##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
    FORM 10-Q    (MARK ONE) þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 FOR THE QUARTERLY PERIOD ENDED March 31, 2005 OR o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from ____________ to ____________. Commission File Number 000-30715 COSINE COMMUNICATIONS, INC. (Exact name of Registrant as specified in its charter)
 Delaware
    
    94-3280301(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification Number)560 South Winchester Blvd. Suite 500, San Jose, CA
    
    95128(Address of principal executive offices)
    
    (Zip Code)
 Registrants telephone number including area code: (408) 236-7518 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 þ 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 þ There were 10,090,635 shares of the Companys Common Stock, par value $.0001, outstanding on April
30, 2005.




---



COSINE COMMUNICATIONS, INC. FORM 10-Q Quarter ended March 31, 2005 TABLE OF CONTENTS PagePART IFINANCIAL INFORMATIONItem 1. Condensed Consolidated Financial Statements:Condensed Consolidated Balance Sheets as of March 31, 2005 and December 31, 2004
    
    
    3Condensed Consolidated Statements of Operations for the Three Months Ended March 31, 2005 and 2004
    
    
    4Condensed Consolidated Statements of Cash Flows for Three Months Ended March 31, 2005 and 2004
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    12Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    26Item 4. Controls and Procedures
    
    
    27PART IIOTHER INFORMATIONItem 1. Legal Proceedings
    
    
    27Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    28Item 6. Exhibits
    
    
    29Signature
    
    
    29Exhibit Index
    
    
    30EXHIBIT 31.1EXHIBIT 32.1
  2




---



##### Table of Contents



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)
 March 31,
    
    
    December 31,2005
    
    
    2004(Unaudited)
    
    
    (1)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    11,020
    
    
    $
    9,203Short-term investments
    
    
    12,640
    
    
    
    15,710Accounts receivable:Trade (net of allowance for doubtful accounts of $90 at March
31, 2005 and December 31, 2004)
    
    
    602
    
    
    
    1,328Other
    
    
    119
    
    
    
    483Prepaid expenses and other current assets
    
    
    806
    
    
    
    949Total current assets
    
    
    25,187
    
    
    
    27,673Long-term deposits and other assets
    
    
    528
    
    
    
    150$
    25,715
    
    
    $
    27,823LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    225
    
    
    $
    252Provision for warranty claims
    
    
    157
    
    
    
    157Accrued other liabilities
    
    
    1,522
    
    
    
    3,129Accrued compensation
    
    
    175
    
    
    
    412Deferred revenue
    
    
    710
    
    
    
    509Total current liabilities
    
    
    2,789
    
    
    
    4,459Total liabilities
    
    
    2,789
    
    
    
    4,459Stockholders equity:Preferred stock, 3,000,000 authorized, none issued and outstanding
    
    
    
    
    
    
    Common stock, $.0001 par value, 300,000,000 shares authorized;
10,090,635 and 10,159,790 shares issued and outstanding at March
31, 2005 and December 31, 2004, respectively
    
    
    1
    
    
    
    1Additional paid-in capital
    
    
    538,947
    
    
    
    540,028Notes receivable from stockholders
    
    
    
    
    
    
    (1,520
    )Accumulated other comprehensive income
    
    
    615
    
    
    
    614Accumulated deficit
    
    
    (516,637
    )
    
    
    (515,759
    )Total stockholders equity
    
    
    22,926
    
    
    
    23,364$
    25,715
    
    
    $
    27,823
 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, 2004. 3




---



##### Table of Contents



COSINE COMMUNICATIONS, INC. 
 CONDENSED CONSOLIDATED
STATEMENTS OF OPERATIONS
 (In thousands, except for per share data)
(Unaudited)
 Three Months EndedMarch 31,2005
    
    
    2004Revenue:Product
    
    $
    216
    
    
    $
    3,719Service
    
    
    681
    
    
    
    736Total revenue
    
    
    897
    
    
    
    4,455Cost of revenue1
    
    
    454
    
    
    
    1,497Gross profit
    
    
    443
    
    
    
    2,958Operating expenses:Research and development2
    
    
    103
    
    
    
    5,255Sales and marketing3
    
    
    105
    
    
    
    3,383General and administrative4
    
    
    1,305
    
    
    
    1,708Restructuring and impairment charges
    
    
    (91
    )
    
    
    35Total operating expenses
    
    
    1,422
    
    
    
    10,381Loss from operations
    
    
    (979
    )
    
    
    (7,423
    )Other income (expenses):Interest income and other
    
    
    113
    
    
    
    83Interest expense
    
    
    
    
    
    
    ( 2
    )Total other income (expenses)
    
    
    113
    
    
    
    81Loss before income tax provision
    
    
    (866
    )
    
    
    (7,342
    )Income tax provision
    
    
    12
    
    
    
    43Net loss
    
    $
    (878
    )
    
    $
    (7,385
    )Basic and diluted net loss per share
    
    $
    (0.09
    )
    
    $
    (0.74
    )Shares used in computing per share amounts
    
    
    10,102
    
    
    
    10,010
 See accompanying notes.   1
    
    Cost of revenue includes nil and ($26) for the three months ended March 31, 2005 and 2004, respectively, of non-cash
(credits) related to equity issuances.2
    
    Research and development expenses include nil and $198 for the three months ended March 31, 2005 and 2004,
respectively, of non-cash charges related to equity issuances.3
    
    Sales and marketing expenses include nil and ($39) for the three months ended March 31, 2005 and 2004, respectively,
of non-cash credits related to equity issuances.4
    
    General and administrative expenses include $61 and ($90) for the three months ended March 31, 2005 and 2004,
respectively, of non-cash charges (credits) related to equity issuances. 4




---



##### Table of Contents



COSINE COMMUNICATIONS, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
 Three Months EndedMarch 31,2005
    
    
    2004Operating activities:Net loss
    
    
    ($878
    )
    
    
    ($7,385
    )Adjustments to reconcile net loss to net cash used in operating
activities:Depreciation
    
    
    
    
    
    
    635Allowance for doubtful accounts
    
    
    
    
    
    
    9Non-cash charges related to inventory write-down
    
    
    
    
    
    
    102Write-down of property and capital equipment
    
    
    
    
    
    
    4Amortization of warrants issued for services
    
    
    61
    
    
    
    15Amortization of deferred stock compensation
    
    
    
    
    
    
    (250
    )Reversal of amortization in excess of vesting
    
    
    
    
    
    
    (115
    )Accrual for bonus to be awarded in shares of common stock
    
    
    
    
    
    
    236Other, net
    
    
    
    
    
    
    16Change in operating assets and liabilities:Accounts receivable, trade
    
    
    726
    
    
    
    927Other receivables
    
    
    364
    
    
    
    (46
    )Inventory
    
    
    
    
    
    
    (33
    )Prepaid expenses and other current assets
    
    
    143
    
    
    
    (408
    )Long-term deposits
    
    
    
    
    
    
    60Accounts payable
    
    
    (27
    )
    
    
    (190
    )Provision for warranty claims
    
    
    
    
    
    
    (97
    )Accrued other liabilities
    
    
    (1,607
    )
    
    
    84Accrued compensation
    
    
    (237
    )
    
    
    462Deferred revenue
    
    
    201
    
    
    
    (1,040
    )Accrued rent
    
    
    
    
    
    
    (6
    )Net cash used in operating activities
    
    
    (1,254
    )
    
    
    (7,020
    )Investing activities:Capital expenditures
    
    
    
    
    
    
    (547
    )Purchase of short-term investments
    
    
    (5,573
    )
    
    
    (14,951
    )Proceeds from sales and maturities of short-term investments
    
    
    8,644
    
    
    
    14,853Net cash provided by (used in) investing activities
    
    
    3,071
    
    
    
    (645
    )Financing activities:Principal payments of equipment and working capital loans and
capital leases
    
    
    
    
    
    
    (129
    )Proceeds from issuance of common stock, net
    
    
    
    
    
    
    120Net cash used in financing activities
    
    
    
