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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 1934FOR THE QUARTERLY PERIOD ENDED September 30, 2004ORo
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934For 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 o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes  o No x There were 10,075,838 shares of the Companys Common Stock, par value $.0001,
outstanding on November 5, 2004.




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COSINE COMMUNICATIONS, INC. FORM 10-Q Quarter ended September 30, 2004 TABLE OF CONTENTS PagePART IFINANCIAL INFORMATIONItem 1. Condensed Consolidated Financial Statements:Condensed Consolidated Balance Sheets as of September 30, 2004 and December 31,
2003
    
    
    3Condensed Consolidated Statements of Operations for the Three and Nine Months
Ended September 30, 2004 and 2003
    
    
    4Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September
30, 2004 and 2003
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 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
    
    
    30Item 5. Other Information
    
    
    31Item 6. Exhibits and Reports on Form 8-K
    
    
    32Signature
    
    
    32Exhibit Index
    
    
    33EXHIBIT 10.1EXHIBIT 10.2EXHIBIT 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)
 September 30,
    
    December 31,2004
    
    2003(Unaudited)
    
    (1)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    11,425
    
    
    $
    19,719Short-term investments
    
    
    22,198
    
    
    
    38,033Accounts receivable:Trade (net of allowance for doubtful accounts of
$90 and $150 at September 30, 2004 and December 31,
2003, respectively)
    
    
    675
    
    
    
    4,962Other
    
    
    589
    
    
    
    494Inventory
    
    
    20
    
    
    
    4,003Prepaid expenses and other current assets
    
    
    3,751
    
    
    
    2,668Total current assets
    
    
    38,658
    
    
    
    69,879Property and equipment, net
    
    
    
    
    
    
    2,900Long-term deposits
    
    
    158
    
    
    
    647$
    38,816
    
    
    $
    73,426LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,059
    
    
    $
    1,657Accrued warranty liability
    
    
    283
    
    
    
    464Other accrued liabilities
    
    
    4,231
    
    
    
    2,560Accrued compensation
    
    
    1,477
    
    
    
    1,821Deferred revenue
    
    
    950
    
    
    
    3,543Current portion of equipment and working capital loans
    
    
    
    
    
    
    129Total current liabilities
    
    
    8,000
    
    
    
    10,174Accrued rent
    
    
    2,049
    
    
    
    2,078Stockholders equity:Preferred
stock, no par value; 3,000,000 shares
authorized; no shares issued and outstanding
    
    
    
    
    
    
    Common
stock, $.0001 par value; 300,000,000 shares authorized; 10,075,838 and 10,176,845 shares issued
and outstanding at; September 30, 2004 and December
31, 2003, respectively
    
    
    1
    
    
    
    1Additional paid-in capital
    
    
    541,537
    
    
    
    546,176Notes receivable from stockholders
    
    
    (3,128
    )
    
    
    (6,659
    )Accumulated other comprehensive income
    
    
    489
    
    
    
    533Deferred compensation
    
    
    
    
    
    
    (455
    )Accumulated deficit
    
    
    (510,132
    )
    
    
    (478,422
    )Total stockholders equity
    
    
    28,767
    
    
    
    61,174$
    38,816
    
    
    $
    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
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Revenue
    
    $
    1,088
    
    
    $
    4,024
    
    
    $
    8,111
    
    
    $
    12,244Cost of
goods sold1
    
    
    4,441
    
    
    
    1,798
    
    
    
    7,373
    
    
    
    5,335Gross profit (loss)
    
    
    (3,353
    )
    
    
    2,226
    
    
    
    738
    
    
    
    6,909Operating expenses:Research and development2
    
    
    3,709
    
    
    
    5,485
    
    
    
    13,316
    
    
    
    15,920Sales and marketing3
    
    
    3,056
    
    
    
    3,191
    
    
    
    9,594
    
    
    
    10,310General and administrative4
    
    
    1,721
    
    
    
    1,817
    
    
    
    4,626
    
    
    
    5,643Restructuring and impairment charges
    
    
    2,871
    
    
    
    14
    
    
    
    5,214
    
    
    
    351Total operating expenses
    
    
    11,357
    
    
    
    10,507
    
    
    
    32,750
    
    
    
    32,224Loss from operations
    
    
    (14,710
    )
    
    
    (8,281
    )
    
    
    (32,012
    )
    
    
    (25,315
    )Other income (expenses):Interest income and other
    
    
    82
    
    
    
    137
    
    
    
    307
    
    
    
    851Interest expense5
    
    
    
    
    
    
    (25
    )
    
    
    (3
    )
    
    
    (214
    )Total other income, net
    
    
    82
    
    
    
    112
    
    
    
    304
    
    
    
    637Loss before income tax provision
(benefit)
    
    
    (14,628
    )
    
    
    (8,169
    )
    
    
    (31,708
    )
    
    
    (24,678
    )Income tax provision (benefit)
    
    
    (9
    )
    
    
    15
    
    
    
    2
    
    
    
    86Net loss
    
    $
    (14,619
    )
    
    $
    (8,184
    )
    
    $
    (31,710
    )
    
    $
    (24,764
    )Basic and diluted net loss per share
    
    $
    (1.47
    )
    
    $
    (0.84
    )
    
    $
    (3.17
    )
    
    $
    (2.54
    )Shares used in computing per share
amounts
    
    
    9,945
    
    
    
    9,797
    
    
    
    9,998
    
    
    
    9,753
   1
 2 Research and development expenses includes $1 and $159 for the three months
ended September 30, 2004 and 2003, respectively, and ($213) and $346 for the
nine months ended September 30, 2004 and 2003, respectively, of non-cash
charges (credits) related to equity issuances. 3 Sales and marketing expenses includes ($2) and $86 for the three months ended
September 30, 2004 and 2003, respectively, and ($195) and ($15) for the nine
months ended September 30, 2004 and 2003, respectively, of non-cash (credits)
charges related to equity issuances. 4 General and administrative expenses includes ($1) and ($60) for the three
months ended September 30, 2004 and 2003, respectively, and ($402) and $209 for
the nine months ended September 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 September 30, 2004 and 2003, and $0 and $30 of non-cash
charges related to equity issuances for the nine months ended September 30,
2004 and 2003, respectively. 4




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COSINE COMMUNICATIONS, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (In thousands)
(Unaudited)
 Nine Months EndedSeptember 30,2004
    
    2003Operating activities:Net loss
    
    ($
    31,710
    )
    
    
    (24,764
    )Adjustments to reconcile net loss to net cash used in operating
activities:Depreciation
    
    
    1,398
    
    
    
    2,003Provision for doubtful accounts
    
    
    14
    
    
    
    88Non-cash charges related to inventory write-down
    
    
    4,220
    
    
    
    61Write-down of property and capital equipment
    
    
    2,308
    
    
    
    Amortization of warrants issued for services
    
    
    78
    
    
    
    75Amortization of deferred stock compensation
    
    
    (971
    )
    
    
    1,431Reversal of stock compensation amortization in excess of vesting
    
    
    (185
    )
    
    
    (802
    )Other non-cash restructuring items
    
    
    75
    
    
    
    12Bonus awarded in shares of common stock
    
    
    228
    
    
    
