dollar amounts in fiscal 1998
and in future periods depending on various factors, including the level of the
Company's revenue and other operations. Selling expenses may also fluctuate
based on the Company's product and territory sales mix, which have different
sales channels and associated cost structures.
In September, 1996 the Company ceased operations of its Defect Monitoring Tool
(DMT) product line. The DMT product group worked exclusively on a single
customer project not in the flat panel market. As a result of the cancellation
of this project, the associated inventory and assets of this product line which
were not transferred to other products were disposed of. The Company recorded a
$844,000 charge to write down the inventory and assets associated with the
product line in fiscal 1996.
Interest income/expense. Interest income in fiscal 1997 decreased to $348,000
from $646,000 in fiscal 1996 as a result of reduced cash and investment
balances. Interest expense and other consists of interest expense and foreign
exchange gains and losses.
Provision for Income Taxes. Provisions for income taxes in fiscal 1996 were
minimal due to the utilization of loss carryforwards and in fiscal 1997 as a
result of the Company's operating loss. As of September 30, 1997 the Company
had available federal and state net operating loss carryforwards of
approximately $14.2 million and $3.6 million, respectively. The Company also
had federal and state research and development tax credit carryforwards of
approximately $1.2 million and $0.5 million, respectively.
<PAGE>
The net operating loss and credit carryforwards will expire at various times
beginning in 1999 through 2012 if not utilized. As of September 30, 1997, the
Company had deferred tax assets of approximately $9.2 million, for which no
benefit has been recorded on the Company's financial statements, and which
consist primarily of net operating loss and research and development tax credit
carryforwards. This deferred tax asset will be recognized in future periods as
taxable income is realized and consistent profits are reported.
Liquidity and Capital Resources
Cash used by operating activities was $3.2 million for fiscal 1997. Working
capital items that significantly impacted cash balances were accounts receivable
and inventory. The Company's accounts receivable balance increased $1.1 million
to $9.8 million. The factors affecting the accounts receivable balance include,
the Company's credit terms to customers, which typically have a small portion of
the payment extended for a period of months after shipment, resulting in a
larger accounts receivable balance. Inventory levels increased $1.0 million,
reflecting an increase in finished goods of new and existing products.
Capital expenditures in fiscal 1997 and fiscal 1996 were $1.6 million and $1.2
million, respectively. The increase was the result of the Company's relocation
to a new facility in the first quarter of fiscal 1997 and the related spending
on leasehold improvements.
The Company has a $7.5 million line of credit financing from Bank of the West
which expires in May 1998. No amounts were outstanding as of September 30,
1997. Borrowings under this line of credit bear interest at the prime rate.
This line of credit is secured by substantially all of the Company's assets and
contains certain financial and other covenants. As of September 30, 1997, the
Company was in default of certain of these financial covenants and as a result
the line is no longer available to the Company. As of September 30, 1997, the
Company had no material outstanding commitments to purchase or lease capital
equipment. In December 1997, the Company obtained a new line of credit financing
from Imperial Bank for $5 million, expiring in December 1998 and bearing
interest at the prime rate.
The Company believes that cash and cash equivalents and income from operations
will be sufficient to satisfy working capital requirements for the next 12
months.
The Company believes that success in its industry requires substantial capital
in order to maintain the flexibility to take advantage of opportunities as they
may arise. The Company may, from time to time, invest in or acquire
complementary businesses, products or technologies. The Company may effect
additional equity or debt financing to fund such activities. The sale of
additional equity or convertible debt could result in additional dilution to the
Company's shareholders.