    
    
    
    (9
    )Net increase (decrease) in cash and cash equivalents
    
    
    1,817
    
    
    
    (7,674
    )Cash and cash equivalents at the beginning of the period
    
    
    9,203
    
    
    
    19,719Cash and cash equivalents at the end of the period
    
    $
    11,020
    
    
    $
    12,045Supplemental information:Cash paid for interest
    
    $
    
    
    
    $
    2Income taxes paid
    
    $
    12
    
    
    $
    43Cancellation of notes receivable due to repurchase of unvested stock
    
    $
    1,520
    
    
    $
    941Net transfer from inventory to property and equipment
    
    $
    
    
    
    $
    266
 See accompanying notes. 5




---



##### Table of Contents



COSINE COMMUNICATIONS, INC. 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 1. BASIS OF PRESENTATION Description of Business CoSine Communications, Inc. (the Company or CoSine) was incorporated in California on
April 14, 1997 and in August 2000 was reincorporated in the State of Delaware. CoSine was engaged
in the development and sale of network-based, high-performance Internet service delivery platforms
for the global business Internet Protocol Service Provider market. Liquidity and Strategic Alternatives The accompanying financial statements have been prepared in conformity with US generally
accepted accounting principles, which contemplate continuation of the Company as a going concern.
However, at March 31, 2005, the Company has an accumulated deficit of $516,637,000 and has
sustained a net loss during the three months ended March 31, 2005 of $878,000. As of December 31,
2004 and March 31, 2005, the Companys business consisted primarily of a customer service
capability operated under contract by a third party. The Companys actions in September 2004, in
connection with its ongoing evaluation of strategic alternatives, to terminate most of its
employees and discontinue production activities in an effort to conserve cash, raise substantial
doubt about its ability to continue as a going concern. The financial statements do not include
any adjustments to reflect the possible future effects relating to the recoverability and
classification of the recorded asset amounts or amounts and classification of liabilities that
might result from the outcome of this uncertainty. 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 that after an extensive evaluation of strategic
alternatives, the Company initiated 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 sold, scrapped
or written its inventory down to estimated net realizable value at December 31, 2004 and March 31,
2005. The Company has taken steps to terminate contract manufacturing arrangements, contractor and
consulting arrangements and facility leases. These activities continued through March 31, 2005 and
will continue in 2005. CoSines business currently consists primarily of a customer service
capability operated under contract by a third party. This customer service capability is set to
expire on or before December 31, 2005. On January 7, 2005, CoSine entered into an Agreement and Plan of Merger with Tut Systems, Inc.
in a stock-for-stock transaction pursuant to which CoSine will merge into a wholly-owned subsidiary
of Tut Systems, Inc. Tut Systems, Inc. will issue approximately 6.0 million shares of its common
stock to the shareholders of CoSine. The merger is subject to shareholder approval and normal
closing conditions. There can be no assurance that the merger will be approved by the shareholders.
On January 18, 2005, CoSine and each of its directors and officers were named as defendants in a
class action lawsuit filed in the San Mateo County Superior Court on behalf of CoSine shareholders.
The complaint alleges that the CoSine directors and officers breached their fiduciary duty to the
corporation in connection with the proposed merger with Tut Systems, Inc. and requests that the
merger be enjoined. CoSine and its directors believe that the allegations are without merit and
intend to defend the action vigorously. Should the merger with Tut Systems, Inc. not be completed, the Company would continue to
explore strategic alternatives, including a sale of the Company, a sale or licensing of products,
intellectual property, or a winding-up and liquidation of the business and a return of capital.
Pending the completion of the proposed merger or, should the merger not be completed, the outcome
of the Companys review of strategic alternatives, and pending 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 6




---



##### Table of Contents



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. The consolidated financial statements include all of the accounts of CoSine and its wholly
owned subsidiaries. All significant intercompany balances and transactions have been eliminated. Use of Estimates The preparation of consolidated financial statements in conformity with US 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 valuations,
accrued liabilities including warranties, and equity issuances. Estimates and assumptions are
reviewed periodically and the effects of revisions are reflected in the consolidated financial
statements in the period of determination. 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 generally accepted accounting principles have been
condensed or omitted pursuant to the Securities Exchange Commissions rules and regulations. In
the opinion of management, all adjustments (consisting of normal recurring items) necessary for a
fair presentation have been included. The results of operations for the three months ended March
31, 2005 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, 2004 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, 2004. Pro Forma Information CoSine has elected to continue to follow Accounting Principles Board Opinion 25 (APB 25),
Accounting for Stock Issued to Employees, and related interpretations to account for employee
stock options because the alternative fair value method of accounting prescribed by Statement of
Financial Accounting Standards 123 (SFAS 123), Accounting for Stock-Based Compensation, as
amended by SFAS 148, Accounting for Stock-Based Compensation  Transition and Disclosure requires
the use of option valuation models that were not developed for use in valuing employee stock
options. Under APB 25, no compensation expense is recognized when the exercise price of employee
stock options equals the market price of the underlying stock on the date of grant. The following table illustrates the effect on CoSines net loss and net loss per share if
CoSine had applied the fair value recognition provisions of SFAS 123 to stock-based employee
compensation (in thousands, except per share data): Three Months EndedMarch 31,2005
    
    
    2004Net loss, as reported
    
    
    ($878
    )
    
    
    ($7,385
    )Add: Stock-based employee compensation expense,
net of tax, included in reported net loss
    
    
    
    
    
    
    (31
    )Deduct: Reversal of amortization in excess of
vesting, net of tax
    
    
    
    
    
    
    (98
    )Deduct: Stock-based employee compensation
expense determined under fair value method for
all stock option grants (SFAS 123 expense), net
of tax
    
    
    
    
    
    
    (365
    )Pro forma net loss
    
    
    ($878
    )
    
    
    ($7,879
    )Basic and diluted net loss per share, as reported
    
    
    ($0.09
    )
    
    
    ($0.74
    )Pro forma basic and diluted net loss per share
    
    
    ($0.09
    )
    
    
    ($0.79
    )
 7




---



##### Table of Contents



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
    
    Three MonthsMarch 31,
    
    Ended March 31,2005
    
    2004Dividend yield
    
    0.0%
    
    0.0%Volatility
    
    0.95
    
    0.94Risk free interest rate
    
    2.6%
    
    2.6%Expected life
    
    4
years
    
    4
years
 In the three months ended March 31, 2005, no shares were issued under the Employee Stock
Purchase Plan and the plan has been terminated. The estimated weighted-average fair value of
shares issued under the Employee Stock Purchase Plan in 2004 was $4.09, using a volatility of 0.64,
risk-free interest rate of 2% and an expected life of one year. Guarantees CoSine from time to time enters into certain types of contracts that require the Company to
indemnify parties against certain third party claims that may arise. These contracts primarily
relate to: (i) certain real estate leases under which the Company may be required to indemnify
property owners for environmental liabilities and other claims arising from the Companys use of
the applicable premises, (ii) certain agreements with the Companys officers, directors and
employees, under which the Company may be required to indemnify such persons for liabilities
arising out of their employment relationship, (iii) contracts under which the Company may be
required to indemnify customers against loss or damage to property or persons as a result of
willful or negligent conduct by CoSine employees or sub-contractors, (iv) contracts under which the
Company may be required to indemnify customers against third party claims that a CoSine product
infringes a patent, copyright or other intellectual property right and (v) procurement or license
agreements under which the Company may be required to indemnify licensors or vendors for certain
claims that may be brought against them arising from the Companys acts or omissions with respect
to the supplied products or technology. Generally, a maximum obligation is not explicitly stated. Because the obligated amounts
associated with this type of agreement are not explicitly stated, the overall maximum amount of the
obligation cannot be reasonably estimated. Historically, CoSine has not been obligated to make
payments for these obligations, and no liabilities have therefore been recorded for these
obligations on its consolidated balance sheet as of March 31, 2005. 2. COMMITMENTS AND CONTINGENCIES On November 15, 2001, we, along with certain of our officers and directors, were named as
defendants in a class action shareholder complaint filed in the United States District Court for
the Southern District of New York, now captioned In re CoSine Communications, Inc. Initial Public
Offering Securities Litigation,Case No. 01 CV 10105. The complaint generally alleges that various
investment bank underwriters engaged in improper and undisclosed activities related to the
allocation of shares in our initial public offering. The complaint brings claims for the violation
of several provisions of the federal securities laws against those underwriters, and also against
us and each of the directors and officers who signed the registration statement relating to the
initial public offering. The plaintiffs seek unspecified monetary damages and other relief.
Similar lawsuits concerning more than 300 other companies initial public offerings were filed
during 2001, and this lawsuit is being coordinated with those actions in the Southern District of
New York before Judge Shira A. Scheindlin. 8




