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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
   FORM 10-Q   (MARK ONE) [X]
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 FOR THE QUARTERLY PERIOD ENDED March 31, 2004 OR [  ]
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the transition period from  to. Commission File Number 000-30715 COSINE COMMUNICATIONS, INC. (Exact name of Registrant as specified in its charter)
 Delaware(State or other jurisdiction of
incorporation or organization)
    
    94-3280301(I.R.S. Employer
Identification Number)1200 Bridge Parkway, Redwood City, CA(Address of principal executive offices)
    
    94065(Zip Code)
 Registrants telephone number including area code: (650) 637-4777 Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [  ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes [  ] No [X] There were 10,183,500 shares of the Companys Common Stock, par value $.0001,
outstanding on April 30, 2004.    Page 1 of 35




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COSINE COMMUNICATIONS, INC. FORM 10-Q Quarter ended March 31, 2004 TABLE OF CONTENTS PagePART I
FINANCIAL INFORMATIONItem 1. Condensed Consolidated Financial Statements:Condensed Consolidated Balance Sheets as
of March 31, 2004 and December 31, 2003
    
    
    3Condensed Consolidated Statements of
Operations for the Three Months Ended March 31, 2004 and 2003
    
    
    4Condensed Consolidated Statements of Cash Flows for Three Months Ended March 31,
2004 and 2003
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    11Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    24Item 4. Controls and Procedures
    
    
    25PART II
OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    26Item 2. Changes in Securities; Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    27Item 6. Exhibits and Reports on Form 8-K
    
    
    27Signature
    
    
    28Exhibit Index
    
    
    29Certifications
    
    
    30EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
 PAGE 2 OF 35




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PART I. FINANCIAL INFORMATION 
 ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS COSINE COMMUNICATIONS, INC. 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except for par value and share data)
 March 31,
    
    December 31,2004
    
    2003(Unaudited)
    
    (1)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    12,045
    
    
    $
    19,719Short-term investments
    
    
    38,125
    
    
    
    38,033Accounts receivable:Trade (net of allowance for doubtful accounts of $151 and $150
at March 31, 2004 and December 31, 2003, respectively)
    
    
    4,026
    
    
    
    4,962Other
    
    
    540
    
    
    
    494Inventory
    
    
    3,668
    
    
    
    4,003Prepaid expenses and other current assets
    
    
    3,061
    
    
    
    2,668Total current assets
    
    
    61,465
    
    
    
    69,879Property and equipment, net
    
    
    3,074
    
    
    
    2,900Long-term deposits
    
    
    587
    
    
    
    647$
    65,126
    
    
    $
    73,426LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,467
    
    
    $
    1,657Provision for warranty claims
    
    
    367
    
    
    
    464Accrued other liabilities
    
    
    2,644
    
    
    
    2,560Accrued compensation
    
    
    2,519
    
    
    
    1,821Deferred revenue
    
    
    2,503
    
    
    
    3,543Current portion of equipment and working capital loans
    
    
    
    
    
    
    129Total current liabilities
    
    
    9,500
    
    
    
    10,174Accrued rent
    
    
    2,072
    
    
    
    2,078Stockholders equity:Preferred stock, 3,000,000 authorized, none issued and outstanding
    
    
    
    
    
    
    Common stock, $.0001 par value, 300,000,000 shares authorized;
10,179,701 and 10,176,845 shares issued and outstanding at March
31, 2004 and December 31, 2003, respectively
    
    
    1
    
    
    
    1Additional paid-in capital
    
    
    544,728
    
    
    
    546,176Notes receivable from stockholders
    
    
    (5,718
    )
    
    
    (6,659
    )Accumulated other comprehensive income
    
    
    544
    
    
    
    533Deferred compensation
    
    
    (194
    )
    
    
    (455
    )Accumulated deficit
    
    
    (485,807
    )
    
    
    (478,422
    )Total stockholders equity
    
    
    53,554
    
    
    
    61,174$
    65,126
    
    
    $
    73,426
 See accompanying notes. (1) The information in this column was derived from the Companys audited
consolidated financial statements for the year ended December 31, 2003. PAGE 3 OF 35




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COSINE COMMUNICATIONS, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except for per share data)
(Unaudited)
 Three Months EndedMarch 31,2004
    
    2003Revenue
    
    $
    4,455
    
    
    $
    2,206Cost of
goods sold1
    
    
    1,497
    
    
    
    715Gross profit
    
    
    2,958
    
    
    
