##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
   FORM 10-Q   (MARK ONE) [X]
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 FOR THE QUARTERLY PERIOD ENDED June 30, 2004 OR [  ]
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from to . Commission File Number 000-30715 COSINE COMMUNICATIONS, INC. (Exact name of Registrant as specified in its charter)
 Delaware
    
    94-3280301(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification Number)1200 Bridge Parkway, Redwood City, CA
    
    94065(Address of principal executive offices)
    
    (Zip Code)
 Registrants telephone number including area code: (650) 637-4777 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 [   ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes [  ] No [X] There were 10,240,354 shares of the Companys Common Stock, par value $.0001,
outstanding on July 28, 2004.




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COSINE COMMUNICATIONS, INC. FORM 10-Q Quarter ended June 30, 2004 TABLE OF CONTENTS PagePART IFINANCIAL INFORMATIONItem 1. Condensed Consolidated Financial Statements:Condensed Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003
    
    
    3Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2004 and 2003
    
    
    4Condensed Consolidated Statements of Cash Flows for Six Months Ended June 30, 2004 and 2003
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    12Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    29Item 4. Controls and Procedures
    
    
    29PART IIOTHER INFORMATIONItem 1. Legal Proceedings
    
    
    30Item 2. Changes in Securities; Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    31Item 6. Exhibits and Reports on Form 8-K
    
    
    31Signature
    
    
    33Exhibit Index
    
    
    34EXHIBIT 4.1EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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PART I. FINANCIAL INFORMATION 
 ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS COSINE COMMUNICATIONS, INC. 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except for par value and share data)
 June 30,
    
    December 31,2004
    
    2003(Unaudited)
    
    (1)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    16,981
    
    
    $
    19,719Short-term investments
    
    
    27,476
    
    
    
    38,033Accounts receivable:Trade (net of allowance for doubtful accounts of $7 and $150 at
June 30, 2004 and December 31, 2003, respectively)
    
    
    830
    
    
    
    4,962Other
    
    
    586
    
    
    
    494Inventory
    
    
    3,325
    
    
    
    4,003Prepaid expenses and other current assets
    
    
    2,319
    
    
    
    2,668Total current assets
    
    
    51,517
    
    
    
    69,879Property and equipment, net
    
    
    427
    
    
    
    2,900Long-term deposits
    
    
    592
    
    
    
    647$
    52,536
    
    
    $
    73,426LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,256
    
    
    $
    1,657Provision for warranty claims
    
    
    329
    
    
    
    464Accrued other liabilities
    
    
    2,506
    
    
    
    2,560Accrued compensation
    
    
    1,641
    
    
    
    1,821Deferred revenue
    
    
    1,370
    
    
    
    3,543Current portion of equipment and working capital loans
    
    
    
    
    
    
    129Total current liabilities
    
    
    7,102
    
    
    
    10,174Accrued rent
    
    
    2,065
    
    
    
    2,078Stockholders equity:Preferred stock, 3,000,000 authorized, none issued and outstanding
    
    
    
    
    
    
    Common stock, $.0001 par value, 300,000,000 shares authorized;
10,240,354 and 10,176,845 shares issued and outstanding at June
30, 2004 and December 31, 2003, respectively
    
    
    1
    
    
    
    1Additional paid-in capital
    
    
    543,146
    
    
    
    546,176Notes receivable from stockholders
    
    
    (4,719
    )
    
    
    (6,659
    )Accumulated other comprehensive income
    
    
    458
    
    
    
    533Deferred compensation
    
    
    (4
    )
    
    
    (455
    )Accumulated deficit
    
    
    (495,513
    )
    
    
    (478,422
    )Total stockholders equity
    
    
    43,369
    
    
    
    61,174$
    52,536
    
    
    $
    73,426
 See accompanying notes. (1) The information in this column was derived from the Companys audited
consolidated financial statements for the year ended December 31, 2003. 3




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COSINE COMMUNICATIONS, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except for per share data)
(Unaudited)
 Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Revenue
    
    $
    2,568
    
    
    $
    6,014
    
    
    $
    7,023
    
    
    $
    8,220Cost of goods sold1
    
    
    1,435
    
    
    
    2,822
    
    
    
    2,932
    
    
    
    3,537Gross profit
    
    
    1,133
    
    
    
    3,192
    
    
    
    4,091
    
    
    
    4,683Operating expenses:Research and development2
    
    
    4,352
    
    
    
    5,178
    
    
    
    9,607
    
    
    
    10,435Sales and marketing3
    
    
    3,155
    
    
    
    3,772
    
    
    
    6,538
    
    
    
    7,119General and administrative4
    
    
    1,197
    
    
    
    2,089
    
    
    
    2,905
    
    
    
    3,826Restructuring and impairment charges
    
    
    2,308
    
    
    
    67
    
    
    
    2,343
    
    
    
    337Total operating expenses
    
    
    11,012
    
    
    
    11,106
    
    
    
    21,393
    
    
    
    21,717Loss from operations
    
    
    (9,879
    )
    
    
    (7,914
    )
    
    
    (17,302
    )
    
    
    (17,034
    )Other income (expenses):Interest income and other
    
    
    142
    
    
    
    288
    
    
    
    225
    
    
    
    714Interest expense5
    
    
    (1
    )
    
    
    (61
    )
    
    
    (3
    )
    
    
    (189
    )Total other income (expenses)
    
    
    141
    
    
    
    227
    
    
    
    222
    
    
    
    525Loss before income tax provision
(benefit)
    
    
    (9,738
    )
    
    
    (7,687
    )
    
    
    (17,080
    )
    
    
    (16,509
    )Income tax provision (benefit)
    
    
    (32
    )
    
    
    29
    
    
    
    11
    
    
    
    71Net loss
    
    $
    (9,706
    )
    
    $
    (7,716
    )
    
    $
    (17,091
    )
    
    $
    (16,580
    )Basic and diluted net loss per share
    
    $
    (0.96
    )
    
    $
    (0.79
    )
    
    $
    (1.70
    )
    
    $
    (1.70
    )Shares used in computing per share
amounts
    
    
    10,062
    
    
    
    9,748

    
    
    
    10,035
    
    
    
    9,733
 1 Cost of goods sold includes ($43) and $48 for the three months ended June 30,
2004 and 2003, respectively, and ($69) and $95 for the six months ended June
30, 2004 and 2003, respectively, of non-cash (credits) charges related to
equity issuances. 2 Research and development expenses includes ($255) and ($11) for the three
months ended June 30, 2004 and 2003, respectively, and ($214) and $187 for the
six months ended June 30, 2004 and 2003, respectively, of non-cash charges
(credits) related to equity issuances. 3 Sales and marketing expenses includes ($154) and $91 for the three months
ended June 30, 2004 and 2003, respectively, and ($193) and ($101) for the six
months ended June 30, 2004 and 2003, respectively, of non-cash credits
(credits) related to equity issuances. 4 General and administrative expenses includes ($311) and $132 for the three
months ended June 30, 2004 and 2003, respectively, and ($401) and $269 for the
six months ended June 30, 2004 and 2003, respectively, of non-cash (credits)
charges related to equity issuances. 5 Interest expense includes no non-cash charges related to equity issuances for
the three months ended June 30, 2004 and 2003, and $0 and $30 of non-cash
charges related to equity issuances for the six months ended June 30, 2004 and
2003, respectively. 4




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COSINE COMMUNICATIONS, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
 Six Months EndedJune 30,2004
    
    2003Operating activities:Net loss
    
    ($
    17,091
    )
    
    ($
    16,580
    )Adjustments to reconcile net loss to net cash used in operating
activities:Depreciation
    
    
    1,250
    
    
    
    1,309Allowance for doubtful accounts
    
    
    (73
    )
    
    
    67Non-cash charges related to inventory write-down
    
    
    657
    
    
    
    Write-down of property and equipment
    
    
    2,308
    
    
    
    Amortization of warrants issued for services
    
    
    33
    
    
    
    61Amortization of deferred stock compensation
    
    
    (975
    )
    
    
    1,073Reversal of amortization in excess of vesting
    
    
    (163
    )
    
    
    (654
    )Bonus awarded in shares of common stock
    
    
    228
    
    
    
    Other, net
    
    
    (12
    )
    
    
    (394
    )Net change in operating assets and liabilities:Accounts receivable, trade
    
    
    4,205
    
    
    
    3,036Other receivables
    
    
    (92
    )
    
    
    (21
    )Inventory
    
    
    (44
    )
    
    
    (424
    )Prepaid expenses and other current assets
    
    
    367
    
    
    
    956Long-term deposits
    
    
    55
    
    
    
    250Accounts payable
    
    
    (401
    )
    
    
    (315
    )Provision for warranty claims
    
    
    (135
    )
    
    
    (367
    )Accrued other liabilities
    
    
    (54
    )
    
    
    (10,277
    )Accrued compensation
    
    
    (180
    )
    
    
    374Deferred revenue
    
    
    (2,173
    )
    
    
    (85
    )Accrued rent
    
    
    (13
    )
    
    
    (7
    )Net cash used in operating activities
    
    
    (12,303
    )
    
    
    (21,998
    )Investing activities:Capital expenditures
    
    
    (1,024
    )
    
    
    (780
    )Purchase of short-term investments
    
    
    (27,182
    )
    
    
    (47,180
    )Proceeds from sales and maturities of short-term investments
    
    
    37,674
    
    
    
    80,879Net cash provided by investing activities
    
    
    9,468
    
    
    
    32,919Financing activities:Principal payments of equipment and working capital loans and
capital leases
    
    
    (129
    )
    
    
    (2,883
    )Proceeds from issuance of common stock
    
    
    226
    
    
    
    315Proceeds from notes receivable from stockholders
    
    
    
    
    
    
    31Repurchase of common stock
    
    
    
    
    
    
    (60
    )Net cash provided by (used in) financing activities
    
    
    97
    
    
    
    (2,597
    )Net increase (decrease) in cash and cash equivalents
    
    
    (2,738
    )
    
    
    8,324Cash and cash equivalents at the beginning of the period
    
    
    19,719
    
    
    
    9,230Cash and cash equivalents at the end of the period
    
    $
    16,981
    
    
    $
    17,554Supplemental information:Cash paid for interest
    
    $
    3
    
    
    $
    159Income taxes paid
    
    $
    11
    
    
    $
    71Cancellation of notes receivable due to repurchase of unvested stock
    
    $
    1,941
    
    
    $
    2,756Issuance of warrant to reseller
    
    $
    48
    
    
    $
    Re-measurement of deferred stock-based compensation
    
    $
    251
    
    
    $
    86Net transfer from inventory to property and equipment
    
    $
    65
    
    
    $
    
 See accompanying notes. 5




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COSINE COMMUNICATIONS, INC. 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 1. BASIS OF PRESENTATION The unaudited condensed consolidated financial statements have been
prepared by CoSine Communications, Inc. pursuant to instructions to Form 10-Q
and Article 10 of Regulation S-X and include the accounts of CoSine
Communications, Inc. and its wholly owned subsidiaries (CoSine or
collectively, the Company). Certain information and footnote disclosures
normally included in financial statements prepared in accordance with U.S.
generally accepted accounting principles have been condensed or omitted
pursuant to the Securities and Exchange Commissions rules and regulations. In
the opinion of management, all adjustments (consisting of normal recurring
items) necessary for a fair presentation have been included. The results of
operations for the three and six months ended June 30, 2004 are not necessarily
indicative of the results to be expected for any subsequent quarter or for the
entire year. The condensed consolidated balance sheet at December 31, 2003 has
been derived from the audited financial statements as of that date. These
unaudited condensed consolidated financial statements should be read in
conjunction with the audited consolidated financial statements and the notes
included in CoSines Annual Report filed on Form 10-K for the year ended
December 31, 2003. On July 29, 2004, CoSine announced that it was exploring various strategic
alternatives and that the Company had hired an investment bank as its financial
advisor. Pending the outcome of the Companys review of strategic alternatives
and any definitive decisions to pursue specific alternatives, the Company will
continue to prepare its financial statements on the assumption that it will
continue as a going concern, which contemplates the realization of assets and
liquidation of liabilities in the normal course of business. As such, the
financial statements do not include any adjustments to reflect possible future
effects on the recoverability and classification of assets or the amounts and
classification of liabilities that may result from any decisions made with
respect to the Companys assessment of its strategic alternatives. If at some
point the Company were to decide to pursue alternative plans, the Company may
be required to present the financial statements on a different basis. As an
example, if the Company were to decide to pursue a liquidation and return of
capital, it would be required to prepare and present financial statements on
the liquidation basis of accounting, whereby assets are stated at their
estimated net realizable values and liabilities are stated at their estimated
settlement amounts. Pro Forma Information CoSine has elected to continue to follow Accounting Principles Board
Opinion 25 (APB 25), Accounting for Stock Issued to Employees, and related
interpretations to account for employee stock options because the alternative
fair value method of accounting prescribed by Statement of Financial Accounting
Standards (SFAS) 123, Accounting for Stock-Based Compensation, as amended
by SFAS 148, Accounting for Stock-Based Compensation  Transition and
Disclosure, requires the use of option valuation models that were not
developed for use in valuing employee stock options. Under APB 25, no
compensation expense is recognized when the exercise price of employee stock
options equals the market price of the underlying stock on the date of grant. The following table illustrates the effect on CoSines net loss and net
loss per share if CoSine had applied the fair value recognition provisions of
SFAS 123 to stock-based employee compensation (in thousands, except per share
data): Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net loss, as reported
    