---



##### Table of Contents



On or about July 1, 2002, an omnibus motion to dismiss was filed in the coordinated litigation
on behalf of the issuer defendants, of which we and our named officer and directors are a part, on
common pleading issues. In October 2002, pursuant to stipulation by the parties, the Court entered
an order dismissing our named officers and directors from the action without prejudice. On
February 19, 2003, the Court dismissed the Section 10(b) and Rule 10b-5 claims against us but did
not dismiss the Section 11 claims against us. In June 2004, a stipulation of settlement and release of claims against the issuer defendants,
including us, was submitted to the court for approval. The terms of the settlement, if approved,
would dismiss and release all claims against the participating defendants (including us). In
exchange for this dismissal, D&O insurance carriers would agree to guarantee a recovery by the
plaintiffs from the underwriter defendants of at least $1 billion, and the issuer defendants would
agree to an assignment or surrender to the plaintiffs of certain claims the issuer defendants may
have against the underwriters. The settlement is subject to a number of conditions, including
court approval, which cannot be assured. If the settlement is not consummated, we intend to defend
the lawsuit vigorously. However, we cannot predict its outcome with certainty. If we are not
successful in our defense of this lawsuit, we could be forced to make significant payments to the
plaintiffs and their lawyers, and such payments could have a material adverse effect on our
business, financial condition and results of operations if not covered by our 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 our business, results of
operations and financial position. On January 18, 2005, CoSine and its officers and directors were named as defendants in a
securities class action lawsuit filed in San Mateo County Superior Court. The suit requests that
the acquisition of CoSine by Tut Systems, Inc be enjoined due to alleged self-dealing and breach of
fiduciary duties by CoSines officers and directors. CoSine believes that the allegations
contained in the complaint are without merit and intends to vigorously defend against such claims.
An unfavorable resolution of this litigation could have a material adverse effect on the proposed
merger with Tut Systems, Inc. or on our ability to consummate a strategic alternative if the Tut
merger is not approved. 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 In the quarter ended September 30, 2004, the Company announced that it had discontinued its
products and accordingly wrote its inventory down to net realizable value. At December 31, 2004
and March 31, 2005, all inventory had been sold, scrapped or written-off and there was no inventory
awaiting customer acceptance. During the three months ended March 31, 2005, $25,000 of previously written-down inventory was
sold. During the three months ended March 31, 2004, $60,000 of previously written-down inventory
was sold and $102,000 of inventory was written down. In addition, charges of $35,000 were recorded
in the three months ended March 31, 2004 in connection with excess purchase commitments at CoSines
contract manufacturers. 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. 9




---



##### Table of Contents



Changes in CoSines warranty liability were as follows, in thousands: Three Months Ended March 31,2005
    
    
    2004(unaudited)Beginning balance
    
    $
    157
    
    
    $
    464Warranty charged to cost of revenue
    
    
    
    
    
    
    75Utilization of warranties
    
    
    
    
    
    
    (154
    )Changes in estimated liability based on experience
    
    
    
    
    
    
    (18
    )Ending balance
    
    $
    157
    
    
    $
    367
 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 582,000 shares and 1,258,000 shares for the three months ended March 31, 2005 and 2004,
respectively. The calculations of basic and diluted net loss per share are shown below, in thousands, except
per share data: Three Months EndedMarch 31,2005
    
    
    2004Net loss
    
    $
    (878
    )
    
    $
    (7,385
    )Basic and diluted:Weighted-average shares of common stock
outstanding
    
    
    10,102
    
    
    
    10,180Weighted-average shares subject to
repurchase
    
    
    
    
    
    
    (170
    )Weighted-average shares used in basic
and diluted net loss per
share
    
    
    10,102
    
    
    
    10,010Basic and diluted net loss per
share
    
    $
    (0.09
    )
    
    $
    (0.74
    )
 5. COMPREHENSIVE LOSS The components of comprehensive loss are shown below, in thousands: Three Months EndedMarch 31,2005
    
    
    2004Net loss
    
    $
    (878
    )
    
    $
    (7,385
    )Other comprehensive loss:Unrealized losses on investments
    
    
    (1
    )
    
    
    (6
    )Translation adjustment
    
    
    
    
    
    
    17Total other comprehensive gain (loss)
    
    
    
    
    
    
    11Comprehensive loss
    
    
    ($879
    )
    
    $
    (7,374
    )
 10




---



##### Table of Contents



6. 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 ended March 31, 2005 and
2004, respectively, were as follows, in thousands: Three Months EndedMarch 31,2005
    
    
    2004RegionUnited States
    
    $
    463
    
    
    $
    2,058Italy
    
    
    52
    
    
    
    733France
    
    
    90
    
    
    
    671Korea
    
    
    16
    
    
    
    624Europe
    
    
    62
    
    
    
    302Japan
    
    
    214
    
    
    
    67Total
    
    $
    897
    
    
    $
    4,455
 7. RESTRUCTURING CHARGES December 2004 Restructuring In the quarter ended December 31, 2004, CoSine continued its previously announced actions to
terminate the remainder of its workforce, terminate the lease of its facilities in Redwood City,
California, and terminated its office lease in Japan. In addition, CoSine accrued for the
termination of non-cancelable software license agreements, as the licenses were not expected to be
used in the ongoing operations. Activity related to the December 2004 restructuring is as follows, (in thousands): Worldwide
    
    
    
    
    
    
    Softwareworkforce
    
    
    Lease
    
    
    Licensereduction
    
    
    Terminations
    
    
    Terminations
    
    
    TotalProvision balance at December 31, 2004
    
    $
    553
    
    
    $
    
    
    
    $
    1,037
    
    
    $
    1,590Cash payments
    
    
    (508
    )
    
    
    
    
    
    
    (389
    )
    
    
    (897
    )Write offs
    
    
    
    
    
    
    
    
    
    
    (23
    )
    
    
    (23
    )Provision balance at March 31, 2005
    
    $
    45
    
    
    $
    
    
    
    $
    625
    
    
    $
    670
 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,
announced discontinuance of the CoSine products, and a charge for unrecoverable royalties, and
termination of third party manufacturing agreements. Effective September 23, 2004, CoSine approved severance agreements to 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 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 each received a retention bonus equal to 100% of
their base 2004 annual salary, paid in January 2005. In addition, upon completion of these
services, CoSine shall pay for the cost of Mr. Goggianos and Mr. Gibsons health care
coverage for a period of 12 months after termination of their respective employment. These amounts
were charged to restructuring in December 2004. 11




---



##### Table of Contents



Activity related to the September 2004 restructuring is as follows (in thousands): Write-down ofWorldwide
    
    
    inventory and
    
    
    Manufacturingworkforce
    
    
    prepaid
    
    
    agreementreduction
    
    
    royalty
    
    
    termination
    
    
    TotalProvision balance at December 31, 2004
    
    $
    424
    
    
    $
    
    
    
    $
    
    
    
    $
    424Cash payments
    
    
    (424
    )
    
    
    
    
    
    
    
    
    
    
    (424
    )Write offs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Provision balance at March 31, 2005
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
 