    Other, net
    
    
    123
    
    
    
    (139
    )Net changes in operating assets and liabilities:Accounts receivable, trade
    
    
    4,273
    
    
    
    2,798Other receivables
    
    
    (192
    )
    
    
    223Inventory
    
    
    (313
    )
    
    
    (738
    )Prepaid expenses and other current assets
    
    
    (641
    )
    
    
    539Long-term deposits
    
    
    245
    
    
    
    252Accounts payable
    
    
    (598
    )
    
    
    242Accrued warranty liability
    
    
    (181
    )
    
    
    (420
    )Accrued compensation
    
    
    (344
    )
    
    
    593Accrued other liabilities
    
    
    1,671
    
    
    
    (11,149
    )Deferred revenue
    
    
    (2,594
    )
    
    
    203Accrued rent
    
    
    (29
    )
    
    
    (8
    )Net cash used in operating activities
    
    
    (23,125
    )
    
    
    (29,500
    )Investing activities:Capital expenditures
    
    
    (1,053
    )
    
    
    (2,023
    )Purchase of short-term investments
    
    
    (34,480
    )
    
    
    (58,828
    )Proceeds from sales and maturities of short-term investments
    
    
    50,267
    
    
    
    103,414Net cash provided by investing activities
    
    
    14,734
    
    
    
    42,563Financing activities:Principal payments of equipment and working capital loans and
capital leases
    
    
    (129
    )
    
    
    (3,486
    )Proceeds from issuance of common stock
    
    
    226
    
    
    
    471Proceeds from notes receivable from stockholders
    
    
    
    
    
    
    31Repurchase of common stock
    
    
    
    
    
    
    (68
    )Net cash provided by (used in) financing activities
    
    
    97
    
    
    
    (3,052
    )Net increase (decrease) in cash and cash equivalents
    
    
    (8,294
    )
    
    
    10,011Cash and cash equivalents at the beginning of the period
    
    
    19,719
    
    
    
    9,230Cash and cash equivalents at the end of the period
    
    $
    11,425
    
    
    $
    19,241Supplemental information:Cash paid for interest
    
    $
    3
    
    
    $
    184Income taxes paid
    
    $
    53
    
    
    $

    86Cancellation of notes receivable due to repurchase of unvested stock
    
    $
    3,531
    
    
    $
    2,936Issuance of warrant to re-seller
    
    $
    48
    
    
    $
    Re-measurement of deferred stock-based compensation
    
    $
    251
    
    
    $
    Net transfer from inventory to property and equipment
    
    $
    173
    
    
    $
    
 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 as an ongoing operating entity have
been included. The results of operations for the three and nine months ended
September 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. On
September 8, 2004, CoSine announced, in connection with its
ongoing evaluation
of strategic alternatives, actions to lay-off most of its
employees, retaining a limited team of employees to provide customer support
and handle matters related to the ongoing exploration of strategic
alternatives. Since September 8, 2004, the Company has taken a number of
actions to reduce its operating expenses and conserve its cash. CoSine has
notified its existing customers that the CoSine products are now formally
discontinued and that existing customers may place lifetime buy orders to
support their platform transition plans. The Company has written its inventory
down to estimated net realizable value at September 30, 2004. The Company has
taken steps to terminate contract manufacturing arrangements, contractor and
consulting arrangements and facility leases. These activities will continue
into the quarter ending December 31, 2004, at which time CoSines business will
consist primarily of a customer service capability operated under contract by a
third party. The Company continues to explore strategic alternatives, including a sale
of the Company, a sale or licensing of products, intellectual property, or
individual assets or a winding-up and liquidation of the business. Pending the
outcome of the Companys review of strategic alternatives and any definitive
decisions to close or liquidate the business, 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 appropriate to prepare and present financial statements on
the liquidation basis of accounting, whereby assets are valued at their
estimated net realizable values and liabilities are stated at their estimated
settlement amounts. Pro Forma Stock-Based Compensation 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
or exceeds the market price of the underlying stock on the date of grant. 6




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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
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net loss, as reported
    
    ($
    14,619
    )
    
    ($
    8,184
    )
    
    ($
    31,710
    )
    
    ($
    24,764
    )Add: Stock-based
employee
compensation expense
(credit), net of
tax, included in
reported net loss
    
    
    4
    
    
    
    357
    
    
    
    (743
    )
    
    
    1,431Deduct: Reversal of
amortization
 of stock-based employee
compensation in
excess of vesting,
net of tax
    
    
    (21
    )
    
    
    (147
    )
    
    
    (184
    )
    
    
    (802
    )Deduct: Stock-based
employee
compensation credit (expense) determined
under the fair value
method for all stock
option grants net
of tax
    
    
    179
    
    
    
    (45
    )
    
    
    (716
    )
    
    
    (1,947
    )Pro forma net loss
    
    ($
    14,457
    )
    
    ($
    8,019
    )
    
    ($
    33,353
    )
    
    ($
    26,082
    )Basic and diluted
net loss per share,
as reported
    
    ($
    1.47
    )
    
    ($
    0.84
    )
    
    ($
    3.17
    )
    
    ($
    2.54
    )Pro forma basic and
diluted net loss per
share
    
    ($
    1.45
    )
    
    ($
    0.82
    )
    
    ($
    3.34
    )
    
    ($
    2.67
    )
 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
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Dividend yield
    
    
    
    
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    0.0
    %Volatility
    
    
    
    
    
    
    0.84
    
    
    
    0.97
    
    
    
    0.81Risk free interest rate
    
    
    
    
    
    
    2.7
    %
    
    
    2.5
    %
    
    
    2.2
    %Expected life
    
    
    
    
    
    4 years
    
    4 years
    
    4 years
 In the three months ended September 30, 2004, there were no options
granted to employees. In the three and nine months ended September 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, dividend yield of zero, 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
dividend yield of zero, 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. 7




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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 condensed consolidated balance sheets as of September 30, 2004 and
December 31, 2003. Use of Estimates The preparation of consolidated financial statements in conformity with
U.S. generally accepted accounting principles 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 impairment evaluations, 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. 2. COMMITMENTS AND CONTINGENCIES As of September 30, 2004, CoSine had commitments of approximately $375,000
relating to purchases of raw materials and semi-finished goods. Subsequent to
September 30, 2004, CoSine terminated its contract manufacturing relationships
and has taken a charge of $375,000 in the quarter ended September 30, 2004 with
respect to the cancellation of such purchase commitments. As of September 30, 2004, CoSine had a contract with an India-based
subcontractor to perform software support services. On October 14, 2004,
CoSine expanded the scope and extended the term of this contract to provide a
service and support capability for CoSines customers through December 31,
2005. The contract, which is cancelable with 90 days notice, calls for
quarterly payments of $450,000 through June 30, 2005 and quarterly payments of
$300,000 through December 31, 2005. In addition, there are set-up costs of
approximately $335,000 to be borne by CoSine in the quarter ended December 31,
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 8




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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 consolidated financial position or results of operations. 3. BALANCE SHEET DETAILS Inventory Inventories, which are stated at the lower of cost (first-in, first-out)
or market, consisted of the following, in thousands: September 30,
    
    December 31,2004
    
    2003(unaudited)Raw materials
    
    $
    20
    
    
    $
    160Semi-finished goods
    
    
    