    ($
    9,706
    )
    
    ($
    7,716
    )
    
    ($
    17,091
    )
    
    ($
    16,580
    )Stock-based employee
compensation expense
(credit), net of
tax, included in
reported net loss
    
    
    (732
    )
    
    
    493
    
    
    
    (747
    )
    
    
    1,073Reversal of
amortization in
excess of vesting,
net of tax
    
    
    (49
    )
    
    
    (249
    )
    
    
    (163
    )
    
    
    (654
    )Stock-based employee
compensation expense
determined under
fair value method
for all stock option
grants (SFAS 123
expense), net of tax
    
    
    (294
    )
    
    
    (1,097
    )
    
    
    (895
    )
    
    
    (1,902
    )Pro forma net loss
    
    ($
    10,781
    )
    
    ($
    8,569
    )
    
    ($
    18,896
    )
    
    ($
    18,063
    )Basic and diluted
net loss per share,
as reported
    
    ($
    0.96
    )
    
    ($
    0.79
    )
    
    ($
    1.70
    )
    
    ($
    1.70
    )Pro forma basic and
diluted net loss per
share
    
    ($
    1.07
    )
    
    ($
    0.88
    )
    
    ($
    1.88
    )
    
    ($
    1.86
    )
 6




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The fair value of CoSines options was estimated at the grant date using
the Black-Scholes option pricing model with the following weighted average
assumptions: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Fair value of options granted
    
    $
    3.73
    
    
    $
    3.36
    
    
    $
    4.41
    
    
    $
    3.27Dividend yield
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %Volatility
    
    
    0.97
    
    
    
    0.81
    
    
    
    0.95
    
    
    
    0.81Risk free interest rate
    
    
    2.5
    %
    
    
    2.1
    %
    
    
    2.6
    %
    
    
    2.1
    %Expected life
    
    4 years
    
    4 years
    
    4 years
    
    4 years
 In the three and six months ended June 30, 2004, 23,491 shares were issued
under the Employee Stock Purchase Plan. The estimated weighted-average fair
value of shares issued under the Employee Stock Purchase Plan in 2004 was
$4.09, using a volatility of .64, risk-free interest rate of 2.0% and an
expected life of one year. The estimated weighted-average fair value of shares
issued under the Employee Stock Purchase Plan in 2003 was $2.22, using a
volatility of 0.47, risk-free interest rate of 1.3% and an expected life of one
year. Guarantees CoSine from time to time enters into certain types of contracts that
require the Company to indemnify parties against certain third party claims
that may arise. These contracts primarily relate to: (i) certain real estate
leases under which the Company may be required to indemnify property owners for
environmental liabilities and other claims arising from the Companys use of
the applicable premises, (ii) certain agreements with the Companys officers,
directors and employees, under which the Company may be required to indemnify
such persons for liabilities arising out of their employment relationship,
(iii) contracts under which the Company may be required to indemnify customers
against loss or damage to property or persons as a result of willful or
negligent conduct by CoSine employees or sub-contractors, (iv) contracts under
which the Company may be required to indemnify customers against third party
claims that a CoSine product infringes a patent, copyright or other
intellectual property right and (v) procurement or license agreements under
which the Company may be required to indemnify licensors or vendors for certain
claims that may be brought against them arising from the Companys acts or
omissions with respect to the supplied products or technology. Generally, a maximum obligation is not explicitly stated. Because the
obligated amounts associated with this type of agreement are not explicitly
stated, the overall maximum amount of the obligation cannot be reasonably
estimated. Historically, CoSine has not been obligated to make payments for
these obligations, and no liabilities have been recorded for these obligations
on its consolidated balance sheet as of June 30, 2004. Use of Estimates The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the amounts reported
in the consolidated financial statements and the accompanying notes. Actual
results could differ from these estimates. Estimates are used in accounting
for, but not limited to, revenue recognition, allowance for doubtful accounts,
inventory valuations, long-lived asset valuations, accrued liabilities,
including warranties, and equity issuances. Estimates and assumptions are
reviewed periodically and the effects of revisions are reflected in the
consolidated financial statements in the period of determination. 7




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2. COMMITMENTS AND CONTINGENCIES As of June 30, 2004, CoSine had commitments of approximately $1,082,000
relating to purchases of raw materials and semi-finished goods. Of that
amount, $373,000 related to excess inventory was accrued at June 30, 2004. On November 15, 2001, CoSine and certain of its officers and directors
were named as defendants in a securities class action lawsuit filed in the
United States District Court, Southern District of New York. The complaint
generally alleges that various investment bank underwriters engaged in improper
and undisclosed activities related to the allocation of shares in CoSines
initial public offering. The complaint brings claims for the violation of
several provisions of the federal securities laws against those underwriters,
and also against the Company and each of the directors and officers who signed
the registration statement relating to the initial public offering. Various
plaintiffs have filed similar actions asserting virtually identical allegations
against more than 250 other companies. The lawsuit and all other IPO
allocation securities class actions currently pending in the Southern District
of New York have been assigned to Judge Shira A. Scheindlin for coordinated
pretrial proceedings. In October 2002, the individual defendants were dismissed
without prejudice pursuant to a stipulation. The issuer defendants filed a
coordinated motion to dismiss on common pleading issues, which the Court
granted in part and denied in part in an order dated February 19, 2003. The
Courts order dismissed the Section 10(b) and Rule 10b-5 claims against the
Company but did not dismiss the Section 11 claims against the Company. In June 2004, a stipulation for the settlement and release of claims
against the issuer defendants, including the Company, was submitted to the
Court for preliminary approval. Under the proposed settlement, the plaintiffs
will dismiss and release all claims against participating issuer defendants in
exchange for a contingent payment guaranty by the insurance companies
collectively responsible for insuring the issuer defendants in all of the
related cases, and the assignment or surrender to the plaintiffs of certain
claims the issuer defendants may have against the underwriters. Under the
guaranty, the insurers will be required to pay the amount, if any, by which $1
billion exceeds the aggregate amount ultimately collected by the plaintiffs
from the underwriter defendants in all the cases, up to the limits of the
applicable insurance policies. The Company will not be required to make any
cash payments under the settlement, unless the Companys insurer is required to
pay on the Companys behalf an amount that exceeds the Companys insurance
coverage. The Company does not believe that this circumstance will occur. The
settlement is still subject to a number of conditions, including certification
of a class for settlement purposes and formal Court approval. If the
settlement is not consummated, the Company intends to defend the lawsuit
vigorously. However, the Company cannot predict its outcome with certainty. If
the Company is not successful in its defense of this lawsuit, it could be
forced to make significant payments to the plaintiffs and their lawyers, and
such payments could have a material adverse effect on the Companys business,
financial condition and results of operations if not covered by the Companys
insurance carrier. Even if these claims are not successful, the litigation
could result in substantial costs and divert managements attention and
resources, which could adversely affect the Companys business, results of
operations and financial position. In the ordinary course of business, CoSine is involved in legal
proceedings involving contractual obligations, employment relationships and
other matters. Except as described above, CoSine does not believe there are
any pending or threatened legal proceedings that will have a material impact on
its financial position or results of operations. 3. BALANCE SHEET DETAILS Inventory Net inventories, stated at the lower of cost (first-in, first-out) or
market, consisted of the following, in thousands: June 30,
    
    December 31,2004
    
    2003(unaudited)Raw materials
    
    $
    190
    
    
    $
    160Semi-finished goods
    
    
    2,541
    
    
    
    3,466Finished goods
    
    
    594
    
    
    
    377$
    3,325
    
    
    $
    4,003
 8




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There were no goods awaiting customer acceptance at June 30, 2004.
Included in net finished goods at December 31, 2003 was $160,000 of goods
awaiting customer acceptance. Included in net finished goods at June 30, 2004
and December 31, 2003 were $251,000 and $126,000, respectively, of goods used
for customer evaluation purposes. During the six months ended June 30, 2004, $271,000 of previously
written-down inventory was sold and $657,000 of inventory was written down.
During the six months ended June 30, 2003, $612,000 of previously written-down
inventory was sold and no inventory was written down. In addition, charges of
$43,000 were recorded in the six months ended June 30, 2004 in connection with
excess purchase commitments at CoSines contract manufacturers. There were no
charges in connection with excess purchase commitments at CoSines contract
manufacturers in the six months ended June 30, 2003. During the three months ended June 30, 2004, $211,000 of previously
written-down inventory was sold and $555,000 of inventory was written down.
During the three months ended June 30, 2004, $276,000 of previously
written-down inventory was sold and no inventory was written down. In
addition, charges of $8,000 were recorded in the three months ended June 30,
2004 in connection with excess purchase commitments at CoSines contract
manufacturers. There were no charges in connection with excess purchase
commitments at CoSines contract manufacturers in the three months ended June
30, 2003. Warranty CoSine provides a basic limited warranty, including repair or replacement
of parts, and technical support. The specific terms and conditions of those
warranties vary depending on the customer or region in which CoSine does
business. CoSine estimates the costs that may be incurred under its basic
limited warranty and records a liability in the amount of such costs at the
time product revenue is recognized. CoSines warranty obligation is affected
by the number of installed units, product failure rates, materials usage and
service delivery costs incurred in correcting product failures. CoSine
periodically assesses the adequacy of its recorded warranty liabilities and
adjusts the amounts as necessary. Changes in CoSines warranty liability were as follows, in thousands: Six Months Ended June 30,2004
    
    2003(unaudited)Beginning balance
    
    $
    464
    
    
    $
    1,103Warranty charged to cost of goods sold
    
    
    177
    
    
    
    126Utilization of warranties
    
    
    (294
    )
    
    
    (396
    )Changes in estimated liability based on experience
    
    
    (18
    )
    
    
    (97
    )Ending balance
    
    $
    329
    
    
    $
    736
 4. WARRANTS In the second quarter of 2004, the Company issued to a reseller a warrant
to acquire 254,489 shares of CoSine stock at an exercise price of $4.65 per
share. The warrant has a two-year term beginning May 28, 2004. If during the
two-year term (1) any person or entity acquires a greater than 50% interest in
CoSine or the ownership or control of more than 50% of the voting stock of
CoSine or (2) CoSine sells substantially all of its intellectual property
assets, the warrant becomes exercisable. The number and kind of securities
purchasable upon exercise of the warrant and the exercise price are subject to
adjustment from time to time upon the occurrence of certain events. CoSine
calculated the fair value of the warrant to be approximately $48,000 using the
Black-Scholes valuation method, using a volatility factor of .97, a risk-free
interest rate of 2.5%, an expected life of two years and a 10% probability that
the warrant would be exercisable during the two-year term. The fair value of
the warrant is being amortized over the two-year expected life of the warrant.
In the second quarter of 2004, CoSine amortized approximately $2,000 to cost of
goods sold. The remaining $46,000 of unamortized fair value of the warrant is
included in prepaid expenses and other current assets. 5. NET LOSS PER COMMON SHARE 9