 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
contains forward-looking statements. We use words such as anticipate, believe, plan,
expect, future, intend and similar expressions to identify forward-looking statements. These
forward-looking statements are subject to certain risks and uncertainties that could cause actual
results to differ materially from those reflected in the forward-looking statements. Factors that
might cause such a difference include, but are not limited to, the continued downturn in the
telecommunications industry, the slow development of the market for network-based IP services, and
technological changes affecting the value of our intellectual property to the extent these
conditions impact strategic alternatives available to us, failure to achieve revenue growth and
profitability, and changes in general economic conditions and in economic conditions in the
customer service market that we currently serve, all as are discussed in more detail in the section
entitled Risk Factors on pages 22 through 26 of this report, as well as the other risk factors
discussed in that section. Readers are cautioned not to place undue reliance on these
forward-looking statements, which reflect managements opinions only as of the date hereof. We
undertake no obligation to revise or publicly release the results of any revision to these
forward-looking statements. Readers should carefully review the risk factors described in other
documents that we file from time to time with the Securities and Exchange Commission, including the
Quarterly Reports on Form 10-Q that we will file in the remainder of fiscal year 2005. OVERVIEW Prior to and during the period ended September 30, 2004, we developed, marketed and sold a
communications platform referred 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.
CoSine provided and will continue to provide customer service and support for our products through
December 31, 2005. 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, which had been first retained in May
2003. 12




---



##### Table of Contents



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, we have taken a number of actions to reduce our
operating expenses and conserve our cash. We have notified our existing customers that the CoSine
products have been formally discontinued and offered existing customers the option to place
lifetime buy orders to support their platform transition plans. We have written our inventory
down to estimated net realizable value at September 30, 2004, December 31, 2004 and March 31, 2005.
We have terminated contract manufacturing arrangements, contractor and consulting arrangements and
facility leases. On October 28, 2004, we announced that we had signed an agreement for early termination of a
lease for our headquarters facility in Redwood City, California. Pursuant to the agreement, the
lease was terminated on December 31, 2004. During the quarter ended December 31, 2004, we continued the actions initiated and announced
in September 2004. Such actions included the termination of all but eight of our employees,
negotiation of transition support plans for our customers, termination of a facility lease in
Japan, and termination of supplier, contractor and consulting agreements, as well as the initiation
of liquidation procedures for certain of our foreign operations. We also completed the sale, scrap
or write-off of our remaining inventory, property and equipment. In January 2005, we terminated our remaining employees and retained our chief executive
officer as a consultant. As a result of these activities, as of December 31, 2004 and March 31, 2005, our business
consisted of primarily a customer service capability operated by a third party through December 31,
2005. On January 7, 2005, we entered into an Agreement and Plan of Merger with Tut Systems, Inc.,
(Tut). The proposed merger is structured as a stock-for-stock transaction. Upon closing,
CoSines shareholders are to receive approximately 6.0 million shares of Tut common stock in
exchange for all the outstanding shares of CoSine. The merger is subject to shareholder approval
and other customary closing conditions. There can be no assurance that the merger will be approved
by the shareholders. CRITICAL ACCOUNTING POLICIES AND ESTIMATES General Our discussion and analysis of our financial condition and results of operations are based on
our consolidated financial statements, which have been prepared in accordance U.S. generally
accepted accounting principles. The preparation of these consolidated financial statements
requires us to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenue and expenses, and related disclosures 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, CoSine announced that it was exploring various strategic alternatives and
that CoSine had hired an investment bank as its financial advisor, which had been first retained in
May 2003. On September 8, 2004, CoSine announced, in connection with its ongoing evaluation of strategic
alternatives, that it had initiated 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 have been formally discontinued and offered existing customers the option
to 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, December 31, 2004 and March
31, 2005. CoSine has terminated contract manufacturing arrangements, contractor and consulting
arrangements and facility leases. 13




---



##### Table of Contents



On October 28, 2004, CoSine announced that it signed an agreement for early termination of its
lease for its headquarters facility in Redwood City, California. Pursuant to the agreement, the
lease was terminated on December 31, 2004. During the quarter ended December 31, 2004, we continued the actions initiated and announced
in September 2004. Such actions included the termination of all but eight of the remaining
employees, negotiation of transition support plans for our customers, termination of a facility
lease in Japan, and termination of supplier, contractor and consulting agreements, as well as the
initiation of liquidation procedures for certain of our foreign operations. We also completed the
sale, scrap or write-off of our remaining inventory, property and equipment. In January 2005, we terminated our remaining employees and retained our chief executive
officer as a consultant. As a result of these activities, as of December 31, 2004 and March 31, 2005, our business
consisted of primarily a customer service capability operated by a third party. On January 7, 2005, we entered into an Agreement and Plan of Merger with Tut Systems, Inc.,
(Tut). The proposed merger is structured as a stock-for-stock transaction. Upon closing,
CoSines shareholders are to receive approximately 6.0 million shares of Tut common stock in
exchange for all the outstanding shares of CoSine. The merger is subject to shareholder approval
and other customary closing conditions. There can be no assurance that the merger will be approved
by the shareholders. 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 the
recognition of our revenue. While the end user of our product is normally a large network service provider, 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 We maintain allowances for doubtful accounts 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, 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 may be required. Inventory Valuation In assessing the value of our inventory, we are required to make judgments about future demand
and then compare that demand with current inventory quantities and firm purchase commitments. If
our inventories and firm purchase commitments are in excess of forecasted demand, we write down the
value of our inventory. We generally used a 12-month forecast to assess future demand. Inventory
write-downs are charged to cost of revenue. At September 30, 2004,
in connection with our decision to discontinue our products, we recorded a charge of $3.5
million to write our inventory down to its estimated net realizable value. Our inventory was either
sold, scrapped or fully written-off at December 31, 2004 and March 31, 2005. During the three
months ended March 31, 2005, we sold $25,000 of previously written-down inventory. During the
three months ended March 31, 2004, we sold $102,000 of previously written-down inventory and
wrote-off $60,000 of inventory. 14




---



##### Table of Contents



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 of the assets 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 on 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 such that we may be required to
record further asset write-downs in the future. During 2004 and 2002, we charged $2.3 million and
$18.8 million, respectively, to operating expenses as a result of impairments. During 2004, we had
a gain of $0.9 million with the sale of previously written-down long-lived assets. At December 31,
2004 and March 31, 2005, all of our long-lived assets had been either sold, scrapped or fully
written-off. Warranties Prior to our announcement in September 2004 that we were discontinuing our products, we
provided a basic limited warranty, including repair or replacement of parts, and technical support.
The specific terms and conditions of those warranties varied depending on the customer or region.
We estimated 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. Our warranty obligation is
affected by the number of installed units, product failure rates, materials usage and service
delivery costs incurred in correcting product failures. 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 revenue may result. We no longer offer warranty on product or service sales. Impact of Equity Issuances on Operating Results Equity issuances have a material impact on our operating results. The equity issuances that
have affected operating results to date include warrants granted to customers and suppliers, stock
options granted to employees and consultants, stock issued in lieu of cash compensation to
suppliers and re-priced stock options. Our cost of revenue, operating expenses and interest expense were affected significantly by
charges related to warrants and options issued for services. Furthermore, some of our employee
stock option transactions have resulted in deferred compensation, which is presented as a reduction
of stockholders equity on our December 31, 2004 and prior consolidated balance sheets and is
amortized over the vesting period of the applicable options using the graded vesting method. The deferred compensation and amortization associated with shares and options relating to the
following transactions is required to be re-measured at the end of each accounting period, based on
the current stock price. 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 these shares until the earlier of repayment of
the note or default. Deferred compensation expense, which is recorded at each
re-measurement, is amortized over the remaining vesting period of the underlying options. The
balance of $1.52 million of non-recourse promissory notes receivable due from former
employees, including an officer, were cancelled during the quarter ended March 31, 2005 in
exchange for 69,155 shares of common stock. The notes were written-off to additional paid-in
capital during the quarter ended March 31, 2005 and the related shares were cancelled. 15