    
    
    
    3,466Finished goods
    
    
    
    
    
    
    377$
    20
    
    
    $
    4,003
 In September 2004, the Company announced the discontinuation of its
products, accordingly, the Company recorded a charge of $3.9 million to cost of
sales in the quarter ended September 30, 2004, consisting of $3.5 million to
write inventory down to estimated net realizable value and $375,000 to
terminate all existing contract manufacturing obligations as of September 30,
2004. There were no goods awaiting customer acceptance at September 30, 2004.
Included in finished goods at December 31, 2003 was $160,000 of goods
awaiting customer acceptance. There was no finished goods at September 30,
2004. Included in finished goods at December 31, 2003 were $126,000 of goods
used for customer evaluation purposes. There were no goods used for
customer evaluation at September 30, 2004. During the nine months ended September 30, 2004, $0.3 million of
previously written-down inventory was sold and $4.1 million of inventory was
written down. During the nine months ended September 30, 2003, $0.8 million of
previously written-down inventory was sold and $0.1 million of inventory was
written down. In addition, charges of $375,000 were recorded in the nine
months ended September 30, 2004 in connection with excess purchase commitments
at CoSines contract manufacturers and with the termination of the contract
manufacturing agreements. During the three months ended September 30, 2004, no previously
written-down inventory was sold and $3.5 million of inventory was written down.
During the three months ended September 30, 2003, $0.1 million of previously
written-down inventory was sold and $0.1 million of inventory was written down.
There were no charges in connection with excess purchase commitments at
CoSines contract manufacturers in the three months ended September 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. It is expected that any product sales in the fourth quarter of 2004 will not
be covered by warranty. 9




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Changes in CoSines warranty liability were as follows, in thousands: Nine Months Ended September 30,2004
    
    2003(unaudited)Beginning balance
    
    $
    464
    
    
    $
    1,103Warranty expense charged to cost of goods sold
    
    
    150
    
    
    
    357Utilization of warranties
    
    
    (313
    )
    
    
    (680
    )Changes in estimated liability based on experience
    
    
    (18
    )
    
    
    (97
    )Ending balance
    
    $
    283
    
    
    $
    683
 4. NET LOSS PER COMMON SHARE 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 1,182,044 shares
and 1,534,000 shares for the nine months ended September 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
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net loss
    
    ($
    14,619
    )
    
    ($
    8,184
    )
    
    ($
    31,710
    )
    
    ($
    24,764
    )Basic and diluted:Weighted-average shares of common stock outstanding
    
    
    10,177
    
    
    
    9,995
    
    
    
    10,199
    
    
    
    9,968Weighted-average shares subject to repurchase
    
    
    (232
    )
    
    
    (198
    )
    
    
    (201
    )
    
    
    (215
    )Weighted-average shares used in basic and
diluted net loss per share
    
    
    9,945
    
    
    
    9,797
    
    
    
    9,998
    
    
    
    9,753Basic and diluted net loss per share
    
    ($
    1.47
    )
    
    ($
    0.84
    )
    
    ($
    3.17
    )
    
    ($
    2.54
    )
 5. 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. Even if the reseller does not
immediately exercise the warrant upon the occurrence of such an event that
makes the warrant exercisable (a trigger event), the reseller shall be
entitled to securities, cash and property to which it would have been entitled
to upon the consummation of the trigger event, less the aggregate price
applicable to the warrant. 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 dividend yield of zero, 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 was to be amortized over the
two-year expected life of the warrant. In the second quarter of 2004, CoSine
amortized approximately $2,000. In the third quarter of 2004, CoSine
wrote-off
the remaining balance of $46,000 of unamortized fair value of the warrant
issued to a reseller. The decision to fully amortize the remaining fair value
of the warrant was due to an announcement made by the reseller terminating the
agreement with CoSine. 10




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6. COMPREHENSIVE LOSS The components of comprehensive loss are shown below, in thousands: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net loss
    
    ($
    14,619
    )
    
    ($
    8,184
    )
    
    ($
    31,710
    )
    
    ($
    24,764
    )Other comprehensive loss:Unrealized gain (losses) on investments
    
    
    17
    
    
    
    (43
    )
    
    
    (48
    )
    
    
    (311
    )Currency translation adjustment
    
    
    18
    
    
    
    43
    
    
    
    3
    
    
    
    172Total other comprehensive loss
    
    
    35
    
    
    
    0
    
    
    
    (45
    )
    
    
    (139
    )Comprehensive loss
    
    ($
    14,584
    )
    
    ($
    8,184
    )
    
    ($
    31,755
    )
    
    ($
    24,903
    )
 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 nine
months ended September 30, 2004 and 2003, respectively, were as follows, in
thousands: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003RegionUnited States
    
    $
    342
    
    
    $
    726
    
    
    $
    3,033
    
    
    $
    5,396Italy
    
    
    52
    
    
    
    71
    
    
    
    804
    
    
    
    92France
    
    
    350
    
    
    
    106
    
    
    
    1,286
    
    
    
    481Korea
    
    
    18
    
    
    
    1,688
    
    
    
    1,580
    
    
    
    1,749Japan
    
    
    50
    
    
    
    587
    
    
    
    664
    
    
    
    2,855Other EMEA
    
    
    266
    
    
    
    620
    
    
    
    714
    
    
    
    1,371Other Asia/Pacific
    
    
    10
    
    
    
    226
    
    
    
    30
    
    
    
    300Total
    
    $
    1,088
    
    
    $
    4,024
    
    
    $
    8,111
    
    
    $
    12,244
 For the three months ended September 30, 2004, Transpac, Equant and Sprint
accounted for 23%, 21% and 18% of the Companys revenue, respectively. For the
three months ended September 30, 2003, Smartnet, Sprint and Cable and Wireless
accounted for 28%, 15% and 14% of the Companys revenue, respectively. For the
nine months ended September 30, 2004, Sprint, Infranet and Transpac accounted
for 26%, 18% and 11% of the Companys revenue, respectively. For the nine
months ended September 30, 2003, Sprint, Nissho and NEC accounted for 40%, 14%
and 10% of the Companys revenue, respectively. At September 30, 2004, Transpac, Equant and Lucent accounted for 45%, 28%
and 8% of CoSines accounts receivable, respectively. 8. RESTRUCTURING CHARGES In September 2004, CoSine announced actions to terminate most of its
workforce, retaining a limited team of employees to provide customer support
and handle matters related to the ongoing exploration of strategic
alternatives. The specific actions include workforce reductions, with a charge
of $2,871,000, announced discontinuance of the CoSine products, with a related
charge to cost of sales of $3,466,000 to write inventory down to net realizable
value and a 11