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##### Table of Contents



Basic net loss per common share is calculated based on the weighted-average
number of common shares outstanding during the periods presented, less
weighted-average shares outstanding that are subject to CoSines right of
repurchase. Common stock equivalents consisting of stock options and warrants
(calculated using the treasury stock method), have been excluded from the
diluted net loss per common share computations, as their inclusion would be
antidilutive. These securities amounted to 1,445,026 shares and 1,580,837
shares for the six months ended June 30, 2004 and 2003, respectively. The calculations of basic and diluted net loss per share are shown below,
in thousands, except per share data: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net loss
    
    ($
    9,706
    )
    
    ($
    7,716
    )
    
    ($
    17,091
    )
    
    ($
    16,580
    )Basic and diluted:Weighted-average shares of common stock outstanding
    
    
    10,218
    
    
    
    9,956
    
    
    
    10,199
    
    
    
    9,954Weighted-average shares subject to repurchase
    
    
    (156
    )
    
    
    (208
    )
    
    
    (164
    )
    
    
    (221
    )Weighted-average shares used in basic and
diluted net loss per share
    
    
    10,062
    
    
    
    9,748
    
    
    
    10,035
    
    
    
    9,733Basic and diluted net loss per share
    
    ($
    0.96
    )
    
    ($
    0.79
    )
    
    ($
    1.70
    )
    
    ($
    1.70
    )
 6. COMPREHENSIVE LOSS The components of comprehensive loss are shown below, in thousands: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net loss
    
    ($
    9,706
    )
    
    ($
    7,716
    )
    
    ($
    17,091
    )
    
    ($
    16,580
    )Other comprehensive loss:Unrealized losses on investments
    
    
    (59
    )
    
    
    123
    
    
    
    (65
    )
    
    
    49Currency translation adjustment
    
    
    (31
    )
    
    
    (195
    )
    
    
    (15
    )
    
    
    (199
    )Total other comprehensive loss
    
    
    (90
    )
    
    
    (72
    )
    
    
    (80
    )
    
    
    (150
    )Comprehensive loss
    
    ($
    9,796
    )
    
    ($
    7,788
    )
    
    ($
    17,171
    )
    
    ($
    16,730
    )
 7. SEGMENT REPORTING CoSine operates in only one operating segment, and substantially all of
CoSines assets are located in the United States. Revenues from customers by geographic region for the three months and six
months ended June 30, 2004 and 2003, respectively, were as follows, in
thousands: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003RegionUnited States
    
    $
    633
    
    
    $
    3,684
    
    
    $
    2,691
    
    
    $
    4,670Italy
    
    
    30
    
    
    
    25
    
    
    
    763
    
    
    
    34France
    
    
    231
    
    
    
    130
    
    
    
    901
    
    
    
    629Korea
    
    
    949
    
    
    
    60
    
    
    
    1,562
    
    
    
    61Japan
    
    
    546
    
    
    
    1,743
    
    
    
    614
    
    
    
    2,268Other EMEA
    
    
    169
    
    
    
    315
    
    
    
    472
    
    
    
    501Other Asia/Pacific
    
    
    10
    
    
    
    57
    
    
    
    20
    
    
    
    57Total
    
    $
    2,568
    
    
    $
    6,014
    
    
    $
    7,023
    
    
    $
    8,220
 10




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For the three months ended June 30, 2004, Infranet, NEC and Call-Net
accounted for 33%, 20% and 11% of CoSines revenue, respectively. For the
three months ended June 30, 2003, Sprint and Nissho accounted for 59% and 23%
of CoSines revenue, respectively. For the six months ended June 30, 2004,
Sprint, Infranet and Lucent accounted for 27%, 21% and 10% of CoSines revenue,
respectively. For the six months ended June 30, 2003, Sprint and Nissho
accounted for 52% and 18% of CoSines revenue, respectively. At June 30, 2004, Transpac, Call-Net and Sonic accounted for 27%, 23% and
12% of CoSines accounts receivable, respectively. 8. RESTRUCTURING AND IMPAIRMENT CHARGES Restructuring In March 2003, CoSines senior management communicated reductions in its
workforce related to the closure of a sales office in the Asia/Pacific Rim
region. The employees were notified in March 2003 that their job functions
would be eliminated and that termination benefits would be paid to them. As a
result of the workforce reduction, five employees were designated for
termination. In May 2002, CoSines senior management approved a restructuring program
to reduce its worldwide workforce, close certain sales offices, exit certain
facilities and dispose of or abandon certain property and equipment. Employees
were notified in May 2002 that certain job functions would be eliminated and
that particular termination benefits would be paid to affected employees. As a
result of the workforce reduction, 146 employees were designated for
termination in the restructuring program. Most of the terminations took place
in the second quarter of 2002, with the remainder taking place in the third
quarter of 2002. The employees in the workforce reduction were from all
functional groups and were located in offices in the United States, Europe and
Asia. The Company also wrote down certain property and equipment to its
expected realizable value as the assets have been either sold, disposed of or
otherwise abandoned. The final $153,000 related to the restructuring program
was paid in the three months ended March 31, 2004. Activity related to the March 2003 and May 2002 restructurings for the six
months ended June 30, 2004 was as follows, (in thousands): Worldwide
    
    Leaseworkforce
    
    terminationreduction
    
    and other
    
    TotalProvision balance at December 31, 2003
    
    $
    48
    
    
    $
    118
    
    
    $
    166Cash payments
    
    
    
    
    
    
    (153
    )
    
    
    (153
    )Accrual adjustment
    
    
    
    
    
    
    35
    
    
    
    35Provision balance at June 30, 2004
    
    $
    48
    
    
    $
    
    
    
    $
    48
 CoSine expects to pay the remaining $48,000 related to the workforce
reduction in 2004. Impairment of Long-lived Assets As a result of the Companys assessment of its business, the Company
concluded that indicators of impairment of its long-lived assets were present
at June 30, 2004. Such indicators included ongoing operating losses, inability
to achieve sustainable revenue growth, including the Companys failure to
capture new customers, and the Companys decision to evaluate strategic
alternatives. Accordingly, the Company performed an impairment test of the
carrying value of its long-lived assets, consisting primarily of property and
equipment in accordance with SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets. Based on an undiscounted cash flow analysis,
the cash flows expected 11




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to be generated by the Company during the long-lived assets estimated
remaining useful lives were not sufficient to recover the net book value of the
assets. Consequently, the Company obtained a valuation report outlining the
estimated fair value of the assets, based on quoted market prices, from an
independent appraiser and recorded an impairment charge of $2.3 million to
write down the carrying value of the long-lived assets held for use to their
fair values in the second quarter of 2004 
 ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS This Managements Discussion and Analysis of Financial Condition and
Results of Operations contain forward-looking statements. We use words such as
anticipate, believe, plan, expect, future, intend and similar
expressions to identify forward-looking statements. These forward-looking
statements are subject to certain risks and uncertainties that could cause
actual results to differ materially from those reflected in the forward-looking
statements. Factors that might cause such a difference include, but are not
limited to, our ability to identify and effectuate desirable strategic
alternatives, the time and costs required to explore and investigate possible
transactions and other corporate actions, management and board interest in and
distraction due to exploring and investigating strategic alternatives, the
reactions, either positive or negative, of investors, competitors, customers,
employees and others to us exploring possible strategic alternatives and
opportunities and to any specific strategic alternative or opportunity selected
by us, failure to achieve revenue growth and profitability, the loss of
business opportunities with large service providers due to our financial
losses, the continued downturn in the telecommunications industry and slow
development of the market for network-based IP services, failure to develop and
maintain distribution partnerships, product development, commercialization and
technology difficulties, manufacturing costs, the impact of competitive
products, pricing, changing customer requirements, timely availability and
acceptance of new products, and changes in economic conditions in the various
markets that we serve, all as are discussed in more detail in the section
entitled Risk Factors on pages 19 through 24 of this report, as well as the
other risk factors discussed in that section. Readers are cautioned not to
place undue reliance on these forward-looking statements, which reflect
managements opinions only as of the date hereof. We undertake no obligation
to revise or publicly release the results of any revision to these
forward-looking statements. Readers should carefully review the risk factors
described in other documents that we file from time to time with the Securities
and Exchange Commission, including the Quarterly Reports on Form 10-Q that we
will file in the remainder of fiscal year 2004. OVERVIEW We develop, market and sell a communications platform that we refer to as
our IP Service Delivery Platform. Our product is designed to enable network
service providers to rapidly deliver a portfolio of communication services to
business and consumer customers. We market our IP Service Delivery Platform
through our direct sales force and through resellers to network service
providers in Asia, Europe and North America. We provide customer service and
support for our products directly and through support partners. The market for our IP Service Delivery Platform is still in the early
stages of development, and the volume and timing of orders are difficult to
predict. A customers decision to purchase our platform typically involves a
significant commitment of its resources and a lengthy evaluation, testing and
product qualification process. The long sales cycle and the timing of our
customers rollout of services made possible by our platform, which affects
repeat business, may cause our revenue and operating results to vary
significantly and unexpectedly from quarter to quarter and may also constrain
our ability to secure new customers. We have not generated sufficient revenue
to fund our operations and must increase our revenue in the near term in order
to reduce our cash consumption and remain a viable and competitive supplier. On July 29, 2004, we announced that we were exploring various strategic
alternatives and that we had hired an investment bank as our financial advisor. There can be no assurance that any transaction or other corporate action
will result from our exploration of strategic alternatives. Further there can
be no assurance concerning the type, form, structure, nature, results, timing
or terms and conditions of any such potential action, even if such an action
does result from this exploration. 12




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##### Table of Contents



Managements overview of the Companys financial position is discussed in
more detail in the Liquidity and Capital Resources section on pages 21-22 and
the Outlook section on page 22. CRITICAL ACCOUNTING POLICIES AND ESTIMATES General Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have
been prepared in accordance with accounting principles generally accepted in
the United States. The preparation of these financial statements requires us
to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenue and expenses, and related disclosure of contingent assets
and liabilities. On an ongoing basis, we evaluate our estimates, including
those related to revenue recognition, allowance for doubtful accounts,
inventory valuation, long-lived assets, warranties and equity issuances.
Additionally, the audit committee of our board of directors reviews these
critical accounting estimates at least annually. We base our estimates on
historical experience and on various other assumptions that we believe to be
reasonable under the circumstances. These estimates form the basis for certain
judgments about the carrying values of assets and liabilities that are not
readily apparent from other sources. Actual results may differ from these
estimates. On July 29, 2004, we announced that we were exploring various strategic
alternatives and that we had hired an investment bank as our financial advisor.
Pending the outcome of our review of strategic alternatives and any definitive
decisions to pursue specific alternatives, we will continue to prepare our
financial statements on the assumption that we will continue as a going
concern, which contemplates the realization of assets and liquidation of
liabilities in the normal course of business. As such, the financial
statements do not include any adjustments to reflect possible future effects on
the recoverability and classification of assets or the amounts and
classification of liabilities that may result from any decisions made with
respect to our assessment of our strategic alternatives. As an example, if we
were to decide to pursue a liquidation and return of capital, we would be
required to prepare and present financial statements on the liquidation basis
of accounting, whereby assets are stated at their estimated net realizable
values and liabilities are stated at their estimated settlement amounts. The following accounting policies are significantly affected by the
judgments and estimates we use in the preparation of our consolidated financial
statements. Revenue Recognition Most of our sales are generated from complex arrangements. Recognizing
revenue in these arrangements requires our making significant judgments,
particularly in the areas of customer acceptance and collectibility. Certain of our sales arrangements require formal acceptance by our
customers. In such cases, we do not recognize revenue until we have received
formal notification of acceptance. Although we work closely with our customers
to help them achieve satisfaction with our products prior to and after
acceptance, the timing of customer acceptance can greatly affect the timing of
our revenue. While the end users of our product are generally large network service
providers, we also sell product and services through small resellers and to
small network service providers in Asia, Europe and North America. To
recognize revenue before we receive payment, we are required to assess that
collection from the customer is probable. If we cannot satisfy ourselves that
collection is probable, we defer revenue recognition until we have collected
payment. Allowance for Doubtful Accounts Receivable We maintain allowances for doubtful accounts receivable in connection with
estimated losses resulting from the inability of our customers to pay our
invoices. In order to estimate the appropriate level of this allowance, we
analyze historical bad debts and write-offs, customer concentrations, current
customer credit-worthiness, current economic trends and changes in our customer
payment patterns. In future periods, if the financial condition of our
customers were to deteriorate and affect their ability to make payments,
additional allowances could be required. Inventory Valuation 13