---



##### Table of Contents




    Re-priced stock options: In November 2002, we re-priced 1,091,453 outstanding employee
stock options to purchase 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.
In July 2001, we re-priced 722,071 unexercised employee stock options to $15.50 per share,
the fair market value of the underlying shares on the re-pricing date. These options had
previously been granted at prices ranging from $40.00 to $400.00 per share. Compensation
will be re-measured for these options until they are exercised, canceled, or expire. At
March 31, 2005, 143,233 stock options re-priced in November 2002 were still outstanding.
The re-priced options did not have an intrinsic value at March 31, 2005 because the stock
price at that date was below the exercise price. Some of the stock options granted to our employees have resulted in 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 consolidated balance sheet
and is then amortized using an accelerated 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. All employees have been terminated as
of January 2005. Deferred compensation amounts were fully amortized at December 31, 2004 and March
31, 2005 and no amortization charges were recorded in the three months ended March 31, 2005. 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 issued is calculated the following quarter based on the
fixed value of the common stock issued, as determined at quarter-end, divided by CoSines stock
price on the issuance date. Compensation expense is accrued in full in the quarter in which it is
earned. No employee bonuses were earned in the second, third or fourth quarters of 2004 as the
quarterly objectives were not met. This program was cancelled in 2004. 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, we announced that after an extensive evaluation of strategic
alternatives, we initiated actions to lay-off most of our 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, we
have taken a number of actions to reduce our operating expenses and conserve our cash. We have
notified our existing customers that the CoSine products are now formally discontinued and that
existing customers may place lifetime buy orders to support their transition plans. We have
written our inventory down to estimated net realizable value at September 30, 2004, December 31,
2004 and March 31, 2005. During the quarter ended December 31, 2004, we continued the actions initiated and announced
in September 2004. Such actions included the termination of all but eight employees, negotiation of
transition support plans for our customers, termination of a facility lease in Japan, and
termination of supplier, contractor and consulting agreements, as well as the initiation of
liquidation procedures for certain of our foreign operations. We also completed the sale, scrap or
write-off of our remaining inventory, property and equipment. These activities will continue in
2005. In January 2005, we terminated our remaining employees and retained our chief executive
officer as a consultant. CoSines business currently consists of a customer support capability supported by a third
party contractor. We do not intend to offer this support capability after December 31, 2005. On January 7, 2005, we entered into an Agreement and Plan of Merger with Tut Systems, Inc.,
(Tut). The proposed merger is structured as a stock-for-stock transaction. Upon closing,
CoSines shareholders are to receive approximately 16




---



##### Table of Contents



6.0 million shares of Tut common stock in
exchange for all the outstanding shares of CoSine. The merger is subject to shareholder approval
and other customary closing conditions. There can be no assurance that the merger will be approved
by the shareholders. Revenue For the three months ended March 31, 2005, revenue was $897,000, of which 24% was from product
sales and 76% was from service. For the three months ended March 31, 2004, revenue was $4.5 million
of which 83% was from product sales and 17% was from service. Revenues by geographic region for the three months ended March 31, 2005 and 2004,
respectively, were as follows, in thousands: Three Months EndedMarch 31,2005
    
    
    2004RegionUnited States
    
    $
    463
    
    
    $
    2,058Italy
    
    
    52
    
    
    
    733France
    
    
    90
    
    
    
    671Korea
    
    
    16
    
    
    
    624Europe-other
    
    
    62
    
    
    
    302Japan
    
    
    214
    
    
    
    67Total
    
    $
    897
    
    
    $
    4,455
 Revenues for the three months ended March 31, 2005 consisted primarily of service contracts as
well as the sale of two non-exclusive software licenses. The decrease in revenue from the three
months ended March 31, 2004 to the three months ended March 31, 2005 is due primarily to our
announcement in September 2004 that we were laying off all our employees and would no longer offer
our product for sale. Our business currently consists of a service operation provided by a third
party contractor. This service will be offered through December 31, 2005. Non-Cash Charges Related to Equity Issuances During the three months ended March 31, 2005, we recorded $61,000 of non-cash charges related
to equity issuances to general and administrative expenses. These charges relate to the
amortization of a stock purchase warrant granted to a reseller. During the three months ended March
31, 2004, we recorded ($0.1) million and $0.2 million of non-cash (credits) charges related to
equity issuances to cost of revenue, operating expenses and interest expense. Below is a reconciliation of non-cash charges related to equity issuances for the three months
ended March 31, 2005 and 2004, as presented in our statement of operations, in thousands: 17




---



##### Table of Contents



Three Months EndedMarch 31,2004
    
    
    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
    
    $
    
    
    
    $
    65Credits related to the reversal of deferred
stock compensation amortization in excess of
vesting for terminated employees
    
    
    
    
    
    
    (115
    )Amortization of deferred compensation
associated with non-recourse promissory
notes
    
    
    
    
    
    
    Amortization of deferred compensation
associated with re-pricing
    
    
    
    
    
    
    (315
    )Accrual for bonus to be awarded in shares
of common stock
    
    
    
    
    
    
    236Amortization of charges related to warrants
or stock options issued to non-employees in
conjunction with reseller, lease and debt
agreements
    
    
    61
    
    
    
    15Net non-cash charges related to equity
issuances
    
    $
    61
    
    
    $
    (114
    )
 Under the stock bonus program, we accrued $236,000 at March 31, 2004, and we granted 43,300
shares of CoSine common stock in the second quarter of 2004, based on CoSines stock price on the
grant date. Cost of Revenue For the three months ended March 31, 2005, cost of revenue was $454,000, which represented the
costs of our third party support contract. For the three months ended March 31, 2004, cost of
revenue was $1.5 million, of which $1.2 million represented materials, labor, production overhead,
warranty and the costs of providing services, $0.2 million represented software royalty expense,
$0.1 million represented inventory written down and $0.1 million represented a benefit associated
with written-down inventory sold. Gross Profit For the three months ended March 31, 2005 and 2004, gross profit was $443,000 and $3.0
million, respectively. Gross margin declined from 66% to 49%. The decrease in gross margin
percentage from the three months ended March 31, 2004 to March 31, 2005 is due primarily to reduced
product sales as a result of the discontinuance of our products, announced in September 2004, lower
service revenues in 2005 as compared to 2004 and the costs of our third party service provider in
2005. We expect our gross margin to continue to be affected by the volume of our service contract
sales and the costs we incur with our third party contractor. We have the ability to modify our
third party support contract every 90 days but we may not be able to accurately predict our future
service contract sales and therefore may experience margin fluctuations, including possibly
negative gross margins. Research and Development Expenses Research and development expenses were $103,000 and $5.3 million for the three months ended
March 31, 2005 and March 31, 2004, respectively. Research and development costs in the three
months ended March 31, 2005 consisted of consulting expenses as well as software license
amortization costs and payments. With our announcement in September 2004 that we were laying off
all employees and discontinuing our products, our engineering activities are limited to providing
consulting to existing customers and our third party contractor. We expect our research and
development costs for the three months ending June 30, 2005 to be essentially consistent with the
amounts reported in the three months ended March 31, 2005. Sales and Marketing Expenses Sales and marketing expenses were $105,000 and $3.4 million for the three months ended March
31, 2005 and 2004, respectively. With our announcement in September 2004 that we were laying off
all employees and were discontinuing our products, we have ceased essentially all ongoing sales and
marketing efforts. Sales and marketing expenses for the three months ended March 31, 2005 consisted
of expenses related to foreign sales offices, all of which are winding 18