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$75,000 charge for unrecoverable royalties, and termination of third party
manufacturing agreements, with a charge of $375,000. The Company also plans to
terminate contractor and consulting agreements, real estate leases, and to
sell or dispose of tangible assets. These activities will result in
additional charges in the quarter ending December 31, 2004. As a result of the workforce reduction, 100 employees were terminated
through September 30, 2004, leaving an employee population of 39.
Substantially all employees will be terminated by December 31, 2004. Effective
September 23, 2004, CoSine approved severance agreements with
Stephen Goggiano, its president and chief executive officer, and Terry Gibson,
its chief financial officer, covering the period of August 1, 2004 through the
earlier of (i) December 31, 2004 or (ii) the termination of their respective
employments due to the elimination of their respective jobs if caused by a
merger, sale, acquisition, liquidation, dissolution, consolidation or similar
corporate transaction, in exchange for their continued service to CoSine as it
explores strategic alternatives, including a sale of the Company, a sale or
licensing of products, intellectual property, or sale of individual assets or a
winding-up and liquidation of the business. In exchange for their continued
service during this time period, Mr. Goggiano and Mr. Gibson will each receive
a retention bonus equal to 100% of their base 2004 annual salary payable on or
before December 31, 2004. In addition, upon completion of these services,
CoSine shall pay for the cost of Mr. Goggianos and Mr. Gibsons COBRA coverage
under the Companys health plan for a period of 12 months after termination of
their respective employment. On completion of this restructuring in December 2004, the company operations
will consist primarily of a customer service capability, performed under
contract by a third party contractor. Activity
related to the September 2004 restructuring is as follows (in
thousands): Worldwide
    
    Write-down of
    
    Manufacturingworkforce
    
    inventory and
    
    agreementreduction
    
    prepaid royalty
    
    termination
    
    TotalSeptember 2004 restructuring charges
    
    $
    2,872
    
    
    $
    3,541
    
    
    $
    375
    
    
    $
    6,788Cash payments
    
    
    (938
    )
    
    
    
    
    
    
    
    
    
    
    (938
    )Write offs
    
    
    
    
    
    
    (3,541
    )
    
    
    (97
    )
    
    
    (3,638
    )Provision balance at September 30, 2004
    
    $
    1,934
    
    
    $
    
    
    
    $
    278
    
    
    $
    2,212
 The
restructuring charges related to worldwide workforce reduction of
$2,872 was charged to operating expenses, and the write-down of
inventory, write-off of prepaid royalty and termination of
manufacturing agreement of $3,916 was charged to cost of sales. Cosine expects to pay the remaining $2,212,000 related to the workforce
reduction and manufacturing agreement termination in the fourth quarter of
2004. 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. Most of
the terminations took place in the second quarter of 2002, with the remainder
taking place in the third quarter of 2002. 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. 12




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Activity related to the March 2003 and May 2002 restructurings for the
nine months ended September 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
    
    
    $
    
    
    
    $
    48Accrual adjustment
    
    
    (10
    )
    
    
    
    
    
    
    (10
    )Provision balance at September 30, 2004
    
    $
    38
    
    
    
    
    
    
    $
    38
 CoSine expects to pay the remaining $38,000 related to the workforce
reduction in the fourth quarter of 2004. Impairment of Long-lived Assets At June 30, 2004, the Company made an assessment of its business and
concluded that indicators of impairment were present at June 30, 2004.
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 to be generated by the Companys long-lived assets during their
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 At September 30, 2004, the Company concluded that indicators of impairment
were again present. Such indicators included ongoing operating losses,
inability to achieve sustainable revenue growth, 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 to be generated by the
Companys long-lived assets during their estimated remaining useful lives were
not sufficient to recover the net book value of the assets. Consequently, the
Company obtained competitive bids from qualified prospective purchasers to
determine their fair values. The fair values of the long-lived assets, as
indicated by competitive bids, exceeded the net book value of the long-lived
assets at September 30, 2004, accordingly, no further impairment adjustment was
made in the third quarter of 2004. In
September 2004, the Company initiated efforts to sell the remaining property and
equipment and, as such, have classified the remaining property and
equipment, as held for sale,
with a net book value of $308,000, in the balance sheet caption
prepaid expenses and other current
assets. 9. SUBSEQUENT EVENTS On October 22, 2004, the Company executed an agreement to terminate the
lease of its facilities in Redwood City, California. The agreement includes a
lump sum payment, including rents through December 31, 2004 and clean-up costs,
of $4.1 million, and the surrender of a $420,000 lease deposit and the
surrender of furniture and fixtures with an estimated value of less than
$50,000. In exchange, the lessor has agreed to terminate the lease as of
December 31, 2004 and to waive the rights to approximately $16.6 million in
contracted rents. In addition, the Company sold or disposed of substantially all of its
fixed assets in October 2004. Cash proceeds from the sale of fixed assets were
$1.1 million. 
 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 13




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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, workforce reductions, announced discontinuance of the CoSine products,
termination of third party manufacturing agreements, termination of contractor
and consulting agreements and termination of real estate leases, the slow development of the market
for network-based IP services, the impact of competitive products, changing
customer requirements, and changes in economic conditions in the various
markets that we have served, all as are discussed in more detail in the section
entitled Risk Factors on pages 26 through 29 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. OVERVIEW Prior to and during the period ended September 30, 2004, we developed,
marketed and sold a communications platform that we refer to as our IP Service
Delivery Platform. Our product was designed to enable network service
providers to rapidly deliver a portfolio of communication services to business
and consumer customers. We marketed our IP Service Delivery Platform through
our direct sales force and through resellers to network service providers in
Asia, Europe and North America. We provided and will continue to provide
customer service and support for our products through our support partner. Even during this period, the market for our IP Service Delivery Platform
was still in the early stages of development, and the volume and timing of
orders were difficult to predict. A customers decision to purchase our
platform typically involved 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 affected repeat business, caused our revenue and operating
results to vary significantly and unexpectedly from quarter to quarter and
constrained our ability to secure new customers. We have not generated

sufficient revenue to fund our operations and have been unable to 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. On
September 8, 2004, we announced, in connection with our ongoing evaluation of
strategic alternatives, that we had initiated actions to lay-off most of our
employees, retaining a limited team of employees to provide customer support
and handle matters related to the ongoing exploration of strategic
alternatives. Since September 8, 2004, the Company has taken a number of
actions to reduce its operating expenses and conserve its cash. CoSine has
notified its existing customers that the CoSine products are now formally
discontinued and that existing customers may place lifetime buy orders to
support their platform transition plans. The Company has written its inventory
down to estimated net realizable value at September 30, 2004. The Company has
taken steps to terminate contract manufacturing arrangements, contractor and
consulting arrangements and facility leases. These activities will continue
into the quarter ending December 31, 2004, at which time CoSines business will
consist primarily of a customer service capability operated under contract by a
third party. The Company continues to explore strategic alternatives, including a sale
of the Company, a sale or licensing of products, intellectual property, or
individual assets or a winding-up and liquidation of the business. Pending the
outcome of the Companys review of strategic alternatives and any definitive
decisions to close or liquidate the business, the Company will continue to
prepare its financial statements on the assumption that it will continue as a
going concern, 14