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##### Table of Contents



In assessing the value of our inventory, we are required to make judgments
as to future demand and then compare that demand with current inventory
quantities and firm purchase commitments. If our inventories on hand and firm
purchase commitments are in excess of forecasted demand, we write down the
value of our inventory. We generally use a 12-month forecast to assess future
demand. Inventory write-downs are charged to cost of good sold. During the
three months ended June 30, 2004, we wrote down $555,000 of inventory and sold
$211,000 of previously written-down inventory. During the six months ended
June 30, 2004, we wrote down $657,000 of inventory and we sold $271,000 of
previously written-down inventory. If actual demand for our products is less
than our forecasts, additional inventory write-downs may be required. Long-lived Assets We evaluate the carrying value of long-lived assets, consisting primarily
of property, plant and equipment, whenever certain events or changes in
circumstances indicate that the carrying amount of these assets may not be
recoverable. In assessing the recoverability of long-lived assets, we compare
the carrying value to the undiscounted future cash flows the assets are
expected to generate. If the total of the undiscounted future cash flows is
less than the carrying amount of the assets, the assets will be written down to
their estimated fair value. Fair value is generally determined by calculating
the discounted future cash flows using a discount rate based upon our weighted
average cost of capital or specific appraisal, as appropriate. Significant
judgments and assumptions are required in the forecast of future operating
results used in the preparation of the estimated future cash flows, including
long-term forecasts of overall market conditions and our participation in the
market. Changes in these estimates could have a material adverse effect on the
assessment of the long-lived assets, thereby requiring us to record further
asset write-downs in the future. As a result of our assessment of our business, we concluded that
indicators of impairment of our long-lived assets were present at June 30,
2004. Such indicators included ongoing operating losses, inability to achieve
sustainable revenue growth, including our failure to capture new customers, and
our decision to evaluate strategic alternatives. Accordingly, we performed an
impairment test of the carrying value of our long-lived assets, consisting
primarily of property and equipment in accordance with SFAS No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets. Based on an
undiscounted cash flow analysis, the cash flows expected to be generated by us
during the long-lived assets estimated remaining useful lives were not
sufficient to recover the net book value of the assets. Consequently, we
obtained a valuation report outlining the estimated fair value of the assets,
based on quoted market prices, from an independent appraiser and recorded an
impairment charge of $2.3 million to write down the carrying value of our
long-lived assets held for use to their fair values in the second quarter of
2004. Warranties We provide a basic limited warranty, including repair or replacement of
parts, and technical support. The specific terms and conditions of those
warranties vary depending on the customer or region in which we do business.
We estimate the costs that may be incurred under our basic limited warranty and
record a liability in the amount of such costs at the time product revenue is
recognized. The number of installed units, product failure rates, and
materials usage and service delivery costs incurred in correcting product
failures, affects our warranty obligation. Each quarter, we assess the
adequacy of our recorded warranty liabilities and adjust the amounts as
necessary. In future periods, if actual product failure rates, materials usage
or service delivery costs differ from our estimates, adjustments to cost of
good sold may result. Impact of Equity Issuances on Operating Results In 2004 and 2003, our operating results have been affected by stock
options previously granted to employees that were subsequently re-priced and by
the amortization of deferred compensation related to stock options granted
prior to September 2000 at an exercise price below their estimated fair value.
These employee stock option transactions have resulted in deferred
compensation, which is presented as a reduction of stockholders equity on our
balance sheet and is amortized over the vesting period of the applicable
options using the graded vesting method. The re-priced stock options are also
required to be re-measured each quarter based on their intrinsic value,
resulting in additional charges or credits. In the first six months of 2004,
our operating results were additionally affected by the grant of CoSine common
stock to employees based on the achievement of certain Company objectives. 14




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##### Table of Contents



The compensation associated with shares and options relating to the
following transactions is required to be re-measured at the end of each
accounting period. The re-measurement at the end of each accounting period
will result in unpredictable charges or credits in future periods, depending on
future fluctuations in the market prices of our common stock:  
    
    Non-recourse promissory notes receivable: During the fourth quarter
of 2000, we converted full-recourse promissory notes received from
employees upon the early exercise of unvested employee stock options to
non-recourse obligations. Accordingly, we are required to re-measure
the compensation associated with the shares underlying the promissory
note until the earlier of repayment of the note or default. Deferred
compensation expense, which is recorded at each re-measurement date, is
amortized over the remaining vesting period of the underlying options.
    
    Re-priced stock options: In November 2002, we re-priced outstanding
employee stock options to purchase 1,091,453 shares of our common stock
with original exercise prices ranging from $5.45 per share to $159.38
per share. These options were re-priced to $5.00 per share, which was
higher than the fair market value of the underlying shares on the
re-pricing date. Compensation will be re-measured for these options
until they are exercised, canceled, or expire. At June 30, 2004,
473,625 stock options re-priced in November 2002 were still outstanding.
Deferred compensation expense, which is recorded at each re-measurement
date, is amortized over the remaining vesting period of the underlying
options. Some of the stock options granted to our employees have generated deferred
compensation as a result of stock options having an exercise price below their
estimated fair value. Deferred compensation is presented as a reduction to
stockholders equity on the balance sheet and is then amortized using a graded
vesting method over the vesting period of the applicable options. When an
employee terminates, an expense credit is recorded for any amortization that
has been previously recorded as an expense in excess of vesting. In the first quarter of 2004, we began a program whereby we grant
employees bonuses in shares of CoSine common stock based on the achievement of
certain Company objectives. At the end of each quarter, we determine whether
objectives have been achieved and set the total value of the common stock
grant. The number of shares to be granted is calculated the following quarter
based on the fixed value of the common stock grant, as determined at
quarter-end, divided by CoSines stock price on the grant date. Compensation
expense is accrued in full in the quarter in which it is earned. No employee
bonuses were earned in the second quarter of 2004 as the quarterly objectives
were not met. In the second quarter of 2004, we issued to a reseller a warrant to
acquire 254,489 shares of CoSine stock at an exercise price of $4.65 per share.
The warrant has a two-year term beginning May 28, 2004. If during the
two-year term (1) any person or entity acquires a greater than 50% interest in
CoSine or the ownership or control of more than 50% of the voting stock of
CoSine or (2) CoSine sells substantially all of its intellectual property
assets, the warrant becomes exercisable. The number and kind of securities
purchasable upon exercise of the warrant and the exercise price are subject to
adjustment from time to time upon the occurrence of certain events. We
calculated the fair value of the warrant to be approximately $48,000 using the
Black-Scholes valuation method, using a volatility factor of .97, a risk-free
interest rate of 2.5%, an expected life of two years and a 10% probability that
the warrant would be exercisable during the two-year term. The fair value of
the warrant is being amortized over the two-year expected life of the warrant.
In the second quarter of 2004, we amortized approximately $2,000 to cost of
goods sold. The remaining $46,000 of unamortized fair value of the warrant is
included in prepaid expenses and other current assets. RESULTS OF OPERATIONS For the three months ended June 30, 2004 and 2003, we reported basic and
diluted net losses per share of $0.96 and $0.79, respectively. The effect of
equity issuances to employees and suppliers decreased net loss per share by
$0.08 for the three months ended June 30, 2004 and increased net loss per share
by $0.03 for the three months ended June 30, 2003. For the six months ended June 30, 2004 and 2003, we reported basic and
diluted net losses per share of $1.70. The effect of equity issuances to
employees and suppliers decreased net loss per share by $0.09 for the six
months ended June 30, 2004 and increased net loss per share by $0.05 for the
six months ended June 30, 2003. 15




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##### Table of Contents



Revenue For the three months ended June 30, 2004, revenue was $2.6 million of
which 67% was from hardware sales, 4% was from software sales and 29% was from
sales of services. For the three months ended June 30, 2003, revenue was $6.0
million of which 84% was from hardware sales, 1% was from software sales and
15% was from sales of services. For the six months ended June 30, 2004,
revenue was $7.0 million, of which 71% was from hardware sales, 8% was from
software sales and 21% was from sales of services. For the six months ended
June 30, 2003, revenue was $8.2 million, of which 81% was from hardware sales,
2% was from software sales and 17% was from sales of services. Revenues from customers by geographic region for the three and six months
ended June 30, 2004 and 2003, respectively, were as follows, in thousands: Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003RegionUnited States
    
    $
    633
    
    
    $
    3,684
    
    
    $
    2,691
    
    
    $
    4,670Italy
    
    
    30
    
    
    
    25
    
    
    
    763
    
    
    
    34France
    
    
    231
    
    
    
    130
    
    
    
    901
    
    
    
    629Korea
    
    
    949
    
    
    
    60
    
    
    
    1,562
    
    
    
    61Japan
    
    
    546
    
    
    
    1,743
    
    
    
    614
    
    
    
    2,268Other EMEA
    
    
    169
    
    
    
    315
    
    
    
    472
    
    
    
    501Other Asia/Pacific
    
    
    10
    
    
    
    57
    
    
    
    20
    
    
    
    57Total
    
    $
    2,568
    
    
    $
    6,014
    
    
    $
    7,023
    
    
    $
    8,220
 Revenue for the three months ended June 30, 2004 decreased $3.4 million
compared to the same period in 2003. Revenue for the six months ended June 30,
2004 decreased $1.2 million compared to the same period in 2003. The decline
in both periods was due to lower sales to major customers in the U.S. and
Japan, due in part to the timing of their expansion plans. Because the market
for network-based IP services is in the early stages of development, service
provider demand for our products may fluctuate until service providers are able
to further develop enterprise demand for such services and accelerate revenue
growth from the sale of such services. We have additionally been unable to
capture new customers to offset the loss in revenue from those existing
customers due in part to concerns about our financial viability and to the
relatively small size of our sales and support staff. See Outlook section on
page 22 and Risk Factors section on pages 23 to 29. For the three months ended June 30, 2004, Infranet, NEC and Call-Net
accounted for 33%, 20% and 11% of our revenue, respectively. For the three
months ended June 30, 2003, Sprint and Nissho accounted for 59% and 23% of our
revenue, respectively. For the six months ended June 30, 2004, Sprint,
Infranet and Lucent accounted for 27%, 21% and 10% of our revenue,
respectively. For the six months ended June 30, 2003, Sprint and Nissho
accounted for 52% and 18% of our revenue, respectively. Non-Cash Charges Related to Equity Issuances During the three months ended June 30, 2004 and 2003, we recorded ($0.8)
million and $0.3 million, respectively, of non-cash charges (credits) related
to equity issuances to cost of goods sold, operating expenses and interest
expense. During the six months ended June 30, 2004 and 2003, we recorded
($0.9) million and $0.5 million, respectively, of non-cash charges (credits)
related to equity issuances to cost of goods sold, operating expenses and
interest expense. Below is a reconciliation of non-cash charges (credits) related to equity
issuances for the three and six months ended June 30, 2004 and 2003, as
presented in our statement of operations, in thousands: 16




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Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Amortization of deferred
compensation related to stock
options granted to employees prior
to our initial public offering
having an exercise price below fair
market value
    
    $
    24
    
    
    $
    380
    
    
    $
    88
    
    
    $
    960Credits related to the reversal of
deferred stock compensation
amortization in excess of vesting
for terminated employees
    
    
    (49
    )
    
    
    (249
    )
    
    
    (163
    )
    
    
    (654
    )Amortization and re-measurement of
deferred compensation associated
with re-pricing
    
    
    (748
    )
    
    
    113
    
    
    
    (1,063
    )
    
