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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the quarterly period ended June 30, 1998
OR
[_] 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 registrant 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) (Zip Code)
(408) 226-9900
(Registrant's telephone number, including area code)
N/A
(Former name, former address, and former fiscal year, if changed since last
report.)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES X NO
--- ---
As of August 10, 1998 7,320,625 shares of the Issuer's Common Stock, no par
value, were outstanding.
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TABLE OF CONTENTS
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PART I: FINANCIAL INFORMATION PAGE
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ITEM 1. Financial Statements (unaudited)
Condensed Consolidated Balance Sheets June 30, 1998 and September 30, 1997............. 2
Condensed Consolidated Statements of Income - three and nine months ended June 30, 1998
and 1997.............................................................................. 3
Condensed Consolidated Statements of Cash Flows - nine months ended June 30, 1998 and
1997.................................................................................. 4
Notes to Condensed Consolidated Financial Statements.................................... 5
ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations... 6
Risk Factors............................................................................ 8
PART II: OTHER INFORMATION
ITEM 1. Legal Proceedings....................................................................... 13
ITEM 2. Changes in Securities................................................................... 13
ITEM 3. Defaults Upon Senior Securities......................................................... 13
ITEM 4. Submission of Matters to a Vote of Security Holders..................................... 13
ITEM 5. Other Information....................................................................... 13
ITEM 6. Exhibits and Reports on Form 8-K........................................................ 13
Signatures.............................................................................. 14
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1
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Photon Dynamics, Inc.
Condensed Consolidated Balance Sheets
(In thousands)
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JUNE 30, 1998 SEPTEMBER 30, 1997
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(UNAUDITED)
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ASSETS
Current assets:
Cash and cash equivalents $ 6,215 $ 4,831
Accounts receivable, net 8,006 9,785
Inventories 5,758 5,076
Prepaid expenses and other current assets 256 512
-------- --------
Total current assets 20,235 20,204
Property, equipment, and leasehold improvements, net 1,849 2,226
Other assets 430 773
-------- --------
Total assets $ 22,514 $ 23,203
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LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 1,741 $ 2,666
Accrued expenses and other liabilities 2,569 2,489
Customer deposits and deferred revenue 111 276
Current portion of long-term debt 4 4
-------- --------
Total current liabilities 4,425 5,435
Noncurrent portion of long-term debt 3 6
Commitments and contingencies
Shareholders' equity:
Common stock 38,791 38,573
Accumulated deficit (20,365) (20,682)
Foreign currency translation adjustment and other (241) (14)
Notes receivable from shareholders (99) (115)
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Total shareholders' equity 18,086 17,762
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Total liabilities and shareholders' equity $ 22,514 $ 23,203
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See accompanying notes to condensed consolidated financial statements
Note: The balance sheet at September 30, 1997 has been derived from the audited
consolidated financial statements at that date but does not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements.
2
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Photon Dynamics, Inc.
Condensed Consolidated Statements of Income
(In thousands, except per share amounts)
(Unaudited)
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THREE MONTHS ENDED NINE MONTHS ENDED
JUNE 30, JUNE 30,
------------------------------------ --------------------------------
1998 1997 1998 1997
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Revenue:
Product revenue $5,625 $6,821 $18,362 $17,002
Non product revenue - - - 1,150
------ ------ ------- -------
5,625 6,821 18,362 18,152
Cost of revenue:
Product revenue 3,061 3,455 10,103 9,442
Non product revenue - - - -
------ ------ ------- -------
3,061 3,455 10,103 9,442
------ ------ ------- -------
Gross margin 2,564 3,366 8,259 8,710
Operating expenses:
Research and development 1,386 2,199 4,738 5,687
Selling, general, and administrative 1,235 1,291 3,728 4,143
Asset recovery related to product line disposal - - (350) -
------ ------ ------- -------
Total operating expenses 2,621 3,490 8,116 9,830
------ ------ ------- -------
Operating income (loss) (57) (124) 143 (1,120)
Interest income 46 76 184 285
Interest expense and other 60 92 11 (39)
------ ------ ------- -------
Income (loss) before provision for income taxes 49 44 338 (874)
Provision for income taxes - 17 21 20
------ ------ ------- -------
Net income (loss) $ 49 $ 27 $ 317 $ (894)
====== ====== ======= =======
Basic net income (loss) per share: $ 0.01 $ 0.00 $ 0.04 $ (0.13)
Diluted net income (loss) per share: $ 0.01 $ 0.00 $ 0.04 $ (0.13)
Shares used in computing basic
net income (loss) per share 7,269 7,058 7,214 7,016
Shares used in computing diluted
net income (loss) per share 7,586 7,493 7,513 7,016
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See accompanying notes to condensed consolidated financial statements
3
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Photon Dynamics, Inc.