    1,491Operating expenses:Research and development2
    
    
    5,255
    
    
    
    5,257Sales and marketing3
    
    
    3,383
    
    
    
    3,347General and administrative4
    
    
    1,708
    
    
    
    1,737Restructuring and impairment charges
    
    
    35
    
    
    
    270Total operating expenses
    
    
    10,381
    
    
    
    10,611Loss from operations
    
    
    (7,423
    )
    
    
    (9,120
    )Other income (expenses):Interest income and other
    
    
    83
    
    
    
    426Interest expense5
    
    
    (2
    )
    
    
    (128
    )Total other income (expenses)
    
    
    81
    
    
    
    298Loss before income tax provision
    
    
    (7,342
    )
    
    
    (8,822
    )Income tax provision
    
    
    43
    
    
    
    42Net loss
    
    $
    (7,385
    )
    
    $
    (8,864
    )Basic and diluted net loss per share
    
    $
    (0.74
    )
    
    $
    (0.91
    )Shares used in computing per share amounts
    
    
    10,010
    
    
    
    9,721
  1
 2 Research and development expenses include $41 and $198 for the three months
ended March 31, 2004 and 2003, respectively, of non-cash charges related to
equity issuances. 3 Sales and marketing expenses include ($39) and ($192) for the three months
ended March 31, 2004 and 2003, respectively, of non-cash credits related to
equity issuances. 4 General and administrative expenses include ($90) and $137 for the three
months ended March 31, 2004 and 2003, respectively, of non-cash (credits)
charges related to equity issuances. 5 Interest expense includes $0 and $30 for the three months ended March 31,
2004 and 2003, respectively, of non-cash charges related to equity issuances. PAGE 4 OF 35




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COSINE COMMUNICATIONS, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
 Three Months EndedMarch 31,2003
    
    2003Operating activities:Net loss
    
    
    ($7,385
    )
    
    
    ($8,864
    )Adjustments to reconcile net loss to net cash used in operating
activities:Depreciation
    
    
    635
    
    
    
    700Allowance for doubtful accounts
    
    
    9
    
    
    
    Non-cash charges related to inventory write-down
    
    
    102
    
    
    
    Write-down of property and capital equipment
    
    
    4
    
    
    
    Amortization of warrants issued for services
    
    
    15
    
    
    
    44Amortization of deferred stock compensation
    
    
    (250
    )
    
    
    581Reversal of amortization in excess of vesting
    
    
    (115
    )
    
    
    (405
    )Accrual for bonus to be awarded in shares of common stock
    
    
    236
    
    
    
    Other, net
    
    
    16
    
    
    
    (210
    )Change in operating assets and liabilities:Accounts receivable, trade
    
    
    927
    
    
    
    3,413Other receivables
    
    
    (46
    )
    
    
    357Inventory
    
    
    (33
    )
    
    
    (1,088
    )Prepaid expenses and other current assets
    
    
    (408
    )
    
    
    (380
    )Long-term deposits
    
    
    60
    
    
    
    250Accounts payable
    
    
    (190
    )
    
    
    (332
    )Provision for warranty claims
    
    
    (97
    )
    
    
    (284
    )Accrued other liabilities
    
    
    84
    
    
    
    (9,581
    )Accrued compensation
    
    
    462
    
    
    
    463Deferred revenue
    
    
    (1,040
    )
    
    
    (313
    )Accrued rent
    
    
    (6
    )
    
    
    8Net cash used in operating activities
    
    
    (7,020
    )
    
    
    (15,641
    )Investing activities:Capital expenditures
    
    
    (547
    )
    
    
    (304
    )Purchase of short-term investments
    
    
    (14,951
    )
    
    
    (16,016
    )Proceeds from sales and maturities of short-term investments
    
    
    14,853
    
    
    
    36,437Net cash provided by (used in) investing activities
    
    
    (645
    )
    
    
    20,117Financing activities:Principal payments of equipment and working capital loans and
capital leases
    
    
    (129
    )
    
    
    (1,471
    )Proceeds from issuance of common stock, net
    
    
    120
    
    
    
    54Proceeds from notes receivable from stockholders
    
    
    
    
    
    
    22Repurchase of common stock
    
    
    
    
    
    
    (3
    )Net cash used in financing activities
    
    
    (9
    )
    
    
    (1,398
    )Net increase (decrease) in cash and cash equivalents
    
    
    (7,674
    )
    
    
    3,078Cash and cash equivalents at the beginning of the period
    
    
    19,719
    
    
    