    
    113Bonus paid in shares of common stock
    
    
    (8
    )
    
    
    
    
    
    
    228
    
    
    
    Amortization of charges related to
warrants or stock options issued to
non-employees in conjunction with
lease and debt agreements and a
reseller agreement
    
    
    18
    
    
    
    16
    
    
    
    33
    
    
    
    61Net non-cash charges related to
equity issuances
    
    ($
    763
    )
    
    $
    260
    
    
    ($
    877
    )
    
    $
    480
 Under the stock bonus program, we issued 43,300 shares of CoSine common
stock in the second quarter of 2004, based on CoSines stock price on the
issuance date. Cost of Goods Sold For the three months ended June 30, 2004, cost of goods sold was $1.4
million, of which $1.0 million represented materials, labor, production
overhead, warranty and the cost of providing services, $0.2 million represented
software royalty expense, $0.5 million represented inventory written down,
offset by a $0.1 million non-cash credit related to equity issuances and other
individually small variances and a $0.2 million benefit associated with the
sale of previously written-down inventory. For the three months ended June 30,
2003, cost of goods sold was $2.8 million, which $2.7 million represented
materials, labor, production overhead, warranty and the cost of providing
services, $0.4 million represented charges resulting from reductions in
inventory overhead capitalization rates, offset by a $0.3 million benefit
associated with the sale of previously written-down inventory. For the six months ended June 30, 2004, cost of goods sold was $2.9
million, of which $2.1 million represented materials, labor, production
overhead, warranty and the cost of providing services, $0.4 million represented
software royalty expense, $0.7 million represented inventory written down,
offset by a $0.3 million benefit associated with the sale of previously
written-down inventory. For the six months ended June 30, 2003, cost of goods
sold was $3.5 million, of which $3.7 million represented materials, labor,
production overhead, warranty and the cost of providing services, $0.4 million
represented charges resulting from reductions in inventory overhead
capitalization rates and $0.6 million represented a benefit associated with the
sale of previously written-down inventory. Gross Profit For the three months ended June 30, 2004 and 2003, gross profit was $1.1
million and $3.2 million, respectively. Gross margin declined from 53% to 44%.
Increased excess inventory charges accounted for a 22 percentage point
decrease in gross margin. Those charges were primarily associated with
reductions in forecasted product demand. Software royalty expense accounted
for a four percentage point decrease in gross margin due primarily to fixed
royalty costs as a percentage of lower sales. Partially offsetting those
decreases in gross margin, a reduction in materials, labor and product overhead
costs as a percentage of sales accounted for a 6 percentage point improvement
in gross margin. More favorable product configurations and reductions in
maintenance contract support costs primarily accounted for the improvement. A
charge related to a reduction in inventory overhead capitalization in the
second quarter of 2003, compared to no similar charges in the second quarter of
2004, caused a 6 percentage point improvement in gross margin. An increase in
the sale of previously written-down inventory as a percentage of sales
accounted for a two percentage point improvement in gross margin. 17




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For the six months ended June 30, 2004 and 2003, gross profit was $4.1
million and $4.7 million, respectively. Gross margin increased from 57% to
58%. A reduction in materials, labor and product overhead costs as a
percentage of sales accounted for a 13 percentage point increase in gross
margin. A charge related to a reduction in inventory overhead capitalization
in the second quarter of 2003, compared to no similar charges in the second
quarter of 2004, caused a 4 percentage point improvement in gross margin.
Partially offsetting those increases in gross margin, increased excess
inventory charges accounted for a 9 percentage point decrease in gross margin.
Those charges were generally associated with reductions in forecasted product
demand. Reductions in the sale of previously written-down inventory accounted
for a four percentage point decrease in gross margin. Software royalty expense
accounted for a two percentage point decrease in gross margin due primarily to
fixed royalty costs as a percentage of lower sales. We expect our gross margin to continue to be primarily affected by
regional product mix and configurations, the volume of product sold and pricing
pressures, the amount of excess inventory charges and the amount of previously
written-down inventory sold. The mix of products that our customers purchase
is unpredictable and, because of lead times required to buy certain components
and the timing of our customers orders, we purchase inventory based on
forecasted demand. The amount of excess inventory purchase commitments and
excess inventory charges related to on-hand inventory is dependent on us
purchasing the correct mix of inventory. In addition, if our unit sales
volumes are significantly lower than forecasted demand, excess inventory
charges will result. Finally, customer perception of our announcement
regarding the retention of an investment banker as a financial advisor to
assist us in assessing strategic alternatives may additionally reduce demand
for our products. Research and Development Expenses Research and development expenses were $4.4 million and $5.2 million for
the three months ended June 30, 2004 and 2003, respectively, representing a
decrease of $0.8 million or 15%. Payroll-related expense declined $0.7 million
reflecting lower headcount due to attrition. Non-cash equity charges declined
$0.2 million primarily due to an expense credit for re-priced options as our
stock price declined below the exercise price of re-priced options at June 30,
2004. Partially offsetting the decline in expenses, outside engineering
services increased $0.3 million due to the transition of our sustaining
engineering and certain software development functions to outside engineering
firms Research and development expenses were $9.6 million and $10.4 million for
the six months ended June 30, 2004 and 2003, respectively, representing a
decrease of $0.8 million or 8%. Payroll-related expense declined $0.9 million
reflecting lower headcount in the current period due to attrition. Non-cash
equity charges declined $0.4 million primarily due to an expense credit for
re-priced options as our stock price declined below the exercise price of
re-priced options at June 30, 2004. Software maintenance and material
consumption costs declined $0.2 million due to cost saving measures. Partially
offsetting the decline in expenses outside engineering services increased $0.8
million due to the transition of our sustaining engineering and certain
software development functions to outside engineering firms. As an on-going business, we expect spending to be somewhat lower than Q2
2004 spending due to lower headcount and the SFAS 144 impairment write-down,
which effectively reduces future depreciation expense. Sales and Marketing Expenses Sales and marketing expenses were $3.2 million and $3.8 million for the
three months ended June 30, 2004 and 2003, respectively, representing a
decrease of $0.6 million or 16%. This resulted partly from a decrease in
payroll-related expense of $0.2 million mainly due to lower commissions as a
result of lower revenue in the three months ended June 30, 2004 compared to
June 30, 2003. Non-cash equity charges declined $0.2 million primarily due to
an expense credit for re-priced options as our stock price declined below the
exercise price of re-priced options at June 30, 2004. Travel expense
decreased $0.1 million due to continued cost saving measures. Facilities rent
expense decreased by $0.1 million due to re-negotiation of rents at certain
offices and the elimination of others. Outside service expense in
international subsidiaries decreased $0.1 million due to reductions in
administrative infrastructure and cost savings measures. Offsetting the
decline in expenses was a $0.2 million charge related to the cost of equipment
provided to a reseller for training and demonstration purposes. Sales and marketing expenses were $6.5 million and $7.1 million for the
six months ended June 30, 2004 and 2003, respectively, representing a decrease
of $0.6 million or 8%. This resulted partly from a decrease in facilities rent
expense of $0.3 million due to re-negotiation of rents at certain offices and
the elimination of others. Outside service 18




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expense in international subsidiaries decreased $0.2 million due to
reductions in administrative infrastructure and cost savings measures. Travel
expense decreased $0.2 million due to continued cost saving measures.
Contractor expense decreased $0.1 million due to cost savings measures.
Depreciation expense declined $0.1 million due primarily to some assets
becoming fully depreciated. Non-cash equity charges declined $0.1 million
primarily due to an expense credit for re-priced options as our stock price
declined below the exercise price of re-priced options at June 30, 2004.
Marketing event and tradeshow expense decreased $0.1 million due to cost
savings measures. Partially offsetting those decreases, absorption to cost of
goods sold of spending to support maintenance contracts and warranty declined
$0.3 million. Such support costs are initially charged to Sales and Marketing
expense and subsequently reclassified to either cost of good sold or the
provision for warranty claims based on associated activity such as product
return levels and technical support case data. Due primarily to a smaller
customer installed base, activity associated with maintenance and warranty was
less than the prior year. Finally, expenses increased $0.3 million as a result
of (i) expensing equipment provided for free to a reseller for training and
demonstration purposes and (ii) an increase in evaluation amortization expense
associated with providing more evaluation units to customers. As an on-going business, we expect spending to be somewhat lower than Q2
2004 spending due to lower headcount and the SFAS 144 impairment write-down,
which effectively reduces future depreciation expense. General and Administrative Expenses General and administrative expenses were $1.2 million and $2.1 million for
the three months ended June 30, 2004 and 2003, respectively, representing a
decrease of $0.9 million or 43%. This resulted partly from a decrease in
non-cash equity charges of $0.4 million primarily due to an expense credit for
re-priced options as our stock price declined below the exercise price of
re-priced options at June 30, 2004. A reduction in the bad debt provision due
to improved collection experience decreased expense by $0.2 million. Reduced
use of contractors and consultants accounted for a $0.1 million decrease in
expense. Payroll-related expense decreased $0.1 million reflecting lower
headcount in the current period due to employee attrition. General and administrative expenses were $2.9 million and $3.8 million for
the six months ended June 30, 2004 and 2003, respectively, representing a
decrease of $0.9 million or 24%. This resulted partly from a decline in
non-cash equity charges of $0.7 million primarily due to an expense credit for
re-priced options as our stock price declined below the exercise price of
re-priced options at June 30, 2004. Payroll-related expense declined $0.2
million reflecting lower headcount in the current period due to employee
attrition. Insurance expense declined by $0.2 million due primarily to lower
director and officer insurance rates. Equipment rental expense decreased by
$0.2 million due to the expiration of an operating lease in the third quarter
of 2003. A reduction in the bad debt provision due to improved collection
experience decreased expense by an additional $0.1 million. Partially
offsetting the decreases, legal and accounting fees increased by $0.3 million
due to higher audit costs and the replacement of internal legal counsel with
outside firms. As an on-going business, we expect spending to be somewhat lower than Q2
2004 spending due to lower headcount and the SFAS 144 impairment write-down,
which effectively reduces future depreciation expense. Restructuring and Impairment Charges March 2003 and May 2002 Restructuring In March 2003, our senior management communicated reductions in our
workforce related to the closure of a sales office in the Asia/Pacific Rim
region. The employees were notified in March 2003 that their job functions
would be eliminated and that termination benefits would be paid to them. As a
result of the workforce reduction, five employees were designated for
termination. In May 2002, our senior management approved a restructuring program to
reduce our worldwide workforce, close certain sales offices, exit certain
facilities and dispose of or abandon certain property and equipment. Employees
were notified in May 2002 that certain job functions would be eliminated and
that particular termination benefits would be paid to affected employees. As a
result of the workforce reduction, 146 employees were designated for
termination in the restructuring program. Most of the terminations took place
in the second quarter of 2002, with the remainder taking place in the third
quarter of 2002. The employees in the workforce reduction were from all
functional groups and were 19




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located in offices in the United States, Europe and Asia. We also wrote
down certain property and equipment to its expected realizable value as the
assets have been either sold, disposed of or otherwise abandoned. The final
$153,000 related to the restructuring program was paid in the three months
ended March 31, 2004. Activity related to the March 2003 and May 2002 restructurings for the six
months ended June 30, 2004 was as follows (in thousands): Worldwide
    
    Leaseworkforce
    
    terminationreduction
    
    and other
    
    TotalProvision balance at December 31, 2003
    
    $
    48
    
    
    $
    118
    
    
    $
    166Cash payments
    
    
    
    
    
    
    (153
    )
    
    
    (153
    )Accrual adjustment
    
    
    
    
    
    
    35
    
    
    
    35Provision balance at June 30, 2004
    
    $
    48
    
    
    $
    
    
    