Condensed Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
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NINE MONTHS ENDED
JUNE 30,
1998 1997
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OPERATING ACTIVITIES
Net Income (loss) $ 317 $ (894)
Adjustments to reconcile net income (loss) to net cash used in operating
activities:
Depreciation and amortization 860 849
Changes in operating assets and liabilities:
Accounts receivable 1,780 (1,865)
Inventories (682) (774)
Prepaid expenses and other current assets 256 72
Other assets 116 (144)
Accounts payable (925) (923)
Accrued expenses and other liabilities 80 636
Customer deposits and deferred revenue (165) (256)
------ -------
Net cash provided by (used in) operating activities 1,637 (3,299)
INVESTING ACTIVITIES
Acquisition of property and equipment (484) (1,753)
Disposal of property and equipment - 453
Maturities of short term investments - 6,811
Acquisition of short term investments - (2,745)
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Net cash provided by (used in) investing activities (484) 2,766
FINANCING ACTIVITIES
Borrowings/ (repayment) under line of credit - 500
Principal payments under capital leases (3) (15)
Proceeds from issuance of common stock, net of issuance costs 218 341
Issuance of note receivable from shareholders - (56)
Payment of note receivable from shareholders 16 21
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Net cash provided by financing activities 231 791
Net increase in cash and cash equivalents 1,384 258
Cash and cash equivalents at beginning of period 4,831 5,108
------ -------
Cash and cash equivalents at end of period $6,215 $ 5,366
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See accompanying notes to condensed consolidated financial statements
4
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PHOTON DYNAMICS, INC
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. SIGNIFICANT ACCOUNTING POLICIES
The accompanying unaudited financial statements have been prepared in
accordance with generally accepted accounting principles for interim financial
information and with the instructions to Form 10-Q. Accordingly, they do not
include all of the information and footnotes required by generally accepted
accounting principles for complete financial statements. In the opinion of
management, all adjustments (consisting of normal recurring accruals) considered
necessary for a fair presentation have been included. Operating results for the
nine months ended June 30, 1998 are not necessarily indicative of the results
that may be expected for the fiscal year ending September 30, 1998. For further
information, refer to the audited consolidated financial statements and
footnotes thereto included in the Company's Annual Report on Form 10-KSB for the
fiscal year ended September 30, 1997.
2. INVENTORIES
Inventories are stated at the lower of cost or market, with cost being
determined on a first-in, first-out basis.
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June 30, September 30,
1998 1997
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Raw materials $1,676 $1,376
Work-in-process 2,692 1,677
Finished goods 1,390 2,023
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$5,758 $5,076
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3. NET INCOME PER SHARE
In February 1997, the Financial Accounting Standards Board issued Statement
No. 128, "Earnings Per Share," which became effective during the Company's
quarter ended December 31, 1997. The Company is required to change the method
currently used to compute earnings per share and to restate all prior periods.
Under the new requirements for calculating basic earnings per share the dilutive
effect of stock options is excluded. Approximately 682,357 options have been
excluded from the calculations below for the three months ended June 30, 1998
and approximately 692,801options have been excluded from the calculations below
for the nine months ended June 30, 1998 as their effect would have been
antidilutive. The following table sets forth the computation of basic and
diluted earnings per share:
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<CAPTION>
(In thousands, except per share amounts) THREE MONTHS ENDED JUNE 30, NINE MONTHS ENDED JUNE 30,
--------------------------- --------------------------
1998 1997 1998 1997
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Numerator for basic and diluted
net income (loss) per share $ 49 $ 27 $ 317 $ (894)
Denominator for basic net income (loss) per share 7,269 7,058 7,214 7,016
Effect of dilutive securities
Employee stock options 207 154 191 -
Warrants 109 281 108 -
------ ------- ------ ------
Denominator for diluted net income (loss) per share 7,586 7,493 7,513 7,016
Basic net income (loss) per share $ 0.01 $ 0.00 $ 0.04 $(0.13)
Diluted net income (loss) per share $ 0.01 $ 0.00 $ 0.04 $(0.13)
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5
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PHOTON DYNAMICS, INC
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
The statements contained in this report on Form 10-Q 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
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-Q. In addition, you should consult the risk factors listed from time to
time in the Company's reports on Form 10-KSB, and annual reports to
shareholders.
The following discussion should be read in conjunction with the attached
condensed consolidated financial statements and notes thereto, and with the
Company's audited financial statements and notes thereto for the year ended
September 30, 1997.