    9,230Cash and cash equivalents at the end of the period
    
    $
    12,045
    
    
    $
    12,308Supplemental information:Cash paid for interest
    
    $
    2
    
    
    $
    98Income taxes paid
    
    $
    43
    
    
    $
    42Cancellation of notes receivable due to repurchase of unvested stock
    
    $
    941
    
    
    $
    1,574Net transfer from inventory to property and equipment
    
    $
    266
    
    
    $
    
 See accompanying notes. PAGE 5 OF 35




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COSINE COMMUNICATIONS, INC. 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 1. BASIS OF PRESENTATION The unaudited condensed consolidated financial statements have been
prepared by CoSine Communications, Inc. pursuant to instructions to Form 10-Q
and Article 10 of Regulation S-X and include the accounts of CoSine
Communications, Inc. and its wholly owned subsidiaries (CoSine or
collectively, the Company). Certain information and footnote disclosures
normally included in financial statements prepared in accordance with generally
accepted accounting principles have been condensed or omitted pursuant to the
Securities and Exchange Commissions rules and regulations. In the opinion of
management, all adjustments (consisting of normal recurring items) necessary
for a fair presentation have been included. The results of operations for the
three months ended March 31, 2004 are not necessarily indicative of the results
to be expected for any subsequent quarter or for the entire year. The
condensed consolidated balance sheet at December 31, 2003 has been derived from
the audited financial statements as of that date. These unaudited condensed
consolidated financial statements should be read in conjunction with the
audited consolidated financial statements and the notes included in CoSines
Annual Report filed on Form 10-K for the year ended December 31, 2003. Pro Forma Information CoSine has elected to continue to follow Accounting Principles Board
Opinion 25 (APB 25), Accounting for Stock Issued to Employees, and related
interpretations to account for employee stock options because the alternative
fair value method of accounting prescribed by Statement of Financial Accounting
Standards (SFAS) 123, Accounting for Stock-Based Compensation, as amended
by SFAS 148, Accounting for Stock-Based Compensation  Transition and
Disclosure requires the use of option valuation models that were not developed
for use in valuing employee stock options. Under APB 25, no compensation
expense is recognized when the exercise price of employee stock options equals
the market price of the underlying stock on the date of grant. The following table illustrates the effect on CoSines net loss and net
loss per share if CoSine had applied the fair value recognition provisions of
SFAS 123 to stock-based employee compensation (in thousands, except per share
data): Three Months EndedMarch 31,2004
    
    2003Net loss, as reported
    
    
    ($7,385
    )
    
    
    ($8,864
    )Add: Stock-based employee compensation expense,
net of tax, included in reported net loss
    
    
    (31
    )
    
    
    581Deduct: Reversal of amortization in excess of
vesting, net of tax
    
    
    (98
    )
    
    
    (405
    )Deduct: Stock-based employee compensation
expense determined under fair value method for
all stock option grants (SFAS 123 expense), net
of tax
    
    
    (365
    )
    
    
    (804
    )Pro forma net loss
    
    
    ($7,879
    )
    
    

    ($9,492
    )Basic and diluted net loss per share, as reported
    
    
    ($0.74
    )
    
    
    ($0.91
    )Pro forma basic and diluted net loss per share
    
    
    ($0.79
    )
    
    
    ($0.98
    )
 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 Months EndedMarch 31,
    
    March 31,2004
    
    2003Dividend yield
    
    
    0.0
    %
    
    
    0.0
    %Volatility
    
    
    0.94
    
    
    