    $
    48
 CoSine expects to pay the remaining $48,000 related to the workforce reduction
in 2004. Impairment of Long-lived Assets As a result of our assessment of our business, we concluded that
indicators of impairment of our long-lived assets were present at June 30,
2004. Such indicators included ongoing operating losses, inability to achieve
sustainable revenue growth, including our failure to capture new customers, and
our decision to evaluate strategic alternatives. Accordingly, we performed an
impairment test of the carrying value of our long-lived assets, consisting
primarily of property and equipment in accordance with SFAS No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets. Based on an
undiscounted cash flow analysis, the cash flows expected to be generated by us
during the long-lived assets estimated remaining useful lives were not
sufficient to recover the net book value of the assets. Consequently, we
obtained a valuation report outlining the estimated fair value of the assets,
based on quoted market prices, from an independent appraiser and recorded an
impairment charge of $2.3 million to write down the carrying value of our
long-lived assets held for use to their fair values in the second quarter of
2004. Interest and Other Income For the three months ended June 30, 2004 and 2003, interest and other
income was $0.1 million and $0.3 million, respectively. For the six months
ended June 30, 2004 and 2003, interest and other income was $0.2 million and
$0.7 million, respectively. The decrease in interest income for both periods
was due to lower levels of cash and short-term investments. Interest Expense For the three months ended June 30, 2004 and 2003, interest expense was
$1,000 and $61,000, respectively. For the six months ended June 30, 2004 and
2003, interest expense was $3,000 and $159,000, respectively. The decrease in
interest expense for both periods was due capital lease and debt repayment. Income Tax Provision For the three months ended June 30, 2004 and 2003, the provisions
(benefits) for income taxes were ($32,000) and $29,000 expense, respectively.
The $32,000 benefit was the result of a tax refund related to one of our
subsidiaries. For the six months ended June 30, 2004 and 2003, the provisions
for income taxes were $11,000 and $71,000, respectively. The decrease in
income tax provisions reflects lower net income among the subsidiaries due to
reduce operating activities and a tax refund related to a subsidiary. Income
tax provisions are comprised entirely of foreign corporate income taxes, which
are a function of our operation of subsidiaries in various countries. 20




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LIQUIDITY AND CAPITAL RESOURCES Currently, we are not generating sufficient revenue to fund our
operations. We expect our operating losses and net operating cash outflows to
continue unless we are able to significantly increase our revenue. In 2001 and
2002 and, to a lesser extent, in March and May 2003, we announced that we had
adopted business plans to reduce our operating expenses to reflect the then
current and expected business conditions. At June 30, 2004, we had $44.5 million in cash and short-term investments.
Cash consumption during the quarter ended June 30, 2004 was $5.7 million. Our
cash consumption for the twelve months ended June 30, 2004 was $31.8 million.
Based on our rate of cash consumption in the last four quarters and on our
expected rate of cash usage for the next four quarters, we believe that we
possess sufficient liquidity and capital resources to fund our operations and
working capital requirements for at least the next 12 months. However, because
of our history of losses and use of cash in operations, as well as the
announcement on July 29, 2004 that we were evaluating strategic alternatives,
certain of our existing and prospective customers appear to have concerns
regarding our long-term financial viability and our ability to support their
businesses. As a result, existing customers may choose to purchase equipment
from other larger and more established suppliers while for recent prospective
customers, this may have contributed to their decision to not purchase from us.
See Outlook on page 22 and Risk Factors on pages 23-29, which describes
strategic alternatives we are currently exploring. We may seek to raise additional funds through debt or equity financing, or
from other sources. There can be no assurances that additional funding will be
available at all, or that if available, such financing will be obtainable on
terms favorable to us. On July 29, 2004, we announced that we were exploring various strategic
alternatives and that that we had hired an investment bank as our financial
advisor. We have prepared our financial statements on the assumption that we
will continue as a going concern, which contemplates the realization of assets
and liquidation of liabilities in the normal course of business. As such, the
financial statements do not include any adjustments to reflect possible future
effects on the recoverability and classification of assets or the amounts and
classification of liabilities that may result from any decisions made with
respect to our assessment of our strategic alternatives. If at some point we
were to decide to pursue alternative plans, we may be required to present the
financial statements on a different basis. As an example, if we were to decide
to pursue a liquidation and return of capital, we would be required to prepare
and present financial statements on the liquidation basis of accounting,
whereby assets are stated at their estimated net realizable values and
liabilities are stated at their estimated settlement amounts. Pending the
outcome of our review of strategic alternatives and any definitive decisions to
pursue specific alternatives, we will continue to prepare and present our
financial statements on the basis noted herein. There can be no assurance that any transaction or other corporate action
will result from our exploration of strategic alternatives. Further there can
be no assurance concerning the type, form, structure, nature, results, timing
or terms and conditions of any such potential action, even if such an action
does result from this exploration. Cash, Cash Equivalents and Short-Term Investments At June 30, 2004, cash, cash equivalents and short-term investments were
$44.5 million. This compares with $57.8 million at December 31, 2003. Operating Activities We used $12.3 million and $22.0 million of cash in operations for the six
months ended June 30, 2004 and 2003, respectively. The decrease in net cash
used in operating activities was primarily the result of the payment of $10.0
million of restructuring expenses in 2003. Investing Activities 21




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For the six months ended June 30, 2004 and 2003, investing activities
provided $9.5 million and $32.9 in cash, respectively. The change reflects a
decrease of $23.1 million of net proceeds from the sale of short-term
investments and a decrease in capital expenditures of $0.3 million. Financing Activities For the six months ended June 30, 2004 and 2003, financing activities
provided $0.1 million and used $2.6 million in cash, respectively. The decrease
primarily reflects lower principal payments on working capital loans and
capital leases, all of which expired by March 31, 2004. OUTLOOK Although capital spending in the telecommunications industry has begun to
recover, the market for network-based IP services continues to develop slowly.
We recognize that we must significantly reduce our cash consumption in the near
term by either significantly increasing revenues or significantly reducing our
expenses, or we will not be able to survive as a stand-alone entity. At June
30, 2004, we had $44.5 million in cash and short-term investments. Cash
consumption during the quarter ended June 30, 2004 was $5.7 million. Our cash
consumption for the twelve months ended June 30, 2004 was $31.8 million. Based
on our rate of cash consumption in the last four quarters and on our expected
rate of cash usage for the next four quarters, we believe that we possess
sufficient liquidity and capital resources to fund our operations and working
capital requirements for at least the next 12 months. In July 2004, we announced that we are exploring various strategic
alternatives to maximize shareholder value. We have retained Broadview
International as our financial advisor. We are actively evaluating a variety of
alternatives, including possible merger and asset sales transactions, licensing
arrangements, and dissolution of the Company and distribution of assets to
stockholders. There can be no assurance that any transaction or other
corporate action will result from our exploration of strategic alternatives.
Further, there can be no assurance concerning the type, form, structure,
nature, result, timing or terms and conditions of any such potential action,
even if such an action does result from this exploration. 22




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RISK FACTORS Investing in our common stock involves a high degree of risk. The risks
described below are not exhaustive of the risks that might affect our business.
Other risks, including those we currently deem immaterial, may also impact our
business. Any of the following risks could materially adversely affect our
business operations, results of operations and financial condition and could
result in a complete loss of your investment. Our exploration of strategic alternatives may be unsuccessful and may have an
adverse effect on our revenue, operating results and stock price. We have engaged Broadview International as our financial advisor to
explore various strategic alternatives to maximize our stockholder value. We
are uncertain as to what strategic alternatives may be available to us or what
impact any particular strategic alternative will have on our stock price if
accomplished. Uncertainties and risks relating to our exploration of strategic
alternatives include:  
    
    the exploration of strategic alternatives may disrupt our operations and distract
management and cause our customers to curtail their purchase plans, which could have
a material adverse effect on our revenue, operating results and the market price of
our common stock;
    
    the process of exploring strategic alternatives may be more time consuming and
expensive than we anticipate;
    
    we may not be able to identify any strategic alternatives that are worth undertaking;
    
    we may not be able to successfully execute or achieve the benefits of a strategic
alternative recommended to us by our financial advisor; and
    
    perceived uncertainties as to the future direction of our company may result in the
loss of customers, employees or business partners. Even if interested third parties are willing to explore strategic transactions
with us, we may not be successful in executing and consummating any
transactions because of the risks and uncertainties associated with our
business. We have a number of risks and uncertainties associated with our business
that may prevent the consummation of a strategic transaction, including but not
limited to:  
    
    the current lack of demand for our products;
    
    the effects of the current economic environment on us and on any potential acquirer;
    
    the dilutive effect of our business to a potential acquirer; and
    
    our long-term headquarters facility lease. These and other risks and uncertainties may prevent us and interested
third parties from exploring and consummating mutually acceptable strategic
alternatives. We may elect to dissolve and distribute assets to our stockholders if our board
of directors determines that such action is in the best interest of our
stockholders. As a result of our exploration of strategic alternatives, our board of
directors may deem it advisable to dissolve the Company and distribute assets
to stockholders. Liquidation and dissolution may not create value to our
stockholders or result in any remaining capital for distribution to our
stockholders. The precise nature, amount and timing of any 23




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distribution to our stockholders would depend on and could be delayed by,
among other things, sales of our non-cash assets and claim settlements with
creditors. We have a history of losses that we expect will continue, and if we do not
achieve profitability we may cease operations. At June 30, 2004, we had an accumulated deficit of $495.5 million. We
have incurred net losses since our incorporation. We cannot be certain that
our revenue will grow or that we will generate sufficient revenue to become
profitable. At June 30, 2004, we had $44.5 million in cash and short-term
investments. Cash consumption for the six months ended June 30, 2004 was $13.3
million. If we do not achieve profitability and are unable to obtain
additional financing, we may run out of cash and cease operations. Due to our losses, we could lose major opportunities with large service
providers who are concerned with our long-term financial viability. Many large telecommunications service providers purchase capital equipment
from vendors with a history of successful operations including positive cash
flow. Our history of losses and use of cash in operations may cause certain
service providers to decide not to purchase equipment from us because of
concerns regarding our long-term financial viability and our ability to support
their businesses. Unless we can generate positive cash flows by increasing
revenues, concerns regarding our long-term financial viability may cause some
potential customers to purchase product from other larger, more established
suppliers including Cisco Systems, Lucent Technologies, Nortel Networks,
Alcatel, Ericsson, Siemens, and Juniper Networks. The market for managed network-based IP services is still in the early stages
of growth. As a result, demand may fluctuate. The market for managed network-based IP services is still in the early
stages of growth. We believe that the market for these services will grow, but
the timing of this growth is linked to the development of this market by
service providers and the growth of enterprise demand. Until the market
develops further, demand may not increase significantly and may continue to
fluctuate. If our quarterly or annual operating results do not meet the
expectations of securities analysts or investors, the trading price of our
common stock could decline. Our ability to sustain or grow our business may be harmed if we are unable to
develop and maintain certain strategic relationships with third parties to
market and sell our products. Because we are a relatively small company with correspondingly small sales
and support groups, our success will depend in part upon our ability to form
and maintain distribution partnerships, including agreements under which we
sell our products to certain service provider customers through distribution
partners. We may not be able to establish sufficient reseller relationships to
enable us to expand our potential market and achieve revenue growth. The amount
and timing of resources that our distribution partners devote to our business,
if any, is not within our control. Our distribution partners may not perform
their obligations as expected. In some cases, agreements with our distribution
partners may be relatively new, and we cannot be certain that we will be able
to achieve expected revenues from such partners or sustain the level of revenue
generated thus far under similar arrangements. If any of our distribution
partners chooses not to renew, breaches or terminates its agreement or fails to
perform its obligations under its agreement, we may not be able to sustain or
grow our business. In the event that such relationships are terminated, we may
not be able to continue to maintain or develop similar relationships or to
replace distribution partners. In addition, any such agreements we enter into
in the future may not be successful. The outlook for capital spending in the telecommunications industry directly
impacts our business. Our business depends on capital expenditures within the telecommunications
industry, which has experienced a significant downturn since 2001. Capital
spending in the industry as a whole has slowed as a result of a lack of
available capital for many emerging service providers and a generally cautious
approach to capital spending within the industry. While the industry in general appears to be recovering, the market for
network-based IP services continues to develop slowly. We anticipate that this
will continue to have a substantial, adverse effect on our revenue growth for
at 24