---



##### Table of Contents



down. The decrease from the
three months ended March 31, 2004 is due to our September 2004 announcement. We expect sales and
marketing expenses in the three months ending June 30, 2005 to be essentially consistent with the
amounts reported in the three months ended March 31, 2005. General and Administrative Expenses General and administrative expenses were $1.3 million and $1.7 million for the three months
ended March 31, 2005 and 2004, respectively. With our announcement in September 2004 that we were
laying off all employees and discontinuing our products, our general and administrative efforts
have been focused on restructuring activities and the ongoing evaluation of strategic alternatives,
as well as the activities related to our proposed merger with Tut Systems Inc., as announced on
January 7, 2005. General and administrative costs for the three months ended March 31, 2005
consisted of costs for consultants and contractors, including our chief executive officer, audit
and tax services, legal services, insurance and banking fees. The decrease from the three months
ended March 31, 2004 is due to the reductions in force initiated in September 2004, partially
offset by increased consulting, audit, tax, legal and banking fees. General and administrative
expenses for the three months ending June 30, 2005 should decrease, as the majority of the
restructuring activities have been completed. Restructuring and Impairment Charges December 2004 Restructuring In the quarter ended December 31, 2004, CoSine continued its previously announced actions to
terminate the remainder of its workforce, terminate the lease of its facilities in Redwood City,
California, and terminated its office lease in Japan. In addition, CoSine accrued for the
termination of non-cancelable software license agreements, as the licenses were not expected to be
used in the ongoing operations. Activity related to the December 2004 restructuring is as follows, (in thousands): Worldwide
    
    
    
    
    
    
    Softwareworkforce
    
    
    Lease
    
    
    Licensereduction
    
    
    Terminations
    
    
    Terminations
    
    
    TotalProvision balance at December 31, 2004
    
    $
    553
    
    
    $
    
    
    
    $
    1,037
    
    
    $
    1,590Cash payments
    
    
    (508
    )
    
    
    
    
    
    
    (389
    )
    
    
    (897
    )Write offs
    
    
    
    
    
    
    
    
    
    
    (23
    )
    
    
    (23
    )Provision balance at March 31, 2005
    
    $
    45
    
    
    $
    
    
    
    $
    625
    
    
    $
    670
 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,
announced discontinuance of the CoSine products, and a charge for unrecoverable royalties, and
termination of third party manufacturing agreements. Effective September 23, 2004, CoSine approved severance agreements to 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 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 each received a retention bonus equal to 100% of their base 2004 annual
salary, paid in January 2005. In addition, upon completion of these services, CoSine shall pay for
the cost of Mr. Goggianos and Mr. Gibsons health care coverage for a period of 12 months after
termination of their respective employment. These amounts were charged to restructuring in
December 2004. 19




---



##### Table of Contents



Activity related to the September 2004 restructuring is as follows (in thousands): Write-down ofWorldwide
    
    
    inventory and
    
    
    Manufacturingworkforce
    
    
    prepaid
    
    
    agreementreduction
    
    
    royalty
    
    
    termination
    
    
    TotalProvision balance at December 31, 2004
    
    $
    424
    
    
    $
    
    
    
    $
    
    
    
    $
    424Cash payments
    
    
    (424
    )
    
    
    
    
    
    
    
    
    
    
    (424
    )Write offs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Provision balance at March 31, 2005
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
 Restructuring and impairments changes During the three months ended March 31, 2005, we sold previously impaired assets for a total of
$67,000 and settled a software contract at a $23,000 discount to our restructuring accrual. Interest Income and Other Income (Expense) For the three months ended March 31, 2005 and 2004, interest income and other income (expense)
was $113,000 and $81,000, respectively. The increase from March 31, 2004 to March 31, 2005 is due
to higher interest rates, partially offset by lower short term investments. Income Tax Provision Provisions for income taxes of $12,000 and $43,000 for the three months ended March 31, 2005
and 2004, respectively, were comprised entirely of foreign corporate income taxes, which are a
function of our operations in subsidiaries in various countries. The provision for income taxes is
based on income taxes on minimum profits the foreign operations generated for services they
provided to us. Our tax expense for fiscal 2005 will continue to depend on the amount and mix of
income derived from sources subject to corporate income taxes of foreign taxing jurisdictions. 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 expect that our revenue will
continue to decline. 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 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 and continued in the quarter ended December 31, 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. However, our restructuring activities and our ongoing review of strategic
alternatives raise substantial doubt as to our ability to continue as a going concern. See
Liquidity and Strategic Alternatives in Note 1 of the Notes to the Condensed Consolidated
Financial Statements. 20




---



##### Table of Contents



On September 8, 2004, we announced that after an extensive evaluation of strategic
alternatives, 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, we have taken a number of actions to reduce our
operating expenses and conserve our cash. We have notified our existing customers that the CoSine
products are now formally discontinued and that existing customers may place lifetime buy orders
to support their transition plans. We have written our inventory down to estimated net realizable
value at September 30, 2004, December 31, 2004 and March 31, 2005. We have taken steps to terminate
contract manufacturing arrangements, contractor and consulting arrangements and facility leases.
These activities continued during the quarter ended December 31, 2004 and March 31, 2005, at which
time our business consisted primarily of a customer support capability supported by a third party
contractor. On January 7, 2005, we entered into an Agreement and Plan of Merger with Tut Systems, Inc.,
(Tut). The proposed merger is structured as a stock-for-stock transaction. Upon closing,
CoSines shareholders are to receive approximately 6.0 million shares of Tut common stock in
exchange for all the outstanding shares of CoSine. The merger is subject to shareholder approval
and other customary closing conditions. There can be no assurance that the merger will be approved
by the shareholders. Should the merger with Tut Systems, Inc not be completed, we would continue to explore
strategic alternatives, including a sale of the company, a sale or licensing of products,
intellectual property, or a winding-up and liquidation of the business and a return of capital.
Pending the completion of the proposed merger or, should the merger not be completed, the outcome
of our review of strategic alternatives, and pending any definitive decisions to close or liquidate
the business, we will continue to prepare our financial statements on the assumption that we will
continue as a going concern, which contemplates the realization of assets and liquidation of
liabilities in the normal course of business. As such, the financial statements do not include any
adjustments to reflect possible future effects of the recoverability and classification of assets
or the amounts and classification of liabilities that may result from any decisions made with
respect to our assessment of our strategic alternatives. If at some point we were to decide to
pursue alternative plans, we may be required to present the financial statements on a different
basis. As an example, if we were to decide to pursue a liquidation and return of capital, 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 March 31, 2005, cash, cash equivalents and short-term investments were $23.7 million. This
compares with $24.9 million at December 31, 2004. Operating Activities We used $1.3 million in cash for operations for the three months ended March 31, 2005, a
decrease of $5.8 million from the amount used in the three months ended March 31, 2004. The
reduced cash usage in the three months ended March 31, 2005 is due primarily to the $6.5 million
reduction in net loss from March 31, 2004 to March 31, 2005, partially offset by reductions in
other liabilities and accrued compensation. Investing Activities Investing activities generated $3.1 million in cash in the three months ended March 31, 2005
as compared to a usage of $645,000 in the three months ended March 31, 2004. There were no capital
expenditures in the three months ended March 31, 2005 as compared to $547,000 in the prior year
period. 21




---



##### Table of Contents



Financing Activities There were no significant financing activities in the three months ended March 31, 2005. In
the three months ended March 31, 2004, we paid-off the balance of our long term debt and capital
leases and realized $120,000 from sales of stock. 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, we announced that after an extensive
evaluation of strategic alternatives, we had initiated 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, we have taken a number of
actions to reduce our operating expenses and conserve our cash. We have notified our 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, we have written our inventory down to estimated net realizable value at
September 30, 2004, December 31, 2004 and March 31, 2005. We have taken steps to terminate
contract manufacturing arrangements, contractor and consulting arrangements and facility leases.
These activities continued into the quarters ended December 31, 2004 and March 31, 2005, at which
time our business consisted primarily of a customer support capability supported by a third party
contractor through December 31, 2005. On January 7, 2005, we entered into an Agreement and Plan of Merger with Tut Systems, Inc.,
(Tut). The proposed merger is structured as a stock-for-stock transaction. Upon closing,
CoSines shareholders are to receive approximately 6.0 million shares of Tut common stock in
exchange for all the outstanding shares of CoSine. The merger is subject to shareholder approval
and other customary closing conditions. There can be no assurance that the merger will be approved
by the shareholders. Should such transaction not be completed, we will continue to support our existing customers
through December 2005 through our transition support programs. We will also continue to explore
strategic alternatives, which could include liquidation of the company and return of capital to
shareholders. At March 31, 2005, we had $23.7 million in cash and short-term investments. Based on
restructuring activities initiated in September and December 2004, on the costs to complete all
such activities, on the significant reduction in cash usage once such activities are completed, and
on the expected net 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. RISK FACTORS This report (including the Outlook section above) contains forward-looking statements. We
use words such as anticipate, believe, plan, expect, future, intend and similar
expressions to identify forward-looking statements. These forward-looking statements are subject
to certain risks and uncertainties that could cause actual results to differ materially from those
reflected in the forward-looking statements. Factors that might cause such a difference include,
but are not limited to, the continued downturn in the telecommunications industry, the slow
development of the market for network-based IP services, and technological changes affecting the
value of our intellectual property to the extend these conditions impact strategic alternatives
available to us, failure to achieve revenue growth and profitability, and changes in general
economic conditions and in economic conditions in the customer service market that we currently
serve, all as are discussed in more detail below in this section, as well as the other risk
factors discussed below. 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 22