Other Factors Affecting Company Results
The Company has experienced, see unaudited quarterly consolidated financial data
(page 7), and expects to continue to experience significant fluctuations in its
quarterly results of operations. The Company derives substantially all of its
revenue from the sale of a relatively small number of systems, which typically
range in price from $400,000 to $1.5 million. As a result, the timing of the
sale of a single system could have a significant impact on the Company's
quarterly revenue and results of operations. The failure to receive anticipated
orders or delays in shipments in a particular quarter, due, for example, to
unanticipated shipment reschedulings or cancellations by customers or unexpected
manufacturing difficulties, may cause revenue for that quarter to fall
significantly below the Company's expectations, which would have a material
adverse effect on the Company's results of operations for such quarter. The
Company's backlog at the beginning of each quarter is not necessarily indicative
of actual sales for any succeeding period. All orders are subject to delay or
cancellation with limited or no penalty. The Company's sales will often reflect
orders shipped in the same quarter that they are received. Other factors which
may have an influence on the Company's results of operations in a particular
quarter include the volume, mix and timing of the receipt of orders from major
customers, competitive pricing pressures, costs of components and subsystems,
the Company's ability to design, manufacture and introduce new products on a
cost effective and timely basis, the delay between incurrence of expenses to
further develop marketing and service capabilities and realization of benefits
from such improved capabilities, fluctuations in foreign exchange rates, the
timing of recognition of revenue under development contracts, the introduction
and announcement of new products by the Company's competitors and changing
conditions in the FPD market worldwide. In particular, due to substantial
differences in gross margin for the Company's products, changes in the mix of
products sold could result in substantial fluctuations in the Company's gross
margin. Accordingly, the Company's results of operations are subject to
significant variability from quarter to quarter. The Company believes that the
current economic conditions in East Asia and specifically Korea could have a
negative impact on the Company's results of operations if the Korean Won
continues to fall against the U.S. dollar. This could result in lower average
sales prices for the Company's products in Korea, cancellation of orders or
failure to place new orders for the Company's equipment. For a further
discussion of the Company's business, please refer to the Company's 1997 Annual
Report on Form 10-KSB.
<PAGE>
Photon Dynamics, Inc.
Consolidated Balance Sheets
(In thousands, except share amounts)
<TABLE>
<CAPTION>
September 30,
-----------------------------
1997 1996
Assets -------- --------
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 4,831 $ 5,108
Short term investments - 4,066
Accounts receivable, net of allowance for doubtful accounts
of $951 ($629 in 1996); including $3,093 receivable from related parties
($1,220 in 1996) 9,785 8,652
Inventories 5,076 4,125
Prepaid expenses and other current assets 512 518
------- -------
Total current assets 20,204 22,469
Property, equipment, and leasehold improvements, net 2,226 $ 2,743
Other assets 773 640
------- -------
Total assets $23,203 $24,958
======= =======
Liabilities and shareholders' equity
Current liabilities:
Accounts payable $ 2,666 $ 2,743
Accrued expenses and other liabilities 2,489 2,067
Customer deposits and deferred revenue 276 353
Current portion of long-term debt 4 16
------- -------
Total current liabilities 5,435 5,179
Noncurrent portion of long-term debt 6 9
Commitments and contingencies
Shareholders' equity:
Preferred stock, no par value, 5,000,000 shares authorized, none issued and
outstanding - -
Common stock, no par value, 20,000,000 shares authorized, 7,147,714 and
6,888,032 shares issued and outstanding 38,573 38,064
Accumulated deficit (20,682) (18,201)
Foreign currency translation adjustment and other (14) (7)
Notes receivable from shareholders (115) (86)
------- -------
Total shareholders' equity 17,762 19,770
------- -------
Total liabilities and shareholders' equity $23,203 $24,958
======= =======
</TABLE>
<PAGE>
Photon Dynamics, Inc.