RESULTS OF OPERATIONS
Revenue. Total revenues for the third quarter of fiscal 1998 decreased 18% to
$5.6 million from $6.8 million in the third quarter of fiscal 1997. Total
revenues for the first nine months of fiscal 1998 grew slightly to $18.4 million
from $18.2 million in the comparable period of 1997. The decrease in revenue
for the third quarter of fiscal 1998 is due to decreased capital spending by
flat panel display ("FPD") manufacturers located in Asia in response to current
adverse economic conditions in the region, particularly in Korea and Japan. In
fiscal 1997, sales to companies based in Korea represented 60% of the Company's
total annual revenue. Based upon the information currently available, the
Company believes that sales to Korea in fiscal 1998 will be substantially less
in both absolute dollars and as a percentage of total revenue than in fiscal
1997. Modest increases in year-to-date sales to Japan as compared to the prior
year have helped to offset this decrease in Korean sales; however, the Company
has seen no indications that this trend will continue beyond the current fiscal
year.
Non-product revenue in the first half of fiscal 1997 consisted of a non
recurring $1 million initial fee paid by a Korean company for the rights to be
the exclusive value added reseller of the Company's FIS Flex-P product in Korea.
Gross Margin. Gross margins as a percent of revenue were 46% and 45% for the
three and nine month periods ended June 30, 1998, respectively, compared to 49%
and 48% for the three and nine month periods ended June 30, 1997, respectively.
The decrease in gross margins in fiscal 1998 was the result of a less favorable
product mix and higher warranty reserves associated with the Company's newer
products. It was also due to a continued investment by the Company in customer
service, especially in Korea. Furthermore, unlike 1997, the Company had no high
margin non-product revenue during the first nine months of fiscal 1998.
Additionally, the Company earned lower margins on systems sold to its partner in
Japan, Ishikawajima-Harima Heavy Industries (IHI). Sales to IHI typically carry
a lower gross margin than other sales because IHI is responsible for certain
sales and support costs in Japan.
Research and Development. The Company decreased its research and development
spending to $1.4 million in the third quarter of fiscal 1998, or 25% of
revenue, from $2.2 million in the third quarter of fiscal 1997, or 32% of
revenue. Research and development spending for the first nine months of fiscal
1998 was $4.7 million, or 26% of revenue, compared to $5.7 million, or 31% of
revenue, in the comparable period in 1997. The decrease in research and
development spending in 1998 reflects the completion of the engineering projects
related to the development of the Company's ArrayChecker system, including a
decrease in spending on prototype materials and outside consultants. The
Company does not expect that research and development expenses will decline in
absolute dollar amounts in the remainder of fiscal 1998.
6
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Selling, General and Administrative. Selling, general and administrative
expenses in the third quarter of fiscal 1998 decreased to $1.2 million, or 22%
of revenue, from $1.3 million, or 19% of revenue, in the third quarter of fiscal
1997. Selling, general and administrative expenses for the first nine months of
fiscal 1998 were $3.7 million, or 20% of revenue, a decrease from $4.1 million,
or 23% of revenue, in the comparable period of fiscal 1997. This decrease is a
result of the Company's collecting receivables against which it had previously
taken reserves. Without this cash collection, selling, general and
administrative expenses for the first nine months of fiscal 1998 would have been
$4 million. Selling, general and administrative expenses may increase in
absolute dollar amounts in fiscal 1998 and in future periods depending on
factors such as 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.
Asset Recovery Related to Product Line Disposal. During the quarter ended
December 31, 1997, the Company received a payment of $350,000 in settlement of a
dispute related to the cancellation of its Defect Monitoring Tool (DMT) product
line. In September 1996, the Company ceased operations of its DMT product line.
The DMT product group worked exclusively on a single customer project not in the
FPD market. As a result of the cancellation of this project, the Company
disposed of the associated inventory and assets of this product line which were
not transferred to other products.
Interest Income. Interest income in the third quarter of fiscal 1998
decreased to $46,000 from $76,000 in the third quarter of fiscal 1997. The
decrease was the result of lower average cash and investment balances.
Interest Expense and Other. Interest expense and other consists of interest
expense and foreign exchange gains and losses. It also includes funds received
from a vendor in conjunction with the sale of obsolete inventory and a small
settlement from an insurance claim during the first quarter of 1998.
Provision for Income Tax. The Company's effective tax rate for the three and
nine months ended June 30, 1998 was 0% and 6%, respectively. The Company's
effective tax rate was lower than the statutory rate of 34% due to the
utilization of loss carryforwards. The Company's effective tax rate for 1997 was
0% due to net operating losses incurred during the period.