    0.32Risk free interest rate
    
    
    2.6
    %
    
    
    3.0
    %Expected life
    
    4 years
    
    4 years
 PAGE 6 OF 35




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In the three months ended March 31, 2004, no shares were issued under the
Employee Stock Purchase Plan. The estimated weighted-average fair value of
shares issued under the Employee Stock Purchase Plan in 2003 was $2.22, using a
volatility of 0.47, risk-free interest rate of 1.3% and an expected life of one
year. Guarantees CoSine from time to time enters into certain types of contracts that
require the Company to indemnify parties against certain third party claims
that may arise. These contracts primarily relate to: (i) certain real estate
leases under which the Company may be required to indemnify property owners for
environmental liabilities and other claims arising from the Companys use of
the applicable premises, (ii) certain agreements with the Companys officers,
directors and employees, under which the Company may be required to indemnify
such persons for liabilities arising out of their employment relationship,
(iii) contracts under which the Company may be required to indemnify customers
against loss or damage to property or persons as a result of willful or
negligent conduct by CoSine employees or sub-contractors, (iv) contracts under
which the Company may be required to indemnify customers against third party
claims that a CoSine product infringes a patent, copyright or other
intellectual property right and (v) procurement or license agreements under
which the Company may be required to indemnify licensors or vendors for certain
claims that may be brought against them arising from the Companys acts or
omissions with respect to the supplied products or technology. Generally, a maximum obligation is not explicitly stated. Because the
obligated amounts associated with this type of agreement are not explicitly
stated, the overall maximum amount of the obligation cannot be reasonably
estimated. Historically, CoSine has not been obligated to make payments for
these obligations, and no liabilities have therefore been recorded for these
obligations on its consolidated balance sheet as of March 31, 2004. Use of Estimates The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the amounts reported
in the consolidated financial statements and the accompanying notes. Actual
results could differ from these estimates. Estimates are used in accounting
for, but not limited to, revenue recognition, allowance for doubtful accounts,
inventory valuations, long-lived asset valuations, accrued liabilities
including warranties, and equity issuances. Estimates and assumptions are
reviewed periodically and the effects of revisions are reflected in the
consolidated financial statements in the period of determination. 2. COMMITMENTS AND CONTINGENCIES As of March 31, 2004, CoSine had commitments of approximately $990,000
relating to purchases of raw materials and semi-finished goods. Of that
amount, $364,000 related to excess inventory was accrued at March 31, 2004. On November 15, 2001, CoSine and certain of its officers and directors
were named as defendants in a securities class action lawsuit filed in the
United States District Court, Southern District of New York. The complaint
generally alleges that various investment bank underwriters engaged in improper
and undisclosed activities related to the allocation of shares in CoSines
initial public offering. The complaint brings claims for the violation of
several provisions of the federal securities laws against those underwriters,
and also against the Company and each of the directors and officers who signed
the registration statement relating to the initial public offering. Various
plaintiffs have filed similar actions asserting virtually identical allegations
against more than 250 other companies. The lawsuit and all other IPO
allocation securities class actions currently pending in the Southern District
of New York have been assigned to Judge Shira A. Scheindlin for coordinated
pretrial proceedings. In October 2002, the individual defendants were dismissed
without prejudice pursuant to a stipulation. The issuer defendants filed a
coordinated motion to dismiss on common pleading issues, which the Court
granted in part and denied in part in an order dated February 19, 2003. The
Courts order dismissed the Section 10(b) and Rule 10b-5 claims against the
Company but did not dismiss the Section 11 claims against the Company. PAGE 7 OF 35




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In June 2003, the plaintiffs in all of the cases presented a settlement
proposal to all of the issuer defendants. Under the proposed settlement, the
plaintiffs will dismiss and release all claims against participating issuer
defendants in exchange for a contingent payment guaranty by the insurance
companies collectively responsible for insuring the issuer defendants in all of
the related cases, and the assignment or surrender to the plaintiffs of certain
claims the issuer defendants may have against the underwriters. Under the
guaranty, the insurers will be required to pay the amount, if any, by which $1
billion exceeds the aggregate amount ultimately collected by the plaintiffs
from the underwriter defendants in all the cases, up to the limits of the
applicable insurance policies. The Company will not be required to make any
cash payments under the settlement, unless the Companys insurer is required to
pay on the Companys behalf an amount that exceeds the Companys insurance
coverage. The Company does not believe that this circumstance will occur. In
July 2003, a special committee of the Companys Board of Directors approved the
proposed settlement. The settlement is subject to acceptance by a substantial
majority of the issuer defendants, and execution of a definitive settlement
agreement. The settlement is also subject to approval of the court, which
cannot be assured. If the settlement is not consummated, the Company intends to
defend the lawsuit vigorously. However, the Company cannot predict its outcome
with certainty. If the Company is not successful in its defense of this
lawsuit, it could be forced to make significant payments to the plaintiffs and
their lawyers, and such payments could have a material adverse effect on the
Companys business, financial condition and results of operations if not
covered by the Companys insurance carrier. Even if these claims are not
successful, the litigation could result in substantial costs and divert
managements attention and resources, which could adversely affect the
Companys business, results of operations and financial position. In the ordinary course of business, CoSine is involved in legal
proceedings involving contractual obligations, employment relationships and
other matters. Except as described above, CoSine does not believe there are
any pending or threatened legal proceedings that will have a material impact on
its financial position or results of operations. 3. BALANCE SHEET DETAILS Inventory Net inventories, stated at the lower of cost (first-in, first-out) or
market, consisted of the following, in thousands: March 31,
    