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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 of
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 appropriate to prepare and present financial statements on
the liquidation basis of accounting, whereby assets are valued at their
estimated net realizable values and liabilities are stated at their estimated
settlement amounts. 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. Managements overview of the Companys position is discussed in more
detail in the Liquidity and Capital Resources section on
pages 24-25 and the
Outlook section on page 25. 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 U.S. generally accepted accounting
principles. 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. On
September 8, 2004, CoSine announced, in connection with its
ongoing evaluation
of strategic alternatives, actions to lay-off most of its
employees, retaining a limited team of employees to provide customer support
and handle matters related to the ongoing exploration of strategic
alternatives. Since September 8, 2004, the Company has taken a number of
actions to reduce its operating expenses and conserve its cash. CoSine has
notified its existing customers that the CoSine products are now formally
discontinued and that existing customers may place lifetime buy orders to
support their transition plans. The Company has written its inventory down to
estimated net realizable value at September 30, 2004. The Company has taken
steps to terminate contract manufacturing arrangements, contractor and
consulting arrangements and facility leases. These activities will continue
into the quarter ending December 31, 2004, at which time CoSines business will
consist primarily of a customer support capability supported by a third party
contractor. The Company continues to explore strategic alternatives, including a sale
of the Company, a sale or licensing of products, intellectual property, or
individual assets or a winding-up and liquidation of the business. Pending the
outcome of the Companys review of strategic alternatives and any definitive
decisions to close or liquidate the business, 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 of
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, 15




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if the Company were to decide to pursue a liquidation and return of
capital, it would be appropriate to prepare and present financial statements on
the liquidation basis of accounting, whereby assets are valued 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 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 sales. During the three
months ended September 30, 2004, we announced that we were discontinuing our
products and recorded a charge of $3.5 million to write our inventory down to
estimated net realizable value. 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 September 30,
2004 and at June 30, 2004. Such indicators included ongoing operating losses,
inability to achieve sustainable revenue growth, 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 16




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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 our long-lived assets during their 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. In September 2004 we initiated efforts to sell the remaining property and
equipment and, as such, classified the remaining property and equipment,
with a net book value of $308,000, to the balance sheet caption
prepaid expenses and other current
assets. The fair value of the property and equipments held for sale, as
indicated by competitive bids, exceeded its net book value at September 30,
2004 and, accordingly, no impairment adjustment was made in the third quarter
of 2004. In October 2004, substantially all of the property and equipment was
sold or otherwise disposed of and the proceeds were $1.1 million. 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
sales may result. It is anticipated that product sales, if any, in the fourth quarter of
2004 will not be covered by warranty. 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 in our
balance sheet as of December 31, 2003 and was 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 the fair
market value of our common stock resulting in additional charges or credits. In the first nine
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. 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 September 30, 2004,
210,643 stock options re-priced in November 2002 were still outstanding.
The re-priced options did not have an intrinsic value at September 30,
2004 because the stock 17




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price on this date was trading below its exercise price. 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 or third quarters 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. Even if the reseller does not
immediately exercise the warrant upon the occurrence of such an event that
makes the warrant exercisable (a trigger event), the reseller shall be
entitled to securities, cash and property to which it would have been entitled
to upon the consummation of the trigger event, less the aggregate price
applicable to the warrant. 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 dividend rate of zero, 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 was to be amortized over the
two-year expected life of the warrant. In the second quarter of 2004, we
amortized approximately $2,000. In the third quarter of 2004,
CoSine wrote-off the remaining balance of $46,000 of unamortized fair value of
the warrant issued to a reseller. The decision to fully amortize the remaining
fair value of the warrant was due to an announcement made by the reseller
terminating the agreement with CoSine. RESULTS OF OPERATIONS 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. On
September 8, 2004, CoSine announced, in connection with its
ongoing evaluation
of strategic alternatives, actions to lay-off most of its
employees, laying off 100 employees in September 2004 while retaining a limited
team of employees to provide customer support and handle matters related to the
ongoing exploration of strategic alternatives. Since September 8, 2004, the
Company has taken a number of actions to reduce its operating expenses and
conserve its cash. CoSine has notified its existing customers that the CoSine
products are now formally discontinued and that existing customers may place
lifetime buy orders to support their platform transition plans. The Company has
written its inventory down to estimated net realizable value at September 30,
2004. The Company has taken steps to terminate contract manufacturing
arrangements, contractor and consulting arrangements and facility leases.
These activities will continue into the quarter ending December 31, 2004, at
which time CoSines business will consist primarily of a customer support
capability supported by a third party contractor. Our announcement that we have discontinued our product and our
announcement regarding the retention of an investment banker as a financial
advisor to assist us in assessing strategic alternatives have adversely
impacted demand for our products. Revenue For the three months ended September 30, 2004, revenue was $1.1 million of
which 41% was from hardware sales, 2% was from software sales and 57% was from
sales of services. For the three months ended September 30, 2003, 18




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##### Table of Contents



revenue was $4.0 million of which 77% was from hardware sales, 2% was from
software sales and 21% from sales of services. For the nine months ended
September 30, 2004, revenue was $8.1 million, of which 67% was from hardware
sales, 7% was from software sales and 26% was from sales of services. For the
nine months ended September 30, 2003, revenue was $12.2 million, of which 80%
was from hardware sales, 2% was from software sales and 18% was from sales of
services. Revenues from customers by geographic region for the three and nine months
ended September 30, 2004 and 2003, respectively, were as follows, in thousands: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003RegionUnited States
    
    $
    342
    
    
    $
    726
    
    
    $
    3,033
    
    
    $
    5,396Italy
    
    
    52
    
    
    
    71
    
    
    
    804
    
    
    
    92France
    
    
    350
    
    
    
    106
    
    
    
    1,286
    
    
    
    481Korea
    
    
    18
    
    
    
    1,688
    
    
    
    1,580
    
    
    
    1,749Japan
    
    
    50
    
    
    
    587
    
    
    
    664
    
    
    
    2,855Other EMEA
    
    
    266
    
    
    
    620
    
    
    
    714
    
    
    
    1,371Other Asia/Pacific
    
    
    10
    
    
    
    226
    
    
    
    30
    
    
    
    300Total
    
    $
    1,088
    
    
    $
    4,024
    
    
    $
    8,111
    
    
    $
    12,244
 Revenue for the three months ended September 30, 2004 decreased $2.9
million compared to the same period in 2003. Revenue for the nine months ended
September 30, 2004 decreased $4.1 million compared to the
same period in 2003.
 The decline in both periods was due to lower sales to major customers in the US
and Japan, due in part to the timing of their expansion plans, and our announcements during the third quarter of 2004 regarding the
retention of an investment banker as a financial advisor to assist us
in assessing strategic alternatives, inability to achieve sustainable
revenue growth, workforce reductions, discontinuance of the CoSine
products, termination of third party manufacturing agreements,
termination of contractor and consulting agreements and termination
of real estate leases, all of which adversely impacted demand for our
products. Because the
market for network-based IP services is in the early stages of development,
service provider demand for our products fluctuate as service providers
were unable 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 25 and Risk Factors section on pages 26
to 29. For the three months ended September 30, 2004, Transpac, Equant and Sprint
accounted for 23%, 21% and 18% of our revenue, respectively. For the three
months ended September 30, 2003, Smartnet, Sprint and Cable and Wireless
accounted for 28%, 15% and 14% of our revenue, respectively. For the nine
months ended September 30, 2004, Sprint, Infranet and Transpac accounted for
26%, 18% and 11% of our revenue, respectively. For the nine months ended
September 30, 2003, Sprint, Nissho and NEC accounted for 40%, 14% and 10% of
our revenue, respectively. Non-Cash Charges Related to Equity Issuances During the three months ended September 30, 2004 and 2003, we recorded
$0.0 million and $0.2 million, respectively, of non-cash charges related to
equity issuances to cost of goods sold, operating expenses and interest
expense. During the nine months ended September 30, 2004 and 2003, we recorded
($0.9) million and $0.7 million, respectively, of non-cash charges related to
equity issuances to cost of goods sold, operating expenses and interest
expense. Below is a reconciliation of non-cash charges related to equity issuances
for the three and nine months ended September 30, 2004 and 2003, as presented
in our statement of operations, in thousands: 19