LIQUIDITY AND CAPITAL RESOURCES
The Company has financed its growth primarily from a combination of amounts
raised in equity financings, loans, lines of credit from a bank and cash flows
from operations. As of June 30, 1998, the Company had working capital of $15.8
million of which $6.2 million was cash or cash equivalents.
Cash provided by operating activities was $1.6 million for the nine months
ended June 30, 1998. Working capital items that significantly impacted cash
balances in the period were accounts receivable and accounts payable. During
the nine month period ended June 30, 1998, the Company's accounts receivable
balance decreased by $1.8 million to $8 million. This was largely due to the
fact that the Company collected certain older receivables. The Company's credit
terms to customers typically extend a small portion of the payment for a period
of months after shipment. Accounts payable balances decreased by $925,000
during the period. This was due to the Company's pattern of inventory build-up
in line with current revenue expectations.
Capital expenditures during the first nine months of fiscal 1998 were
$484,000 compared to $1.8 million in the first nine months of fiscal 1997. In
the first quarter of fiscal 1997, the Company relocated to a new facility and as
a result spent $682,000 on capital additions which related primarily to
leasehold improvements for the new facility.
The Company has a $5 million line of credit from Imperial Bank which expires
in December 1998. This line of credit is secured by substantially all of the
Company's assets and contains certain financial and other covenants. Borrowings
under this line of credit bear interest at the prime rate. At June 30, 1998, no
amounts were outstanding under this line and the Company was not in violation of
any of its covenants.
7
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The Company believes that cash and cash equivalents and cash flow from
operations will be sufficient to satisfy working capital requirements and
capital equipment needs for the next 12 months. As of June 30, 1998, the Company
had no material outstanding commitments to purchase or lease capital equipment.
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.
YEAR 2000 COMPUTER SYSTEM COMPLIANCE
The Company is in the process of addressing internal and external year 2000
issues. Many currently installed computer systems and software products are
coded to accept only two digit entries in the date code field. These date code
fields will need to accept four digit entries to distinguish 21st century dates
from 20th century dates. As a result, in less than two years, computer systems
and software used by many companies may need to be upgraded to comply with such
"Year 2000" requirements. Although the Company believes that its products and
internal systems are Year 2000 compliant, there can be no assurance that the
Company's suppliers, vendors or other enterprises with which the Company
interacts are or will be Year 2000 compliant. Failure of third-party
enterprises with which the Company interacts to achieve Year 2000 compliance
could have a material adverse effect on the Company's business, financial
condition and results of operations.
RISK FACTORS
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. The Company believes that the current economic conditions in
East Asia and specifically Korea, have had and will continue to have a negative
impact on the Company's results of operations. The continued fall of the Korean
won against the U.S. dollar has resulted and may continue to result in a failure
to place new orders for the Company's equipment by Korean FPD manufacturers.
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
8
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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 strength 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, have had and will continue to have a negative impact on the Company's
results of operations. The continued fall of the Korean won against the U.S.
dollar has resulted and may continue to result in a failure to place new orders
for the Company's equipment by Korean FPD manufacturers.
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.
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.
9
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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 time 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 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 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
10
<PAGE>
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 business and results of operations.
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 business and results of operations.
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.
11
<PAGE>
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 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.
12
<PAGE>
PART II: OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
- --------------------------
None.
ITEM 2. CHANGES IN SECURITIES
- ------------------------------
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
- ----------------------------------------
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
- ------------------------------------------------------------
None.
ITEM 5. OTHER INFORMATION
- --------------------------
Rider 13A:
Pursuant to recent changes to the proxy rules, unless a shareholder who
wishes to bring a matter before the shareholders at the Company's 1999 annual
meeting of shareholders notifies the Company of such a matter prior to November
16, 1998, management will have discretionary authority to vote all shares for
which it has proxies in opposition to such matter
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
- -----------------------------------------
(a) EXHIBITS
27 Financial Data Schedule
(b) REPORTS ON FORM 8-K
The Company filed a report on Form 8-K on April 9, 1998 for the purpose
of disclosing the effect of adoption of FAS 128, "Earnings Per Share", on
the Annual Report on Form 10-KSB for the fiscal year ended September 30,
1997.
13
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
PHOTON DYNAMICS, INC.
(Registrant)
Date: August 12, 1998 /s/ Vincent Sollitto
----------------------------------------
Vincent Sollitto
Chief Executive Officer and Director
(Principal Executive Officer)
Date: August 12, 1998 /s/ Vincent Sollitto
----------------------------------------
Vincent Sollitto
Acting Chief Financial Officer and Secretary
(Principal Financial and Accounting Officer)
14
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