Consolidated Statements of Operations
(In thousands, except per share amounts)
<TABLE>
<CAPTION>
YEARS ENDED SEPTEMBER 30,
------------------------------------
1997 1996
-------- -------
<S> <C> <C>
Revenue:
Product revenue $23,157 $23,381
Non product revenue 1,350 1,382
-------- -------
24,507 24,763
Cost of revenue:
Product revenue 13,789 12,294
Non product revenue - 962
-------- -------
13,789 13,256
-------- -------
Gross margin 10,718 11,507
Operating expenses:
Research and development 7,776 3,982
Selling, general, and administrative 5,637 6,118
Asset write-off related to product
line disposal - 844
Total operating expenses -------- -------
13,413 10,944
Operating income (loss) -------- -------
(2,695) 563
Interest income
Interest expense and other 348 646
(114) (316)
Income (loss) before provision for -------- -------
income taxes
(2,461) 893
Provision for income taxes
20 39
Net income (loss) -------- -------
$(2,481) $ 854
======== =======
Net income (loss) per share
Shares used in computing net income $(0.35) $ 0.12
(loss) per share
7,049 7,387
See accompanying notes to consolidated financial statements
</TABLE>
<PAGE>
Photon Dynamics, Inc.
Consolidated Statements of Cash Flows
(In thousands)
<TABLE>
<CAPTION>
YEARS ENDED SEPTEMBER 30,
-----------------------------
1997 1996
-------- --------
<S> <C> <C>
OPERATING ACTIVITIES
Net income (loss) $(2,481) $ 854
Adjustments to reconcile net income to net cash used in operating
activities:
Depreciation and amortization 1,186 723
Changes in operating assets and liabilities:
Accounts receivable (1,133) (3,372)
Inventories (951) (1,139)
Prepaid expenses and other current assets 6 (299)
Other assets (140) (418)
Accounts payable (77) 1,044
Accrued expenses and other liabilities 422 (301)
Customer deposits and deferred revenue (77) (898)
-------- --------
Net cash used in operating activities (3,245) (3,806)
INVESTING ACTIVITIES
Acquisition of property and equipment net (1,563) (1,154)
Acquisition of short term investments (2,745) (10,554)
Maturities of short term investments 6,811 6,488
-------- --------
Net cash provided by (used in) investing activities 2,503 (5,220)
FINANCING ACTIVITIES
Repayment of lines of credit - (2,325)
Principal payments under capital leases (15) (30)
Issuance of common stock 509 226
Proceeds from initial public offering, net - 16,895
Repayment of notes receivable from shareholders 27 49
Issuance of note receivable from shareholder (56) -
Payment of notes payable - (979)
-------- --------
Net cash provided by financing activities 465 13,836
-------- --------
Net increase (decrease) in cash and cash equivalents (277) 4,810
Cash and cash equivalents at beginning of period 5,108 298
-------- --------
Cash and cash equivalents at end of period $ 4,831 $ 5,108
======== ========
</TABLE>
See accompanying notes to consolidated financial statements
<PAGE>
Photon Dynamics, Inc.
Consolidated Statements of Shareholders' Equity
(In thousands)
<TABLE>
<CAPTION>
FOREIGN NOTES
CONVERTIBLE CURRENCY RECEIVABLE TOTAL
PREFERRED STOCK COMMON STOCK ACCUMULATED TRANSLATION FROM SHAREHOLDERS'
DEFICIT ADJUSTMEMT SHAREHOLDERS EQUITY
AND OTHER
----------------------------------------
SHARES AMOUNT SHARES AMOUNT
-------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance at October 1, 1995 9,823 $ 17,935 1,156 $ 3,008 $(19,055) $ 104 $(135) $ 1,857
Issuance of common stock - - 122 226 - - - 226
Conversion of preferred stock to
common stock (9,823) (17,935) 3,482 17,935 - - - -
Initial public offering, net
of offering costs - - 2,128 16,895 - - - 16,895
Foreign currency translation
adjustment - - - - - (111) - (111)
Repayment of notes receivable - - - - - - 49 49
Net income - - - - 854 - - 854
-----------------------------------------------------------------------------------------------
Balance at September 30, 1996 - - 6,888 38,064 (18,201) (7) (86) 19,770
Issuance of common stock - - 260 509 - - - 509
Foreign currency translation
adjustment - - - - - (7) - (7)
Issuance of notes receivable - - - - - - (56) (56)
Repayment of notes receivable - - - - - - 27 27
Net loss - - - - (2,481) - - (2,481)
-----------------------------------------------------------------------------------------------
Balance at September 30, 1997 - $ - 7,148 $38,573 $(20,682) $ (14) $ (115) $17,762
===============================================================================================
</TABLE>
See accompanying notes to consolidated financial statements
<PAGE>
Notes to consolidated Financial Statements
NOTE 1 - Summary of Significant Accounting Policies
Basis of Presentation. The consolidated financial statements include the
accounts of the Company and its wholly-owned subsidiaries after elimination of
all material intercompany balances and transactions.