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##### Table of Contents



Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 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
    
    $
    4
    
    
    $
    275
    
    
    $
    92
    
    
    $
    1,236Credits related to the reversal of
deferred stock compensation
amortization in excess of vesting
for terminated employees
    
    
    (21
    )
    
    
    (147
    )
    
    
    (185
    )
    
    
    (802
    )Amortization of deferred
compensation associated with
re-pricing
    
    
    
    
    
    
    82
    
    
    
    (1,063
    )
    
    
    195Bonus paid in shares of common stock
    
    
    
    
    
    
    
    
    
    
    228
    
    
    
    Amortization of charges related to
warrants or stock options issued to
non-employees in conjunction with
lease and debt agreements and
re-seller agreement
    
    
    20
    
    
    
    15
    
    
    
    53
    
    
    
    75Net non-cash charges related to
equity issuances
    
    $
    2
    
    
    $
    225
    
    
    ($
    875
    )
    
    $
    704
 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 September 30, 2004, cost of goods sold was $4.4
million, of which $3.5 million represented the write-down of inventory, $0.4
million represented costs to terminate contract manufacturing agreements, and
$0.5 million represented materials, labor, production overhead, warranty and
the cost of providing services. For the three months ended September 30,
2003, cost of goods sold was $1.8 million, which $1.9 million represented
materials, labor, production overhead, warranty and the cost of providing
services, $0.1 million represented inventory write-downs and $0.1 million
represented a credit associated with the sale of written-down inventory. For the nine months ended September 30, 2004, cost of goods sold was $7.4
million, of which $3.9 million represents a one-time restructuring charge, $2.7
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
nine months ended September 30, 2003, cost of goods sold was $5.3 million, of
which $5.6 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, $0.1 represented
inventory written down and $0.8 million represented a benefit associated with
the sale of previously written-down inventory. Gross Profit (Loss) For the three months ended September 30, 2004 and 2003, gross profit
(loss) was ($3.4) million and $2.2 million, respectively. Gross profit
declined from 55% to negative 308%. The decrease in gross profit is due to
one-time charges of $3.9 million related to write-down of inventory and
termination of contract manufacturing agreement as part of the restructuring
program initiated in the quarter. Decrease in revenue resulting from the
announcement to discontinue the product contributed also to the decrease in
gross profit. There was no sell through of inventory previously written down
in the quarter ended September 30, 2004. For the nine months ended September 30, 2004 and 2003, gross profit was
$.7 million and $6.9 million, respectively. Gross profit decreased from 56% to
9%. One-time charges related to write-down of inventory and termination of
contract manufacturing agreement accounted for the decrease. Decrease in
revenue resulting from the announcement to discontinue the product contributed
also to the decrease in gross profit. The sell through of inventory previously
written down was $0.7 million for the nine-months ended September 30, 2004. The Company, in connection with its decision to discontinue its product
lines, offered its existing customers lifetime buy orders to support their
platform transition plan. We expect minimal revenue to be derived from this
offer. 20




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##### Table of Contents



Customer support will be offered for a fee through a third-party
contractor. We do not have sufficient information at this time to quantify the
revenue to be derived from this offer. Future gross margins will be dependent on the sales volume of lifetime
buys of CoSines product as well as the volume of customer service revenues,
net of the costs of our third party support contracts. Even though the third
party support contract is cancelable in 90 days, gross margins will likely
continue to be negative, depending on service revenue volume. Research and Development Expenses Research and development expenses were $3.7 million and $5.5 million for
the three months ended September 30, 2004 and 2003, respectively, representing
a decrease of $1.8 million or 33%. The decrease is due to headcount reductions
and reduced project spending in 2004. Due to the September 2004 restructuring,
we expect research and development costs to be approximately $0.5 million in
the quarter ending December 31, 2004. Research and development expenses were $13.3 million and $15.9 million for
the nine months ended September 30, 2004 and 2003, respectively, representing a
decrease of $2.6 million for 16%. The decrease is due to a decline in
headcount as well as reduced project spending in 2004. Sales and Marketing Expenses Sales and marketing expenses were $3.1 million and $3.2 million for the
three months ended September 30, 2004 and 2003, respectively. Due to the
September 2004 restructuring, we expect sales and marketing expenses to be
approximately $1.2 million in the quarter ending December 31, 2004. Sales and marketing expenses were $9.6 million and $10.3 million for the
nine months ended September 30, 2004 and 2003, respectively, representing a
decrease of $0.7 million or 7%. The decrease is due to employee attrition in
2004 and reduced travel and entertainment spending. General and Administrative Expenses General and administrative expenses were $1.7 million and $1.8 million for
the three months ended September 30, 2004 and 2003, respectively, representing
a decrease of $0.1 million or 6 %. The decrease is due to employee attrition.
General and administrative expenses were $4.6 million and $5.6 million for the
nine months ended September 30, 2004 and 2003, respectively, representing a
decrease of $1.0 million or 18%. The decrease is due primarily to employee
attrition. Due to the September 2004 restructuring, we expect general and
administrative costs to be approximately $5.1 million in the quarter ending
December 31, 2004, including $4.1 million paid in October, 2004 to
terminate a real estate lease. Restructuring and Impairment September 2004 Restructuring In September 2004, CoSine announced actions to terminate most of its
workforce, retaining a limited team of employees to provide customer support
and handle matters related to the ongoing exploration of strategic
alternatives. The specific actions include workforce reductions, with a charge
of $2,872,000, announced discontinuance of the CoSine products, with a related
charge to cost of sales of $3,466,000 to write inventory down to net realizable
value and a $75,000 charge for unrecoverable royalties, and termination of
third party manufacturing agreements, with a charge of $375,000. The Company
also plans to terminate contractor and consulting agreements, real estate
leases, and to sell or dispose of tangible assets. These activities will
result in additional charges in the quarter ending December 31, 2004 (refer
also to Note 8 to the Condensed Consolidated Financial Statements). As a result of the workforce reduction, 100 employees were
terminated through September 30, 2004, leaving an employee population of 39.
Substantially all employees will be terminated by December 31, 2004. Effective
September 23, 2004, CoSine approved severance agreements with
Stephen Goggiano, its president and chief executive officer, and Terry Gibson,
its chief financial officer, covering the period of August 1, 2004 through the
earlier of (i) December 31, 2004 or (ii) the termination of their respective
employments due to the elimination of their respective 21