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least the remainder of the current fiscal year. No assurance can be given
that our net revenue and operating results will not be further adversely
affected by the telecommunication industrys cautious approach to capital
spending and the slow development of network-based IP services. If we fail to predict our manufacturing requirements accurately, we could incur
additional costs or manufacturing delays. We provide forecasts of our demand to our contract manufacturers up to
twelve months before scheduled delivery of products to our customers. If we
overestimate our manufacturing requirements, we may have excess or obsolete
inventory, which could harm our operating results. Additionally, our
announcement that we have hired an investment banker and are exploring of
strategic alternatives may have a negative impact on customer demand for our
products, and consequently could require us to increase our level of inventory
reserves. If we underestimate our requirements, our contract manufacturers may have
an insufficient inventory, which could interrupt manufacturing of our products
and result in delays in shipments and revenue. If we do not accurately
anticipate lead times for components, we may experience component shortages. If we fail to retain key personnel, our operations could suffer and our stock
price could be negatively impacted. Maintaining key personnel may be difficult for a number of reasons,
including but not limited to market demand, stock price, growth opportunities,
management philosophy, company performance and competitive activity. Our
announcement in July 2004 that we were evaluating strategic alternatives could
also adversely impact employee retention. If we lose key personnel we may find
it difficult and costly to recruit new management and other personnel and this
may have a negative effect on our performance and in turn on our stock price. The long sales cycle for our platform may cause our revenue and operating
results to vary significantly from quarter to quarter, and the price of our
stock to decline. A customers decision to purchase our IP Service Delivery Platform
involves a significant commitment of its resources and a lengthy evaluation,
testing and product qualification process that may run from three to twelve
months. Network service providers and other customers with complex networks
usually expand their networks in increments on a periodic basis. We may
receive purchase orders for significant dollar amounts on an irregular and
unpredictable basis. These events may cause our revenue and operating results
to vary significantly and unexpectedly from quarter to quarter, which could
cause our stock price to decline. We participate in a competitive marketplace, and our failure to compete
successfully would limit our ability to increase our market share and harm our
business. Competition in the network infrastructure market is intense, and we expect
that competition in the market for IP networking services will also be intense.
If we are unable to compete effectively, our revenue and market share will be
negatively affected. We face competition from companies in the network infrastructure market,
including Cisco Systems, Lucent Technologies, Nortel Networks, Alcatel,
Ericsson, Siemens, and Juniper Networks. Many of our competitors are larger
companies with significantly greater resources than we have, and we expect to
face increased competition from larger companies in the future. Some of these
larger competitors have pre-existing relationships involving a range of product
lines with the network service providers who are the principal potential
customers for our IP Service Delivery Platform. These competitors may offer
vendor financing, which we generally do not offer, undercut our prices or use
their pre-existing relationships with our customers to induce them not to use
our IP Service Delivery Platform. Future consolidation in the telecommunications equipment industry may increase
competition that could harm our business. The markets in which we compete are characterized by increasing
consolidation both within the data communications sector and by companies
combining or acquiring data communications assets and assets for delivering
voice-related services. We cannot predict with certainty how industry
consolidation will affect our competitors. We may not be able to compete
successfully in an increasingly consolidated industry. Increased competition
and consolidation in 25




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our industry could require that we reduce the prices of our products and
result in our loss of market share, which would materially adversely affect our
business, financial condition and results of operations. Because we may be
dependent on certain strategic relationships with third parties in our
industry, any additional consolidation involving these parties could reduce the
demand for our products and otherwise harm our business prospects. If our customers are unable to generate sales of services using our products
and to manage delivery of these services to their customers, we may be unable
to sell our products. Our future success depends on network service providers, who are our
customers, generating revenue from the sale of services delivered using our
products. Sales of our products may decline or be delayed if our customers do
not successfully introduce commercial services derived from our IP Service
Delivery Platform or if our customers do not generate revenue from these
services sufficient to realize an attractive return on their investment in our
IP Service Delivery Platform. In addition, the long cycle for service
providers to introduce new services made possible by our platform may cause our
revenue and operating results to vary significantly from quarter to quarter. Our ability to generate future revenue also depends on whether network
service providers successfully forecast market trends and identify customer
demand for the services and features that our products would enable network
service providers to offer their customers. If our IP Service Delivery Platform does not achieve market acceptance, we may
be unable to achieve profitability. Our products offer a new approach for delivering services by network
service providers, who may perceive our products as being more expensive than
the other technologies and products they purchase. If network service
providers do not accept our IP Service Delivery Platform as a method for
delivering services to their customers, our ability to increase our revenue,
achieve profitability and continue operations would be harmed. Our IP Service Delivery Platform is our only product line, and our future
revenue depends on its commercial success. Our IP Service Delivery Platform, which is comprised of hardware and
software, is the only product line that we currently offer to our customers.
Our future revenue depends on the commercial success of our IP Service Delivery
Platform. If customers do not adopt, purchase and successfully implement our
IP Service Delivery Platform in large numbers, our revenue will not grow. If our products contain defects, we may be subject to significant liability
claims from our customers, distribution partners and the end-users of our
products and incur significant unexpected expenses and lost sales. Our products are technically complex and can be adequately tested only
when put to full use in large and diverse networks with high amounts of
traffic. They have in the past contained, and may in the future contain,
undetected or unresolved errors or defects. Despite extensive testing, errors,
defects or failures may be found in our current or future products or
enhancements after commencement of commercial shipments. If this happens, we
may experience delay in or loss of market acceptance and sales, product
returns, diversion of development resources, injury to our reputation,
inability to attract new customers, or increased service and warranty costs,
any of which could have a material adverse effect on our business, financial
condition and results of operations. Moreover, because our products are
designed to provide critical communications services, we may receive
significant liability claims. We attempt to include in our agreements with
customers and distribution partners provisions intended to limit our exposure
to liability claims. However, our customers and distribution partners may not
be willing to agree to such provisions, and in any event such provisions may
not be effective in any or all cases or under any or all scenarios, and they
may not preclude all potential claims resulting from a defect in one of our
products or from a defect related to the installation or operation of one of
our products. Although we maintain product liability and errors and omissions
insurance covering certain damages arising from implementation and use of our
products, our insurance may not cover all claims sought against us. Liability
claims could require us to spend significant time and money in litigation or to
pay significant damages. As a result, any such claims, whether or not
successful, could seriously damage our reputation and our business. If we fail to develop and market new products or features, we will have
difficulty attracting customers. Based on our prior experience, we expect that our customers will require
product features that our current IP Service Delivery Platform does not have.
Our products are technically complex, and the development of new products 26




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or features is an uncertain, time-consuming and labor-intensive process.
We may experience design, manufacturing or marketing problems with our new
products. If we fail to develop new or enhanced products that meet customer
requirements, our ability to attract and retain customers will be hindered. If we fail to introduce new products in a timely manner we may experience
erratic revenue growth, which could negatively affect profitability and in turn
have a negative impact on our stock price. In addition, such a failure could
result in additional costs such as excess inventory, customer conversion costs,
higher than expected product costs and higher than expected operating expenses
in research and development and in sales and marketing. If our products do not work the way our customers expect, orders for our
products may be cancelled and the market perception of our products could be
harmed. If our products do not work with our customers or their end-users
networks, the market perception of our products could be harmed and orders for
our products could be cancelled. In particular, if an actual or perceived
breach of network security occurs in a customers or its end-users network
that uses our products, we may be subject to lawsuits for losses suffered by
customers or their end-users. If we have to redesign or modify our products to make them compatible with
a customers or end-users network, our sales cycle could be extended, our
research and development costs may increase and profit margins on our products
may decline. Because the markets in which we compete are prone to rapid technological change
and the adoption of standards different from those that we use, our products
could become obsolete, and we could be required to incur substantial costs to
modify our products to remain competitive. The market for our IP Service Delivery Platform is prone to rapid
technological change, the adoption of new standards, frequent new product
introductions and changes in customer and end-user requirements. We may be
unable to respond quickly or effectively to these developments. We may
experience difficulties that could prevent our development of new products and
features. The introduction of new products or technologies by competitors, or
the emergence of new industry standards, could render our products obsolete or
could require us to incur costs to redesign our products. We rely upon a limited number of customers, and any decrease in revenue from
these customers or failure to increase our customer base could harm our
operating results. The loss of one or more of our customers, a reduction in purchases of our
products by certain of our customers or the decline of a key customers
business may limit our revenue growth and harm our operating results. Our
customers may reduce or discontinue purchases of our products at any time. In
the second quarter of 2004, we generated 81 percent of our revenue from four
customers. Our future success will depend on attracting additional customers.
Failure to increase our customer base would hinder our growth and harm our
operating results. A failure of our contract manufacturers or our sole source and limited source
suppliers to meet our needs would seriously harm our ability to timely fill
customer orders. If any of our manufacturers terminates its relationship with us or is
unable to produce sufficient quantities of our products in a timely manner and
at satisfactory quality levels, our ability to fill customer orders on time,
our reputation and our operating results will suffer. Our contract
manufacturers do not have a long-term obligation to supply products to us.
Qualifying new contract manufacturers and starting volume production is
expensive and time consuming and would disrupt our business. We purchase several key components, including field programmable gate
arrays, some integrated circuits and memory devices, and power supplies from a
single source or a limited number of sources. We do not have long-term supply
contracts for these components. If our supply of these components is
interrupted, we may be unable to locate an alternate source in a timely manner
or at favorable prices. Interruption or delay in the supply of these
components could cause us to lose sales to existing and potential customers. 27




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If any of our significant suppliers were to terminate their relationships with
us or compete against us, our revenue and market share would likely be reduced. Many of our suppliers also have significant development and marketing
relationships with our competitors and have significantly greater financial and
marketing resources than we do. If they develop and market products in the
future in competition with us, or form or strengthen arrangements with our
competitors, our revenue and market share will likely be reduced. If necessary licenses of third-party technology are terminated or become
unavailable or too expensive, our competitive position and our product offering
will suffer. We license from third-party suppliers certain software applications
incorporated in our IP Service Delivery Platform. Also, we may need to license
technology from other third-party suppliers to enable us to develop new
products or features. Our inability to renew or obtain any third-party license
that we need could require us to obtain substitute technology of lower quality
or at greater cost. These outcomes could seriously impair our ability to sell
our products and could harm our operating results. We rely on our intellectual property rights to be competitive, and if we are
unable to protect these rights, we may never become profitable. We rely on a combination of copyright, trademark, patent and trade secret
laws and restrictions on disclosure to protect our intellectual property
rights. Monitoring unauthorized use of our products is difficult, and we
cannot be certain that the steps we have taken will prevent unauthorized use of
our technology. If we are unable to protect our intellectual property rights,
our ability to supply our products as they have been designed could suffer, and
our ability to become profitable could be harmed. If we become involved in an intellectual property dispute, we could be subject
to significant liability, the time and attention of our management could be
diverted and we could be prevented from selling our products. We may become a party to litigation in the future to protect our
intellectual property or because others may allege infringement of their
intellectual property. These claims and any resulting lawsuit could subject us
to significant liability for damages or invalidate our proprietary rights.
These lawsuits, regardless of their merits, likely would be time-consuming and
expensive to resolve and would divert management time and attention. Any
potential intellectual property litigation alleging our infringement of a
third-partys intellectual property also could force us to: -
    stop selling products or services that use the challenged
intellectual property;-
    obtain from the owner of the infringed intellectual property
right a license to sell the relevant technology, which license may
not be available on reasonable terms, or at all; or-
    redesign those products or services that use the infringed
technology.
 If we become subject to unfair hiring claims, we could be prevented from hiring
needed personnel, or from pursuing or implementing our research, and could
incur substantial liabilities or costs. Companies in our industry whose employees accept positions with
competitors frequently claim that these competitors have engaged in unfair
hiring practices or that the employment of these persons would involve the
disclosure or use of trade secrets or information subject to an obligation of
confidentiality. We have been threatened with claims like these in the past
and may receive claims of this kind in the future. These claims could prevent
us from hiring personnel or from using the knowledge and experience brought to
us by the personnel whom we hire. We could also incur substantial costs and
damages in defending against these claims, regardless of their merits.
Defending ourselves against such claims could divert the attention of our
management away from our operations. If we cannot obtain director and officer liability insurance in acceptable

amounts for acceptable rates, we may have difficulty recruiting and retaining
qualified directors and officers. 28