Photon Dynamics, Inc. is a manufacturer of test, inspection and repair systems
for the flat panel display industry.
Use of Estimates. The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the amounts in the financial statements and
accompanying notes. Actual results could differ from those estimates.
Cash Equivalents and Short Term Investments. The Company considers all highly
liquid investments purchased with a maturity of three months or less on the date
of purchase to be cash equivalents. At September 30, 1996, short term
investments consisted of commercial paper and fixed rate notes classified as
available for sale which matured during the year. The cost of these securities
approximated the fair value and the amount of realized gains or loss was not
significant. There were no short term investments as of September 30, 1997.
Inventories. Inventories are stated at the lower of cost or market, with cost
being determined on a first-in, first-out basis.
<TABLE>
<CAPTION>
SEPTEMBER 30,
----------------------
1997 1996
------ ------
<S> <C> <C>
Inventories comprise (in thousands):
Raw materials $1,376 $1,970
Work-in-progress 1,677 1,247
Finished goods 2,023 908
------ ------
$5,076 $4,125
====== ======
</TABLE>
Property, Equipment and Leasehold Improvements. Property and equipment are
recorded at cost. Depreciation is computed using the straight-line method based
upon the estimated useful lives of the assets, generally three to five years.
Equipment recorded under capital leases is amortized using the straight-line
method over the lesser of the lease terms or the lives of the related assets.
<TABLE>
<CAPTION>
SEPTEMBER 30,
------------------------
1997 1996
------- --------
<S> <C> <C>
Property and equipment comprise (in
thousands):
Equipment $ 3,772 $ 3,553
Office furniture and fixtures 330 265
Leasehold improvements 455 459
------- -------
4,557 4,277
Less accumulated depreciation
and amortization (2,331) (2,428)
------- -------
$ 2,226 $ 1,849
======= =======
</TABLE>
Accrued Liabilities. Accrued expenses and other liabilities consist of the
following:
<TABLE>
<CAPTION>
SEPTEMBER 30,
--------------------------
1997 1996
--------- ---------
<S> <C> <C>
Accrued liabilities comprise (in
thousands):
Warranty $1,001 $ 603
Compensation 820 585
Other accrued expenses 668 879
------ ------
$2,489 $2,067
====== ======
</TABLE>
Foreign Currency Translation. Assets and liabilities of the Company's foreign
subsidiaries are translated into U.S. dollars at year-end exchange rates and
revenues and expenses are translated at average rates prevailing during the
year. Translation
<PAGE>
adjustments are included in a separate component of shareholders' equity.
Foreign currency transaction gains and losses are included in results of
operations.
Revenue Recognition. The Company generally recognizes revenue from product sales
at the time of shipment, which usually precedes final acceptance. The Company
also sells one-year service contracts, for which revenue is recognized ratably
over the contract period. Non product revenue includes a $1 million fee paid by
a Korean company to be the exclusive value added reseller of the Company's
inspection products in Korea.
Concentration of Credit Risk. The Company markets its products primarily to a
limited number of customers in the Far East, primarily Japan and Korea. The
Company is subject to economic conditions, and specifically exchange rate
movements, affecting its customers and the countries in which it operates. The
Company believes its credit evaluation and monitoring process mitigates this
credit risk and does not generally require collateral. In 1997, sales to three
unaffiliated and one affiliated customer accounted for 26%, 20%, 11% and 26%
respectively. In 1996, sales to two unaffiliated and one affiliated customer
represented 30%, 14% and 19% of total revenue. International sales accounted
for 98% and 88% of total revenue in 1997 and 1996, respectively.