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##### Table of Contents



jobs if caused by a merger, sale, acquisition, liquidation, dissolution,
consolidation or similar corporate transaction, in exchange for their continued
service to CoSine as it explores strategic alternatives, including a sale of
the Company, a sale or licensing of products, intellectual property,
or sale of
individual assets or a winding-up and liquidation of the business. In exchange
for their continued service during this time period, Mr. Goggiano and Mr.
Gibson will each receive a retention bonus equal to 100% of their base 2004
annual salary payable on or before December 31, 2004. In addition, upon
completion of these services, CoSine shall pay for the cost of Mr. Goggianos
and Mr. Gibsons COBRA coverage under the Companys health plan for a period of
12 months after termination of their respective employment. On completion of this restructuring in December 2004, the Company operations
will consist primarily of a customer service capability, performed under
contract by a third party contractor. Activity related to the September 2004 restructuring is as follows. (in
thousands): Write-down ofWorldwide
    
    inventory and
    
    Manufacturingworkforce
    
    prepaid
    
    agreementreduction
    
    royalty
    
    termination
    
    TotalSeptember 2004 restructuring charges
    
    $
    2,872
    
    
    $
    3,541
    
    
    $
    375
    
    
    $
    6,788Cash payments
    
    
    (938
    )
    
    
    
    
    
    
    
    
    
    
    (938
    )Write offs
    
    
    
    
    
    
    (3,541
    )
    
    
    (97
    )
    
    
    (3,638
    )Provision balance at September 30, 2004
    
    $
    1,934
    
    
    $
    

    
    
    $
    278
    
    
    $
    2,212
 Cosine expects to pay the remaining $2,212,000 related to the workforce
reduction and manufacturing agreement termination in the fourth quarter of
2004. 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 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. 22




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##### Table of Contents



Activity related to the March 2003 and May 2002 restructurings for the
nine months ended September 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
    
    
    $
    
    
    
    $
    48Accrual adjustment
    
    
    (10
    )
    
    
    
    
    
    
    (10
    )Provision balance at September 30, 2004
    
    $
    38
    
    
    
    
    
    
    $
    38
 CoSine expects to pay the remaining $38,000 related to the workforce
reduction in 2004. Impairment of Long-lived Assets September 30, 2004 and June 30, 2004 Impairment As a result of our assessment of our business, we concluded that indicators of
impairment of our long-lived assets were present at September 30, 2004 and at
June 30, 2004. Such indicators included ongoing operating losses, inability to
achieve sustainable revenue growth, 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 our long-lived assets during their 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. At September 30, 2004, the Company obtained
competitive bids from qualified prospective purchasers to determine the fair
values of long-lived assets. The fair values, as indicated by competitive
bids, exceeded the net book value of the long-lived assets at September 30,
2004, accordingly no adjustment was made in the third quarter of 2004. Interest and Other Income For the three months ended September 30, 2004 and 2003, interest and other
income was $0.1 million and $0.1 million, respectively. For the nine months
ended September 30, 2004 and 2003, interest and other income was $0.3 million
and $1.1 million, respectively. The decrease in interest income for both
periods was primarily due to lower levels of cash and short-term investments. Income Tax Provision (Benefit) For the three months ended September 30, 2004 and 2003, the provisions
(benefit) for income taxes was ($9,000) and $15,000, respectively. For the
nine months ended September 30, 2004 and 2003, the provisions for income taxes
were $2,000 and $86,000, 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. Impact of Equity Issuances on Loss Per Share For the three months ended September 30, 2004 and 2003, we reported basic
and diluted net losses per share of $1.47 and $0.84, respectively. The equity
issuances to employees and suppliers increased net loss per share by $0.02 for
the three months ended September 30, 2004 and increased net loss per share by
$0.02 for the three months ended September 30, 2003. For the nine months ended September 30, 2004 and 2003, we reported basic
and diluted net losses per share of $3.17 and $2.54. The effect of equity
issuances to employees and suppliers decreased net loss per share by $0.09 for
the nine
months ended September 30, 2004 and increased net loss per share by $0.07
for the nine months ended September 30, 2003. 23




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##### Table of Contents



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 and do not expect to sustain or significantly increase our revenue. 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. On September 8, 2004, we announced that we were laying-off
substantially all of our employees and were discontinuing our products while
continuing to evaluate strategic alternatives.Based on restructuring activities
initiated in September 2004, on the costs to complete all such activities, on
the significant reduction in cash usage once such activities are completed, and
on the costs to extend customer support activities through December 2005, 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.
See Outlook on page 25 and Risk
Factors on pages 26-29, which
describes strategic alternatives we are currently exploring. On
September 8, 2004, CoSine announced, in connection with its
ongoing evaluation
of strategic alternatives, actions to lay-off most of its
employees, retaining a limited team of employees to provide customer support
and handle matters related to the ongoing exploration of strategic
alternatives. Since September 8, 2004, the Company has taken a
number of additional actions to reduce its operating expenses and conserve its cash. CoSine has
notified its existing customers that the CoSine products are now formally
discontinued and that existing customers may place lifetime buy orders to
support their platform transition plans. The Company has written its inventory down to
estimated net realizable value at September 30, 2004. The Company has taken
steps to terminate contract manufacturing arrangements, contractor and
consulting arrangements and facility leases. These activities will continue
into the quarter ending December 31, 2004, at which time CoSines business will
consist primarily of a customer support capability supported by a third party
contractor under a contract that extends through December 31, 2005. The Company continues to explore strategic alternatives, including a sale
of the Company, a sale or licensing of products, intellectual property, or
individual assets or a winding-up and liquidation of the business. Pending the
outcome of the Companys review of strategic alternatives and any definitive
decisions to close or liquidate the business, 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 of
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 appropriate to prepare and present financial statements on
the liquidation basis of accounting, whereby assets are valued at their
estimated net realizable values and liabilities are stated at their estimated
settlement amounts. 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 September 30, 2004, cash, cash equivalents and short-term investments
were $33.6 million. This compares with $57.8 million at December 31, 2003. Operating Activities We used $23.1 million and $29.5 million of cash in operations for the nine
months ended September 30, 2004 and 2003, respectively. 24




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Investing Activities For the nine months ended September 30, 2004 and 2003, investing
activities provided $14.7 million and $42.6 million in cash, respectively. Financing Activities For the nine months ended September 30, 2004 and 2003, financing
activities provided $0.1 and used $3.1 million in cash, respectively. OUTLOOK Although capital spending in the telecommunications industry has begun to
recover, the market for network-based IP services continues to develop slowly.
We do not believe we can achieve the sustainable revenue growth necessary to
survive as a stand-alone entity. 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. On September 8, 2004, CoSine
announced, in connection with its ongoing evaluation of strategic alternatives, actions to lay-off most of its employees, retaining a limited team of employees
to provide customer support and handle matters related to the ongoing
exploration of strategic alternatives. Since September 8, 2004, the Company has
taken a number of additional actions to reduce its operating expenses and conserve its
cash. CoSine has notified its existing customers that the CoSine products are
now formally discontinued and that existing customers may place lifetime buy
orders to support their transition plans. Based on our current forecasts for
future product demand, the Company has written its inventory down to estimated
net realizable value at September 30, 2004. The Company has taken steps to
terminate contract manufacturing arrangements, contractor and consulting
arrangements and facility leases. These activities will continue into the
quarter ending December 31, 2004, at which time CoSines business will consist
primarily of a customer support capability supported by a third party
contractor under a contract that extends through December 31, 2005. At
September 30, 2004, we had $33.6 million in cash and short-term
investments. Cash consumption during the quarter ended September 30, 2004 was
$11.1 million. Our cash consumption for the twelve months ended September 30,
2004 was $33.3 million. Based on restructuring activities initiated in
September 2004, on the costs to complete all such activities, on the
significant reduction in cash usage once such activities are completed, and on
the costs to extend customer support activities through December 2005, 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.
     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. 25