    December 31,2004
    
    2003(unaudited)Raw materials
    
    $
    216
    
    
    $
    160Semi-finished goods
    
    
    3,029
    
    
    
    3,466Finished goods
    
    
    423
    
    
    
    377$
    3,668
    
    
    $
    4,003
 Included in net finished goods at March 31, 2004 and December 31, 2003 was
$190,000 and $160,000, respectively, of goods awaiting customer acceptance.
Included in net finished goods at March 31, 2004 and December 31, 2003 were
$66,000 and $126,000, respectively, of goods used for customer evaluation
purposes. 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.
During the three months ended March 31, 2003, $336,000 of previously
written-down inventory was sold and no 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. There were no charges in connection with excess purchase
commitments at CoSines contract manufacturers in the three months ended March
31, 2003. Warranty CoSine provides a basic limited warranty, including repair or replacement
of parts, and technical support. The specific terms and conditions of those
warranties vary depending on the customer or region in which CoSine does
business. CoSine estimates the costs that may be incurred under its basic
limited warranty and records a liability in the amount of such costs at the
time product revenue is recognized. CoSines warranty obligation is affected
by the number of installed units, product failure rates, materials usage and
service delivery costs incurred in correcting product failures. CoSine
periodically assesses the adequacy of its recorded warranty liabilities and
adjusts the amounts as necessary. PAGE 8 OF 35




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Changes in CoSines warranty liability were as follows, in thousands: Three Months Ended March 31,2004
    
    2003(unaudited)Beginning balance
    
    $
    464
    
    
    $
    1,103Warranty charged to cost of goods sold
    
    
    75
    
    
    
    Utilization of warranties
    
    
    (154
    )
    
    
    (187
    )Changes in estimated liability based on experience
    
    
    (18
    )
    
    
    (97
    )Ending balance
    
    $
    367
    
    
    $
    819
 4. NET LOSS PER COMMON SHARE Basic net loss per common share is calculated based on the
weighted-average number of common shares outstanding during the periods
presented, less weighted-average shares outstanding that are subject to
CoSines right of repurchase. Common stock equivalents consisting of stock
options and warrants (calculated using the treasury stock method), have been
excluded from the diluted net loss per common share computations, as their
inclusion would be antidilutive. These securities amounted to 1,258,000 shares
and 1,181,000 shares for the three months ended March 31, 2004 and 2003,
respectively. The calculations of basic and diluted net loss per share are shown below,
in thousands, except per share data: Three Months EndedMarch 31,2004
    
    2003Net loss
    
    
    ($7,385
    )
    
    $
    (8,864
    )Basic and diluted:Weighted-average shares of common stock outstanding
    
    
    10,180
    
    
    
    9,953Weighted-average shares subject to repurchase
    
    
    (170
    )
    
    
    (232
    )Weighted-average shares used in basic and
diluted net loss per share
    
    
    10,010
    
    
    
    9,721Basic and diluted net loss per share
    
    
    ($0.74
    )
    
    $
    (0.91
    )
 5. COMPREHENSIVE LOSS The components of comprehensive loss are shown below, in thousands: Three Months EndedMarch 31,2004
    
    2003Net loss
    
    
    ($7,385
    )
    
    $
    (8,864
    )Other comprehensive loss:Unrealized losses on investments
    
    
    (6
    )
    
    
    (75
    )Currency translation adjustment
    
    
    17
    
    
    
    (4
    )Total other comprehensive gain (loss)
    
    
    11
    
    
    
    (79
    )Comprehensive loss
    
    
    ($7,374
    )
    
    $
    (8,943
    )
 6. SEGMENT REPORTING CoSine operates in only one operating segment, and substantially all of
CoSines assets are located in the United States. PAGE 9 OF 35




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Revenues from customers by geographic region for the three months ended
March 31, 2004 and 2003, respectively, were as follows, in thousands: Three Months EndedMarch 31,2004
    
    2003RegionUnited States
    
    $
    2,058
    
    
    $
    986Italy
    
    
    733
    
    
    
    France
    
    
    671
    
    
    
    499Korea
    
    
    613
    
    
    
    2Europe
    
    
    302
    
    
    
    195Japan
    
    
    67
    
    
    
    524Asia/Pacific
    
    
    11
    
    
    