Warranty and Installation. The Company generally warrants its systems for a
period of 12 months from installation for material and labor to repair and
service the system. A provision for the estimated cost of installation and
warranty is recorded upon shipment.
Fair Value of Financial Instruments. The Company has evaluated the estimated
fair value of financial instruments. The amounts reported for cash and cash
equivalents, accounts receivable, accounts payable and accrued expenses
approximate the fair value due to their short maturities.
Net Income (Loss) Per Share. Income (loss) per share is computed using the
weighted average number of shares of common stock and dilutive common stock
equivalents from stock options and warrants (using the treasury stock method).
In February 1997, The Financial Accounting Standards Board issued Statement
("FASB") No. 128, Earnings Per Share, which is effective for the Company's
quarter ended March 31, 1998. At that time, the Company will be required to
change the method currently used to compute earnings per share and to restate
all prior periods. Under the new requirements for calculating primary earnings
per share the dilutive effect of stock options will be excluded. The impact is
expected to result in an increase in primary earnings per share for the year
ended September 30, 1996 of $0.01. There is no impact for the year ended
September 30, 1997. The impact of Statement 128 on the calculation of fully
diluted earnings per share, which has not been materially different than primary
earnings per share for these periods, is not expected to be material.
Stock Based Compensation Plans. The Company accounts for its stock option plans
and its employee stock purchase plan in accordance with the provisions of the
Accounting Principles Board's Opinion No.25 "Accounting For Stock Issued to
Employees" (APB 25). Pro forma information regarding net income (loss) per
share is disclosed as required by the FASB's Statement No. 123, "Accounting for
Stock-Based Compensation" (FAS 123), see note 6.
Impact of Recently Issued Accounting Standards. In June 1997, the FASB released
Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive
Income" (FAS 130). FAS 130 establishes standards for the reporting and display
of comprehensive income and its components in a full set of general purpose
financial statements. The Company will adopt the standard in fiscal 1999. The
Company believes that adoption of FAS 130 will not have a material impact on
the Company's consolidated financial statements.
In June 1997, the FASB released Statement of Financial Accounting Standards No.
131, "Disclosure about Segments of an Enterprise and Related Information" (FAS
131). This statement establishes standards for the way that public business
enterprises report information about operating segments in annual financial
statements and requires that those enterprises report selected information about
operating segments in interim financial reports issued to stockholders. The
Company will adopt the standard in fiscal 1999. The Company believes that
adoption of FAS 131 will not have a material impact on the Company's
consolidated financial statements.
Reclassifications have been made to the prior years' consolidated financial
statements to conform to the current years' presentation.
NOTE 2 - Related Parties
During 1997 and 1996 the Company sold approximately $6,341,000 and $4,651,000 of
its systems to LG Electronics, Inc. LG Electronics owns approximately 8% of the
Company's common stock, and warrants to purchase 28,333 shares of
<PAGE>
Common Stock at an exercise price of $0.60 per share, as well as a seat on the
board of directors. The Company believes its sales to LG Electronics were made
on terms no less favorable than would have been obtained from unaffiliated
parties.
NOTE 3 - Asset Write-off Related to Product Line Disposal
In September, 1996 the Company ceased operations of its Defect Monitoring Tool
(DMT) product line. The DMT product group worked exclusively on a single
customer project not in the flat panel market. As a result of the cancellation
of this project, the associated inventory and assets of this product line which
were not transferred to other products were disposed of. The Company recorded a
$844,000 charge to write down the inventory and assets associated with the
product line in fiscal 1996.