---



##### Table of Contents



from time to time with the Securities and Exchange Commission, including the
Annual Report on Form 10-K and the Quarterly Reports on Form 10-Q that we file in the remainder of
fiscal year 2005. The following discussion describes certain risk factors related to our business as well as to
our industry in general. CoSine has signed a definitive agreement to be acquired by Tut Systems, Inc. (Tut), in a
stock-for-stock transaction in which CoSine would be merged into a wholly owned subsidiary of Tut.
If the merger is not completed, a continued investment in CoSine by its stockholders is subject to
substantial risks. CoSine has ceased substantially all revenue generating operations and sold its
operating assets. CoSine has incurred losses since inception and expects that its net losses and negative cash
flow will continue for the foreseeable future as CoSine seeks to consummate the merger with Tut or
another strategic alternative, if any. In September 2004, CoSine announced the termination of most of
its employees to facilitate the strategic alternatives then in
consideration. In addition, as CoSine
seeks to consummate the merger with Tut or another strategic
alternative, CoSine continues to expend its
remaining cash resources. Further, CoSine may incur significant expenses in connection with the merger
with Tut or other possible strategic alternatives, to the extent
CoSine is able to do so pursuant to
the terms of the merger agreement with Tut. If Cosine fails to merge
with Tut, or if CoSine fails to
consummate another strategic alternative or raise additional capital, the resulting reduction of
CoSines available cash resources could result in CoSine ceasing operations and liquidating. In the case
of a liquidation or bankruptcy, CoSine would need to hold back or distribute assets to cover
liabilities before paying stockholders and, therefore, stockholders may not receive any proceeds
for their ownership in CoSine. However, CoSine believes it has adequate cash resources to continue to
realize its assets and discharge its liabilities as a company through 2005. Failure to complete the merger could cause our stock price to decline. If the merger with Tut is not consummated, CoSines stock price may decline due to any or all
of the following potential consequences:  
    CoSine may not be able to dispose of its assets or business for values equaling or
exceeding the value represented by the merger; in particular, its
assets may
be diminished in value;
    CoSines costs related to the merger, such as legal, accounting and financial
advisor fees, must be paid even if the merger is not completed; and
    CoSine may have difficulty retaining its key remaining consultant. If the merger with Tut is not completed, CoSines stock may be delisted from the Nasdaq National

Market. If the merger with Tut is not consummated, CoSine may be unable to satisfy the requirements
for continued listing of its common stock on the Nasdaq National Market. The rules of the Nasdaq
National Market require that companies listed on the Nasdaq National Market continue to have an
operating business. If the merger with Tut is not consummated, CoSine may be forced to cease its
business operations. If Nasdaq delists CoSines common stock from the Nasdaq National Market, the
ability of CoSine stockholders to buy and sell shares will be materially impaired, and the trading
price of CoSines common stock may be materially impaired. 23




---



##### Table of Contents



There can be no assurance that CoSine will be able to consummate a strategic alternative. CoSine has incurred recurring operating losses, and operations have not generated positive
cash flows. In the event CoSine is unable to effect the merger with Tut or effect another
strategic alternative, CoSine will be required to find another buyer or distribute its assets. In
the case of a distribution, CoSine would need to hold back assets to cover liabilities, and
stockholders may receive less value than they would in the merger. In the event the merger with Tut is not consummated, CoSine may elect to dissolve and distribute
assets to stockholders if CoSines board of directors determines that such action is in the best
interest of the stockholders. As a result of CoSines exploration of strategic alternatives, its board of directors may deem
it advisable to dissolve the company and distribute assets to stockholders. The precise nature, amount and timing of any distribution to
CoSines stockholders would depend on and could be delayed by,
among other things, sales of its
non-cash assets and claim settlements with creditors. CoSines customers may sue it because CoSine has announced the discontinuance of its products and
may not meet all their contractual commitments. Certain of CoSines customer contracts contain provisions relating to the availability of
products, spare parts and services for periods up to ten years. CoSine is in discussions with its
customers and CoSine and its customers are jointly developing alternative plans, but CoSines
customers may choose to sue CoSine for breach of contract. The outlook for capital spending in the telecommunications industry directly impacts the strategic
alternatives that may be available to CoSine. 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 CoSine
and thereby causing its stock price to decline. CoSines IP Service Delivery Platform was its only product line, and the availability of strategic
alternatives may depend on its perceived value in the telecommunications industry. CoSines IP Service Delivery Platform, which is comprised of hardware and software, was the
only product line that CoSine offered to our customers and has been discontinued. CoSine has no
plans to offer any other product line. If the telecommunications industry does not value CoSines
intellectual property, its strategic alternatives will be adversely impacted. If CoSines products contain defects, CoSine may be subject to significant liability claims from
customers, distribution partners and the end-users of CoSines products and incur significant
unexpected expenses and lost sales. CoSines 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 CoSines current
products or enhancements after commencement of commercial shipments. If this happens, CoSine
may experience product returns, injury to its reputation, increased service and warranty costs, any
of which could have a material adverse effect on its business, financial condition and results of
operations. Moreover, because CoSines products are designed to provide critical communications
services, CoSine may receive significant liability claims. CoSine attempted to include in its
agreements with customers and distribution partners provisions intended to limit CoSines exposure
to liability claims. However, its customers and distribution partners may not be willing to agree
to such provisions, and in any event 24




---



##### Table of Contents



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 CoSines products or from a defect related to the installation or operation of one of its
products. Although CoSine maintains product liability and errors and omissions insurance covering
certain damages arising from implementation and use of their products, CoSines insurance may not
cover all claims sought against it. Liability claims could require it 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 CoSines reputation and its business. Because the markets in which CoSine competes are prone to rapid technological change and the
adoption of standards different from those that CoSine use, its products could become obsolete
adversely impacting strategic alternatives available to it. 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 CoSines intellectual property obsolete adversely impacting
strategic alternatives available to them. If necessary licenses of third-party technology are terminated or become unavailable or too
expensive, CoSine may be unable to consummate an acceptable strategic alternative. CoSine licenses from third-party suppliers certain software applications incorporated in their
IP Service Delivery Platform. Their inability to renew or obtain any third party license that
CoSine needs could require it to obtain substitute technology at a lower quality and higher cost.
These outcomes could seriously impair CoSines ability to consummate an acceptable strategic
alternative. If CoSine is unable to protect its intellectual property rights, acceptable strategic alternatives
may not be available. CoSine relies on a combination of copyright, trademark, patent and trade secret laws and
restrictions on disclosure to protect their intellectual property rights. Monitoring unauthorized
use of CoSines products is difficult, and CoSine cannot be certain that the steps it has taken
will prevent unauthorized use of CoSines technology. If CoSine is unable to protect its
intellectual property rights, the value of its intellectual property may be impaired, adversely
impacting its ability to consummate acceptable strategic alternatives. If CoSine becomes involved in an intellectual property dispute, it could be subject to significant
liability, the time and attention of CoSines management could be diverted from pursuing strategic
alternatives. CoSine may become a party to litigation in the future to protect its intellectual property or
because others may allege infringement of their intellectual property. These claims and any
resulting lawsuits could subject it to significant liability for damages or invalidate CoSines
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 CoSines infringement of a third-partys intellectual property also
could force it to:  
    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. CoSine has a history of losses that may continue, and if it does not achieve profitability it may
cease operations. At March 31, 2005, CoSine had an accumulated deficit of $517 million. CoSine has incurred net
losses since its incorporation. If it does not achieve profitability, is unable to obtain
additional financing or complete a strategic alternative to its current operations, CoSine will
cease operations and liquidate. 25