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Like most other public companies, we carry insurance protecting our
officers and directors against claims relating to the conduct of our business.
This insurance covers, among other things, the costs incurred by companies and
their management to defend against and resolve claims relating to management
conduct and results of operations, such as securities class action claims.
These claims typically are expensive to defend against and resolve. We pay
significant premiums to acquire and maintain this insurance, which is provided
by third-party insurers, and we agree to underwrite a portion of such exposures
under the terms of the insurance coverage. One consequence of the current
economic downturn and decline in stock prices has been a substantial increase
in the number of securities class actions and similar claims brought against
public corporations and their management, including our company and certain of
our current and former officers and directors. Consequently, insurers providing
director and officer liability insurance have in recent periods sharply
increased the premiums they charge for this insurance, raised retentions (that
is, the amount of liability that a company is required to pay to defend and
resolve a claim before any applicable insurance is provided), and limited the
amount of insurance they will provide. Moreover, insurers typically provide
only one-year policies. The insurance policies that may cover the current
securities lawsuit against us have a $250,000 retention. As a result, the costs
we incur in defending this lawsuit will not be reimbursed until they exceed
$250,000. The policies that would cover any future lawsuits may not provide any
coverage to us and may cover the directors and officers only in the event we
are unwilling or unable to cover their costs in defending against and resolving
any future claims. As a result, our costs in defending any future lawsuits
could increase significantly. Particularly in the current economic environment,
we cannot assure you that in the future we will be able to obtain sufficient
director and officer liability insurance coverage at acceptable rates and with
acceptable deductibles and other limitations. Failure to obtain such insurance
could materially harm our financial condition in the event that we are required
to defend against and resolve any future or existing securities class actions
or other claims made against us or our management arising from the conduct of
our operations. Further, the inability to obtain such insurance in adequate
amounts may impair our future ability to retain and recruit qualified officers
and directors. 
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Interest Rate Sensitivity We do not currently use derivative financial instruments for speculative
trading or hedging purposes. In addition, we maintain our cash equivalents in
government and agency securities, debt instruments of financial institutions
and corporations and money market funds. Our exposure to market risks from
changes in interest rates relates primarily to corporate debt securities. We
place our investments with high credit quality issuers and, by policy, limit
the amount of the credit exposure to any one issuer. Our general policy is to limit the risk of principal loss and ensure the
safety of invested funds by limiting market and credit risk. All highly-liquid
investments with a maturity of less than three months at the date of purchase
are considered to be cash equivalents, and all investments with maturities of
three months or greater are classified as available-for-sale and considered to
be short-term investments. A sensitivity analysis was performed on our investment portfolio as of
June 30, 2004 based on a modeling technique that measures hypothetical fair
market value changes that would result from a parallel shift in the yield curve
of plus or minus 100 basis points. Based on this analysis, a hypothetical 100
basis point increase or decrease in interest rates would result in a $118,000
decrease or increase, respectively, in the fair value of our investments in
debt securities as of June 30, 2004. Exchange Rate Sensitivity Currently, all of our revenue and most of our expenses are denominated in
U.S. dollars. However, since a portion of our operations sales and service
activities are outside of the U.S., we have entered into transactions in other
currencies. We are primarily exposed to changes in exchange rates for the Euro,
Japanese Yen, and British Pound. Because we transact expenses only in foreign
currency, we are adversely affected by a weaker U.S. dollar relative to major
currencies worldwide. Additionally, because some of our obligations are
denominated in foreign currencies, a weaker U.S. dollar creates foreign
exchange losses. We have not engaged in any foreign exchange hedging
activities to date. 
 ITEM 4. CONTROLS AND PROCEDURES 29




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Evaluation of Disclosure Controls and Procedures. The Securities and Exchange
Commission defines the term disclosure controls and procedures to mean a
companys controls and other procedures that are designed to ensure that
information required to be disclosed in the reports that it files or submits
under the Securities Exchange Act of 1934 is recorded, processed, summarized
and reported, within the time periods specified in the Commissions rules and
forms. While our disclosure controls and procedures are designed to provide
reasonable assurance of achieving their objectives, the design of any system of
controls is based in part upon certain assumptions about the likelihood of
future events, and there can be no assurance that any design will succeed in
achieving its stated goals under all potential future conditions regardless of
how remote. Our president and chief executive officer and our executive vice
president and chief financial officer have concluded, based on the evaluation
of the effectiveness of the disclosure controls and procedures by our
management, as of the end of the period covered by this report, that our
disclosure controls and procedures were effective for this purpose. Changes in Internal Controls.There has been no change in our internal
control over financial reporting during the fiscal quarter ending June 30, 2004
that has materially affected, or is reasonably likely to materially affect, our
internal control over financial reporting. 
 PART II. OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS On November 15, 2001, CoSine and certain of its officers and directors
were named as defendants in a securities class action lawsuit filed in the
United States District Court, Southern District of New York. The complaint
generally alleges that various investment bank underwriters engaged in improper
and undisclosed activities related to the allocation of shares in CoSines
initial public offering. The complaint brings claims for the violation of
several provisions of the federal securities laws against those underwriters,
and also against the Company and each of the directors and officers who signed
the registration statement relating to the initial public offering. Various
plaintiffs have filed similar actions asserting virtually identical allegations
against more than 250 other companies. The lawsuit and all other IPO
allocation securities class actions currently pending in the Southern District
of New York have been assigned to Judge Shira A. Scheindlin for coordinated
pretrial proceedings. In October 2002, the individual defendants were dismissed
without prejudice pursuant to a stipulation. The issuer defendants filed a
coordinated motion to dismiss on common pleading issues, which the Court
granted in part and denied in part in an order dated February 19, 2003. The
Courts order dismissed the Section 10(b) and Rule 10b-5 claims against the
Company but did not dismiss the Section 11 claims against the Company. In June 2004, a stipulation for the settlement and release of claims against
the issuer defendants, including the Company, was submitted to the Court for
preliminary approval. Under the proposed settlement, the plaintiffs will
dismiss and release all claims against participating issuer defendants in
exchange for a contingent payment guaranty by the insurance companies
collectively responsible for insuring the issuer defendants in all of the
related cases, and the assignment or surrender to the plaintiffs of certain
claims the issuer defendants may have against the underwriters. Under the
guaranty, the insurers will be required to pay the amount, if any, by which $1
billion exceeds the aggregate amount ultimately collected by the plaintiffs
from the underwriter defendants in all the cases, up to the limits of the
applicable insurance policies. The Company will not be required to make any
cash payments under the settlement, unless the Companys insurer is required to
pay on the Companys behalf an amount that exceeds the Companys insurance
coverage. The Company does not believe that this circumstance will occur. The
settlement is still subject to a number of conditions, including certification
of a class for settlement purposes and formal Court approval. If the
settlement is not consummated, the Company intends to defend the lawsuit
vigorously. However, the Company cannot predict its outcome with certainty. If
the Company is not successful in its defense of this lawsuit, it could be
forced to make significant payments to the plaintiffs and their lawyers, and
such payments could have a material adverse effect on the Companys business,
financial condition and results of operations if not covered by the Companys
insurance carrier. Even if these claims are not successful, the litigation
could result in substantial costs and divert managements attention and
resources, which could adversely affect the Companys business, results of
operations and financial position. In the ordinary course of business, CoSine is involved in legal
proceedings involving contractual obligations, employment relationships and
other matters. Except as described above, CoSine does not believe there are
any pending or threatened legal proceedings that will have a material impact on
its financial position or results of operations. 30




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ITEM 2. CHANGES IN SECURITIES; USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY
SECURITIES  (a)
    
    On September 25, 2000, in connection with our initial public
offering, a Registration Statement on Form S-1 (File No. 333-35938)
was declared effective by the Securities and Exchange Commission,
pursuant to which 1,150,000 shares of our common stock were offered
and sold for our account at a price of $230 per share, generating
gross offering proceeds of $264.5 million. The managing underwriters
were Goldman, Sachs & Co., Chase Securities Inc., Robertson Stephens,
Inc. and JP Morgan Securities Inc. Our initial public offering closed
on September 29, 2000. The net proceeds of the initial public
offering were approximately $242.5 million after deducting
approximately $18.5 million of underwriting discounts and
approximately $3.5 million of other offering expenses.We did not pay directly or indirectly any of the underwriting discounts
or other related expenses of the initial public offering to any of our
directors or officers, any person owning 10% or more of any class of
our equity securities, or any of our affiliates.We have used approximately $198 million of the funds from the initial
public offering to fund our operations. We expect to use the remaining
net proceeds for general corporate purposes, to fund our operations,
working capital and capital expenditures. Pending further use of the
net proceeds, we have invested them in short-term, interest-bearing,
investment-grade securities.(e)
    
    The following table provides information about purchases by the
Company during the quarter ended June 30, 2004 of equity securities
that are registered by the Company pursuant to Section 12 of the
Exchange Act: ISSUER PURCHASES OF EQUITY SECURITIES Total number of Shares
    
    Maximum Number ofTotal Number of
    
    
    
    
    
    that Purchased as Part
    
    Shares that May Yet beShares
    
    Average Price
    
    of Publicly Announced
    
    Purchased Under thePurchased
    
    Paid per Share
    
    Plans
    
    PlansApril 1, 2004  April 30, 2004
    
    
    1,000
    
    
    $
    95.00
    
    
    not applicable
    
    not applicableMay 1, 2004  May 30, 2004
    
    
    3,937
    
    
    
    95.00
    
    
    not applicable
    
    not applicableJune 1, 2004  June 30, 2004
    
    
    6,000
    
    
    
    82.50
    
    
    not applicable
    
    not applicableTotal
    
    
    10,937
    
    
    $
    88.14
 Under our 1997 Plan, we are authorized to repurchase shares of our common
stock that were previously issued pursuant to the exercise of stock options
granted under the 1997 Plan. Such common stock is reacquired by us privately
pursuant to repurchase rights contained in restricted stock purchase agreements
or pursuant to optionee defaults on non-recourse promissory notes issued in
connection with the exercise of such options. All shares repurchased in the
second quarter of 2004 were reacquired pursuant to optionee defaults on
promissory notes and were therefore non-cash. As of the date of this report,
149,539 outstanding shares remain subject to the foregoing repurchase right 
 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K  (a)
    
    Exhibit Index on page 32.(b)
    
    Reports on Form 8-K.On April 29, 2004, the Company issued a press release in which it
reported earnings for the quarter ended March 31, 2004. A copy of such
press release was furnished by the Company with a Form 8-K on April 29,
2004 as Exhibit 99.1. 31




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On July 29, 2004, the Company issued a press release in which it
reported results for the quarter ended June 30, 2004 and announced that
it had hired an investment bank to evaluate strategic alternatives. 32




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SIGNATURE 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. COSINE COMMUNICATIONS, INC.By:
    /s/ Terry GibsonTerry GibsonExecutive Vice President and Chief
Financial Officer
(Principal Financial and
Accounting Officer) Dated: August 9, 2004 33




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EXHIBIT INDEX Exhibit Number
    
    Description4.1
    
    Form of warrant to purchase common stock issued by the
Registrant to Fujitsu pursuant to the Reseller Agreement
dated as of May 28, 2004.31.1
    
    Certification of Stephen Goggiano, President and Chief
Executive Officer of CoSine Communications, Inc., pursuant
to 15 U.S.C. Section 7241, as adopted pursuant to Section
302 of the Sarbanes-Oxley Act of 200231.2
    
    Certification of Terry Gibson, Executive Vice President and
Chief Financial Officer of CoSine Communications, Inc.,
pursuant to 15 U.S.C. Section 7241, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 200232.1
    
    Certification of Stephen Goggiano, President and Chief
Executive Officer of CoSine Communications, Inc., pursuant
to 18 U.S.C. Section 1350, as adopted pursuant to Section
906 of the Sarbanes-Oxley Act of 200232.2
    
    Certification of Terry Gibson, Executive Vice President and
Chief Financial Officer of CoSine Communications, Inc.,
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
 34