NOTE 4 - Short Term Borrowings
The Company has a $7.5 million line of credit financing from Bank of the West,
which expires in May 1998. No amounts were outstanding as of September 30,
1997. Borrowings under this line of credit bear interest at the prime rate.
This line of credit is secured by substantially all of the Company's assets and
contains certain financial and other covenants. As of September 30, 1997 the
Company was in default of certain of these financial covenants and as a result
the line is no longer available to the Company. See note 10.
NOTE 5 - Lease Obligations and Commitments
The Company leases its main facility under a noncancelable operating lease
agreement that expires in fiscal 2002.
<TABLE>
<CAPTION>
OPERATING LEASES
----------------
<S> <C>
1998 $574
1999 591
2000 609
2001 627
2002 52
</TABLE>
Rental expense for the years ended September 30, 1997 and 1996 was $781,000 and
$352,000, respectively.
NOTE 6 - Shareholders' Equity
Warrants. The Company has 148,832 warrants outstanding to purchase shares of
Series E preferred stock, which are currently exercisable in exchange for 49,610
shares of common stock at $5.50 per share. The warrants expire from 2000 to
2002. The Company also has 128,055 warrants outstanding to purchase shares of
common stock at $0.60 per share. These warrants expire in 1999.
Stock Reserved for Future Issuance. As of September 30, 1997, the Company has
reserved 1,391,783 shares of common stock for future issuance.
Stock Option and Purchase Plans. Under the Company's stock option plans, the
Board of Directors may, at its discretion, grant incentive or nonqualified stock
options to employees and directors. Options granted under the plan are for
periods not to exceed ten years, at prices at least equal to the fair market
value of common stock at the grant date, and become exercisable generally over a
period of four years.
<PAGE>
The following table summarizes activity under the Plans:
<TABLE>
<CAPTION>
SHARES UNDER OPTION WEIGHTED AVERAGE
EXERCISE PRICE
---------------------------------------
<S> <C> <C>
Balance at October 1, 1995 819,580 $1.55
Granted 591,900 $7.51
Exercised (91,905) $1.03
Canceled (217,056) $2.00
---------------------------------------
Balance at September 30, 1996 1,102,519 $4.58
Granted 239,933 $6.24
Exercised (179,649) $1.29
Canceled (154,298) $6.65
---------------------------------------
Balance at September 30, 1997 1,008,505 $5.24
=======================================
</TABLE>
Options to purchase 170,653 shares of common stock are available for grant as of
September 30, 1997. Options for 452,173 shares are currently exercisable
(options for 354,119 shares at September 30, 1996).
The Company has reserved 100,000 shares of common stock to be issued under the
1995 Employee Stock Purchase Plan. The plan permits eligible employees to
purchase common stock, through payroll deductions, at 85% of the lower of the
fair market value of the common stock on the date at the beginning of the two-
year offering period or the last day of the purchase period. Substantially all
employees are eligible to participate in the plan. Employees purchased 46,924
shares in fiscal 1997 for $289,000 and 18,116 shares for $117,000 in fiscal
1996. At September 30, 1997 34,960 shares were available for issuance under the
plan.
Accounting for Stock Based Compensation Plans. In accordance with the provisions
of FAS 123, the Company applies APB Opinion 25 and related Interpretations in
accounting for its Stock Option and Employee Stock Purchase plans and
accordingly, does not recognize compensation expense in the statement of
operations because the exercise price of the employees' stock options equals the
market price of the underlying stock on the date of grant. If the Company had
elected to recognize compensation expense based on the fair value of the options
granted at the grant date as prescribed by FAS 123, net income (loss) and net
income (loss) per share would have been adjusted to the pro forma amounts
indicated in the
table below:
<TABLE>
<CAPTION>
Year ended September 30, 1997 1996
(in thousands except per share amounts) ---------------------
<S> <C> <C>
Net income (loss) as reported $(2,481) $ 854
Net income (loss) pro forma $(3,325) $ 515
Net income (loss) per share - as reported $ (0.35) $0.12
Net income (loss) per share - pro forma $ (0.47) $0.07
</TABLE>
The effects on pro forma disclosures of applying FAS 123 are not likely to be
representative of the effects on pro forma disclosures of future years because
FAS 123 is applicable only to options granted subsequent to October 1, 1995.