---



##### Table of Contents



If CoSine 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, CoSine carries insurance protecting its 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. Cosine pays
significant premiums to acquire and maintain this insurance, which is provided by third-party
insurers, and CoSine agrees 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 the company and certain of its
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 CoSine have a $500,000
retention. As a result, the costs CoSine incurs in defending this lawsuit will not be reimbursed
until they exceed $500,000. The policies that would cover any future lawsuits may not provide any
coverage to CoSine and may cover the directors and officers only in the event CoSine is unwilling
or unable to cover their costs in defending against and resolving any future claims. As a result,
CoSines costs in defending any future lawsuits could increase significantly. Particularly in the
current economic environment, CoSine cannot assure you that in the future it 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 CoSines financial condition in the event that it is required to defend against and resolve
any future or existing securities class actions or other claims made against it or its management
arising from the conduct of its operations. Further, the inability to obtain such insurance in
adequate amounts may impair CoSines 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 March 31, 2005 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 100 basis points. Based on this analysis, a hypothetical
100 basis point increase in interest rates would result in a $40,000 decrease in the fair value of
our investments in debt securities as of March 31, 2005. 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. 26




---



##### Table of Contents



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 were no changes in our internal control over
financial reporting during the fiscal quarter ended March 31, 2005 that have materially affected,
or are reasonably likely to materially affect, our internal control over financial reporting. In connection with its audit of our consolidated financial statements for the year ended December
31, 2004, Burr, Pilger & Mayer LLP identified significant deficiencies, which represent material
weaknesses. The material weaknesses were related to a lack of adequate segregation of duties. In
addition, significant audit adjustments were needed to accrued expenses and stockholders equity
that were the result of an insufficient quantity of experienced resources involved with the
financial reporting and year end closing process resulting from staff reductions associated with
the downsizing of the Company. Prior to the issuance of our consolidated financial statements, we completed the account
reconciliations, analyses and our management review such that we can certify that the information
contained in our consolidated financial statements for the year ended December 31, 2004 and for the
three months ended March 31, 2005, fairly presents, in all material respects, the financial
condition and results of operations of the Company. Limitations on Effectiveness of Controls and Procedures.Our management, including our chief
executive officer and chief financial officer, does not expect that our disclosure controls and
procedures or our internal controls will prevent all errors and all fraud. A control system, no
matter how well conceived and operated, can provide only reasonable, not absolute, assurance that
the objectives of the control system are met. Further, the design of a control system must reflect
the fact that there are resource constraints and the benefits of controls must be considered
relative to their costs. Because of the inherent limitations in all control systems, no evaluation
of controls can provide absolute assurance that all control issues and instances of fraud, if any,
within the Company have been detected. These inherent limitations include, but are not limited to,
the realities that judgments in decision-making can be faulty and that breakdowns can occur because
of simple error or mistake. Additionally, controls can be circumvented by the individual acts of
some persons, by collusion of two or more people, or by management override of the control. The
design of any system of controls also 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. Over time, controls may become inadequate
because of changes in conditions, or the degree of compliance with the policies or procedures may
deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements
due to error or fraud may occur and not be detected. 
 PART II. OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS On November 15, 2001, we along with certain of our officers and directors were named as
defendants in a class action shareholder complaint filed in the United States District Court for
the Southern District of New York, now captioned In re CoSine Communications, Inc. Initial Public
Offering Securities Litigation,Case No. 01 CV 10105. The 27




---



##### Table of Contents



complaint generally alleges that various
investment bank underwriters engaged in improper and undisclosed activities related to the
allocation of shares in our initial public offering. The complaint brings claims for the violation
of several provisions of the federal securities laws against those underwriters, and also against
us and each of the directors and officers who signed the registration statement relating to the
initial public offering. The plaintiffs seek unspecified monetary damages and other relief.
Similar lawsuits concerning more than 300 other companies initial public offerings were filed
during 2001, and this lawsuit is being coordinated with those actions in the Southern District of
New York before Judge Shira A. Scheindlin. On or about July 1, 2002 an omnibus motion to dismiss was filed in the coordinated litigation
on behalf of the issuer defendants, of which we and our named officer and directors are a part, on
common pleading issues. In October 2002, pursuant to stipulation by the parties, the Court entered
an order dismissing our named officers and directors from the action without prejudice. On
February 19, 2003, the Court dismissed the Section 10(b) and Rule 10b-5 claims against us but did
not dismiss the Section 11 claims against us. In June 2004, a stipulation of settlement and release of claims against the issuer defendants,
including us, was submitted to the court for approval. The terms of the settlement, if approved,
would dismiss and release all claims against the participating defendants (including us). In
exchange for this dismissal, D&O insurance carriers would agree to guarantee a recovery by the
plaintiffs from the underwriter defendants of at least $1 billion, and the issuer defendants would
agree to an assignment or surrender to the plaintiffs of certain claims the issuer defendants may
have against the underwriters. The settlement is subject to a number of conditions, including
court approval, which cannot be assured. If the settlement is not consummated, we intend to defend
the lawsuit vigorously. However, we cannot predict its outcome with certainty. If we are not
successful in our defense of this lawsuit, we could be forced to make significant payments to the
plaintiffs and their lawyers, and such payments could have a material adverse effect on our
business, financial condition and results of operations if not covered by our 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 our business, results of
operations and financial position. On January 18, 2005, CoSine and our officers and directors were named as defendants in a
securities class action lawsuit filed in San Mateo County Superior Court. The suit requests that
the acquisition of CoSine by Tut Systems, Inc. be enjoined due to alleged self-dealing and breach
of fiduciary duties by our officers and directors. We believe that the allegations contained in
the complaint are meritless and intend to vigorously defend against such claims. An unfavorable
resolution of this litigation will have a material adverse effect on our ability to consummate a
strategic alternative to our current operations. In the ordinary course of business, we are involved in legal proceedings involving contractual
obligations, employment relationships and other matters. Except as described above, we do not
believe there are any pending or threatened legal proceedings that will have a material impact on
our consolidated financial position or results of operations. 
 ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES On September 25, 2000, in connection with our initial public offering, a Registration
Statement on Form S-1 (File No. 333-35938) was declared effective by the Securities and Exchange
Commission, pursuant to which 1,150,000 shares of our common stock were offered and sold for our
account at a price of $230 per share, generating gross offering proceeds of $264.5 million. The
managing underwriters were Goldman, Sachs & Co., Chase Securities Inc., Robertson
Stephens, Inc. and JP Morgan Securities Inc. Our initial public offering closed on September
29, 2000. The net proceeds of the initial public offering were approximately $242.5 million after
deducting approximately $18.5 million of underwriting discounts and approximately $3.5 million of
other offering expenses. We did not pay directly or indirectly any of the underwriting discounts or other related
expenses of the initial public offering to any of our directors or officers, any person owning 10%
or more of any class of our equity securities, or any of our affiliates. We have used approximately $219 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. 28




---



##### Table of Contents



ITEM 6. EXHIBITS Exhibit Index on page 30. 
 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 GibsonDated: May 13, 2005
    
    
    
    Chief Executive Officer and Chief Financial Officer
 29




---



##### Table of Contents



EXHIBIT INDEX Exhibit Number
    
    Description31.1
    
    Certification of Terry Gibson, Chief Executive Officer 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 Terry Gibson, Chief Executive Officer 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
 30