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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 any remaining 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
    
    The value, if any, that may be attributed to our intellectual property. 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 discontinuance of 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
    
    the value, if any, that may be attributed to our intellectual property.. 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 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. 26




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Our customers may sue us because we have announced the discontinuance of our
products and may not meet all our contractual commitments. Certain of our customer contracts contain provisions relating to the
availability of products, spare parts and services for periods up to ten
years. We are in discussions with our customers and are jointly developing
alternative plans but our customers may choose to sue us for breach of
contract. We have a history of losses that we expect will continue, and if we do not
achieve profitability we may cease operations. At September 30, 2004, we had an accumulated deficit of $510 million. We
have incurred net losses since our incorporation. It is unlikely at this date
that we will generate sufficient revenue to become profitable. At September
30, 2004, we had $33.6 million in cash and short-term investments. Cash
consumption for the nine months ended September 30, 2004 was $24.1 million. If
we do not achieve profitability and are unable to obtain additional financing,
we may run out of cash and cease operations. The market for managed network-based IP services is still in the early stages
of growth. As a result, strategic alternatives may not be available to us. 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. Due to this uncertainty, strategic alternatives may not be
available to us, as a result of which the trading price of our common stock
could decline. The outlook for capital spending in the telecommunications industry directly
impacts the strategic alternatives that may be available to us. Capital expenditures within the telecommunications industry have
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. Until the market
develops further, demand for network-based IP services may not increase
significantly, limiting the strategic alternatives available to us and thereby
causing our stock price to decline. Our IP Service Delivery
Platform was our only product line, and the availability
of strategic alternatives may depend on its on its perceived value in the
telecommunications industry Our IP Service Delivery Platform, which is comprised of hardware and
software, was the only product line that we offered to our customers
and has been discontinued. We have no plans to offer any other
product line. If the
telecommunications industry does not value our intellectual property, our
strategic alternatives will be adversely impacted. 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 product returns, injury to our reputation, 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 27




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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. 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 adversely impacting strategic alternatives
available to us. The
market for managed network-based IP services is prone to rapid
technological change, the adoption of new standards, frequent new
product introductions and changes in customer and end-user
requirements. The introduction of new products or technologies by
competitors, or the emergence of new industry standards, could
render our intellectual property obsolete adversely impacting
strategic alternatives available to us. If necessary licenses of third-party technology are terminated or become
unavailable or too expensive, we may be unable to consummate an acceptable
strategic alternative. We license from third-party suppliers certain software applications
incorporated in our IP Service Delivery Platform. Our inability to renew or
obtain any third party license that we need could require us to obtain
substitute technology at a lower quality and higher cost. These outcomes could
seriously impair our ability to consummate an acceptable strategic alternative. If we are unable to protect our intellectual property rights, acceptable
strategic alternatives may not be available to us. 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,
the value of our intellectual property may be impaired, adversely impacting our
ability to consummate acceptable strategic alternatives. 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 from pursuing strategic alternatives. 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 cannot obtain director and officer liability insurance in acceptable
amounts for acceptable rates, we may have difficulty recruiting and retaining
qualified directors and officers. 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 28




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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
September 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 $90,000 decrease or increase, respectively, in the fair value of
our investments in debt securities as of September 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 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 generally 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 September 30,
2004 that has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting. Although
we terminated most of our workforce and reorganized our finance group
as a result of resignations and lay-offs of personnel in the finance
staff during the fiscal quarter ending September 30, 2004, which
significantly affected the Companys level of staffing for
functions related to the internal controls for financial reporting,
there have been no significant changes in the nature of the internal
control procedures or the manner in which transactions are recorded,
classified, and summarized in the preparation of interim financial
information as compared to the internal control and accounting
systems in effect during the preceding fiscal year, the preceding
quarter, and the corresponding quarter of the preceding year. We
believe that the reduction in and reorganization of our finance staff
has not resulted in any significant deficiencies or material
weaknesses
in the design or operation of internal control over financial
reporting due to:  a corresponding and concurrent reduction in the number of
routine financial transactions reflecting workforce reductions,
discontinuance of our products, and the general decline in the volume
of business we are experiencing,; and  the
retention of experienced finance personnel who are
responsible for the accounting related to the more complex
transactions including, restructuring charges, termination of third
party manufacturing agreements, termination of contractor and
consulting agreements and termination of real estate leases as well
as financial reporting. 29




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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. 
 ITEM 2. UNREGISTERED SALES
OF EQUITY SECURITIES AND USE OF PROCEEDS  (a)
    
    Not applicable.(b)
    
    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. 30




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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 $204 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.(c)
    
    The following table provides information about purchases by the
Company during the quarter ended September 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
    
    PlansJuly 1, 2004 - July 31, 2004
    
    
    150
    
    
    $
    210.00
    
    
    not applicable
    
    not applicableAugust 1, 2004 - August 31, 2004
    
    
    6,280
    
    
    
    20.79
    
    
    not applicable
    
    not applicableSeptember 1, 2004 - September 30, 2004
    
    
    158,086
    
    
    
    42.65
    
    
    not applicable
    
    not applicableTotal
    
    
    164,516
    
    
    $
    273.44
 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 5. OTHER INFORMATION Our former independent auditor, Ernst & Young LLP (E&Y), recently notified
the Securities and Exchange Commission (SEC), the Public Company Accounting Oversight
Board, and the Companys Audit Committee that, during 2001 and 2002, E&Ys
China-based affiliate effected payments of certain taxes on the Companys
behalf related to our employees located in China, using our funds. Such
handling of the Companys funds is not permitted under SEC auditor independence
rules. The Company ceased using E&Y to provide these services during 2002, and
has concluded that both the amount of the tax payments made on our behalf by
E&Y and the fees paid to E&Ys affiliate in China in connection with these
services were de minimis. The Audit Committee and E&Y discussed E&Ys independence for its 2001,
2002 and 2003 audits with respect to the Company in light of the foregoing
facts. The Audit Committee and E&Y do not believe that, in the circumstances,
E&Ys handling of the Companys funds impaired E&Ys independence with respect
to E&Ys audits of the Companys consolidated financial statements. Further,
the Company, based on its own review, is not aware of any other services that
may have compromised E&Ys independence in performing audit services for the
Company. 31




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ITEM 6. EXHIBITS Exhibit Index
on page 33. 
 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:
November 15, 2004
 32




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EXHIBIT INDEX Exhibit Number
    
    Description10.1
    
    Form of Severance Agreement extended to Stephen Goggiano,
President and Chief Executive Officer of CoSine
Communications, Inc., and Terry Gibson, Chief Financial
Officer of CoSine Communications, Inc., as of September 23,
200410.2
    
    Statement of Work between CoSine Communications and Wipro
Limited, dated October 14, 200431.1
    
    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
 33