Compensation expense for the fair value of each stock option grant is estimated
on the date of grant using the Black-Scholes option pricing model for the
multiple option approach with the following weighted average assumptions:
<TABLE>
<CAPTION>
1997 1996
---------------------
<S> <C> <C>
Expected dividend yield - -
Expected stock price volatility 0.70 0.70
Risk free interest rate 6.01% 6.20%
Expected life of options (from grant date) 3 years 3 years
</TABLE>
<PAGE>
The following table summarizes information about stock options outstanding at
September 30, 1997:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
--------------------------------------------------------------------------------------------------
RANGE OF NUMBER WEIGHTED WEIGHTED AVERAGE NUMBER WEIGHTED AVERAGE
EXERCISE PRICES OUTSTANDING AT AVERAGE EXERCISE PRICE OUTSTANDING AT EXERCISE PRICE
9/30/97 REMAINING 9/30/97
CONTRACTUAL LIFE
(YEARS)
--------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
$0.60-$0.90 222,498 6.32 $ 0.73 174,712 $ 0.75
$2.40-$5.88 202,194 8.31 $ 4.29 77,668 $ 3.69
$6.00-$6.75 462,880 8.86 $ 6.70 148,404 $ 6.65
$7.20-$9.00 51,883 8.44 $ 7.94 25,658 $ 8.01
$11.00 69,050 8.61 $11.00 25,731 $11.00
--------------------------------------------------------------------------------------------------
$0.60-$11.00 1,008,505 8.15 $ 5.24 452,173 $ 4.19
</TABLE>
The weighted average grant date fair value of stock options and employee
purchase plan rights granted in fiscal 1997 and 1996 was approximately $3.00 and
$3.69, respectively.
NOTE 7 - Notes Receivable from shareholders
Notes receivable from shareholders arose from certain employees exercising their
stock options as well as advances to purchase stock on the open market. The
notes bear interest at 6.83% per annum, and are secured by the shares of common
stock.
NOTE 8 - income taxes
The provision for income taxes for the year ended September 30, 1997 consists of
the following:
<TABLE>
<CAPTION>
In thousands Year Ended September 30,
---------------------------------
1997 1996
<S> <C> <C>
Federal - current $ - $ 29
State - current - 10
Foreign - current 20 -
---------------------------------
Total $20 $39
</TABLE>
The provisions for taxes on income differed from the provisions calculated by
applying the federal statutory rate to income before taxes as follows:
<TABLE>
<CAPTION>
In thousands
Year Ended September 30,
----------------------------------
1997 1996
<S> <C> <C>
Expected provision (benefit) at statutory rate $(868) $ 313
Foreign taxes 20 -
Alternative minimum taxes - 39
Benefit of operating loss carryforwards - (313)
Unbenefited current year loss 868 -
----------------------------------
$ 20 $ 39
</TABLE>
As of September 30, 1997, the Company has federal and state net operating loss
carryforwards of approximately $14,200,000 and $3,600,000, respectively. The
Company also has federal and state research and development tax credit
carryforwards of approximately $1,200,000 and $540,000, respectively. The net
operating loss and credit carryforwards will expire at various times beginning
in 1999 through 2012, if not utilized.
Under certain provisions of the Internal Revenue Code of 1986, as amended, the
availability of the Company's net operating loss and tax credit carryforwards
may be subject to limitation if it should be determined that there has been a
change in ownership of more than 50% of the value of the Company's stock. Such
determination could limit the utilization of net operating loss and tax credit
carryforwards.
<PAGE>
Deferred tax assets reflect the net tax effects of temporary differences between
the carrying amounts of assets and liabilities for financial reporting purposes
and the amounts used for income tax purposes, net operating loss and credit
carryforwards.
Significant components of the Company's deferred tax assets are as follows:
<TABLE>
<CAPTION>
In thousands Year Ended September 30,
------------------------
Deferred tax assets: 1997 1996
<S> <C> <C>
Net operating loss carryforwards $ 5,043 $ 4,712
Research credit carryforwards 1,551 920
Capitalized research costs 424 335
Inventory valuation 851 771
Other individually immaterial items 1,321 1,063
------------------------
Total deferred tax assets 9,190 7,801
Valuation allowance (9,190) (7,801)
------------------------
Net deferred tax assets $ - $ -
========================
</TABLE>
NOTE 9 - Statements of Cash Flows Data
<TABLE>
<CAPTION>
(In thousands) 1997 1996
---- ----
<S> <C> <C>
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Interest paid $ 4 $ 272
Income taxes paid $20 $ 110
SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND
FINANCING ACTIVITIES
Conversion of Preferred Stock to Common Stock $ - $17,935
</TABLE>
NOTE 10 - Subsequent Event (Unaudited)
In December 1997, the Company obtained a new line of credit financing from
Imperial Bank for $5 million, expiring in December 1998 and bearing interest at
the prime rate.
<PAGE>
EXHIBIT 21.1
PHOTON DYNAMICS, INC.
The Company has two subsidiaries: K.K. Photon Dynamics, which is incorporated in
Japan, and Photon Dynamics, Korea which is incorporated in Korea.
<PAGE>
EXHIBIT 23.1
CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
We consent to the incorporation by reference in this Annual Report (Form 10-KSB)
of Photon Dynamics, Inc. of our report dated October 24, 1997 included in the
1997 Annual Report to Shareholders of Photon Dynamics, Inc. We also consent to
the incorporation by reference in the Registration Statement (Form S-8 Nos. 33-
98232-LA, and 333-05283) pertaining to the 1995 Employee Stock Purchase Plan,
the 1987 Stock Option Plan and the 1995 Stock Option Plan of Photon Dynamics,
Inc. of our report dated October 24, 1997, with respect to the consolidated
financial statements of Photon Dynamics, Inc. incorporated by reference in the
Annual Report (Form 10-KSB) for the year ended September 30, 1997.
Ernst & Young LLP
San Jose, California
December 22, 1997
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C> <C>
<PERIOD-TYPE> 12-MOS 12-MOS
<FISCAL-YEAR-END> SEP-30-1997 SEP-30-1996
<PERIOD-START> OCT-01-1996 OCT-01-1995
<PERIOD-END> SEP-30-1997 SEP-30-1996
<CASH> 4,831 5,108
<SECURITIES> 0 4,066
<RECEIVABLES> 9,785 0
<ALLOWANCES> (951) (629)
<INVENTORY> 5,076 4,125
<CURRENT-ASSETS> 20,204 22,469
<PP&E> 4,557 4,277
<DEPRECIATION> (2,331) (2,428)
<TOTAL-ASSETS> 23,203 24,958
<CURRENT-LIABILITIES> 5,435 5,179
<BONDS> 0 0
0 0
0 0
<COMMON> 38,573 38,064
<OTHER-SE> (20,811) (18,294)
<TOTAL-LIABILITY-AND-EQUITY> 17,762 19,770
<SALES> 23,157 23,381
<TOTAL-REVENUES> 24,507 24,763
<CGS> 13,789 12,294
<TOTAL-COSTS> 13,789 13,256
<OTHER-EXPENSES> 13,413 10,944
<LOSS-PROVISION> 0 0
<INTEREST-EXPENSE> 4 383
<INCOME-PRETAX> (2,461) 893
<INCOME-TAX> 20 39
<INCOME-CONTINUING> (2,481) 854
<DISCONTINUED> 0 0
<EXTRAORDINARY> 0 0
<CHANGES> 0 0
<NET-INCOME> (2,481) 854
<EPS-PRIMARY> (0.35) 0.12
<EPS-DILUTED> (0.35) 0.12
</TABLE>