    Total
    
    $
    4,455
    
    
    $
    2,206
 For the three months ended March 31, 2004, Sprint, Lucent, Infranet
(Korea) and Transpac accounted for 38%, 16%, 13% and 10% of CoSines revenue,
respectively. For the three months ended March 31, 2003, Sprint, NEC, Equant
and Transpac accounted for 33%, 17%, 12% and 11% of CoSines revenue,
respectively. At March 31, 2004, Infranet (Korea), Sprint and Transpac
accounted for 28%, 27% and 13% of CoSines accounts receivable, respectively.
At December 31, 2003, Sprint and Lucent accounted for 52% and 19% of CoSines
accounts receivable, respectively. 7. RESTRUCTURING CHARGES March 2003 and May 2002 Restructuring In March 2003, CoSines senior management communicated reductions in its
workforce related to the closure of a sales office in the Asia/Pacific Rim
region. The employees were notified in March 2003 that their job functions
would be eliminated and that termination benefits would be paid to them. As a
result of the workforce reduction, five employees were designated for
termination. In May 2002, CoSines senior management approved a restructuring program
to reduce its worldwide workforce, close certain sales offices, exit certain
facilities and dispose of or abandon certain property and equipment. Employees
were notified in May 2002 that certain job functions would be eliminated and
that particular termination benefits would be paid to affected employees. As a
result of the workforce reduction, 146 employees were designated for
termination in the restructuring program. Most of the terminations took place
in the second quarter of 2002, with the remainder taking place in the third
quarter of 2002. The employees in the workforce reduction were from all
functional groups and were located in offices in the United States, Europe and
Asia. The Company also wrote down certain property and equipment to its
expected realizable value as the assets have been either sold, disposed of or
otherwise abandoned. The final $153,000 related to the restructuring program
was paid in the three months ended March 31, 2004. Activity related to the March 2003 and May 2002 restructurings for the
three months ended March 31, 2004 was as follows, (in thousands): Worldwide workforce
    
    Lease terminationreduction
    
    and other
    
    TotalProvision balance at December 31, 2003
    
    $
    48
    
    
    $
    118
    
    
    $
    166Cash payments
    
    
    
    
    
    
    (153
    )
    
    
    (153
    )Accrual adjustment
    
    
    
    
    
    
    35
    
    
    
    35Provision balance at March 31, 2004
    
    $
    48
    
    
    $
    
    
    
    $
    48
 PAGE 10 OF 35




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CoSine expects to pay the remaining $48,000 related to the workforce
reduction in 2004. 
 ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS This Managements Discussion and Analysis of Financial Condition and
Results of Operations 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, failure to achieve revenue growth and profitability, the loss of
business opportunities with large service providers due to our
financial losses,
the continued downturn in the telecommunications industry and slow development
of the market for network-based IP services, failure to develop and maintain
distribution partnerships, product development, commercialization and
technology difficulties, manufacturing costs, the impact of competitive
products, pricing, changing customer requirements, timely availability and
acceptance of new products, and changes in economic conditions in the various
markets that we serve, all as are discussed in more detail in the section
entitled Risk Factors on pages 19 through 24 of this report, as well as the
other risk factors discussed in that section. Readers are cautioned not to
place undue reliance on these forward-looking statements, which reflect
managements opinions only as of the date hereof. We undertake no obligation
to revise or publicly release the results of any revision to these
forward-looking statements. Readers should carefully review the risk factors
described in other documents that we file from time to time with the Securities
and Exchange Commission, including the Quarterly Reports on Form 10-Q that we
will file in the remainder of fiscal year 2004. OVERVIEW We develop, market and sell a communications platform that we refer to as
our IP Service Delivery Platform. Our product is designed to enable network
service providers to rapidly deliver a portfolio of communication services to
business and consumer customers. We market our IP Service Delivery Platform
through our direct sales force and through resellers to network service
providers in Asia, Europe and North America. We provide customer service and
support for our products directly and through support partners. The market for our IP Service Delivery Platform is still in the early
stages of development, and the volume and timing of orders are difficult to
predict. A customers decision to purchase our platform typically involves a
significant commitment of its resources and a lengthy evaluation, testing and
product qualification process. The long sales cycle and the timing of our
customers rollout of services made possible by our platform, which affects
repeat business, may cause our revenue and operating results to vary
significantly and unexpectedly from quarter to quarter and may also
constrain our ability to secure new customers. While we believe that
the market for network-based IP services will continue to grow and represents a
significant opportunity, we have not generated sufficient revenue to fund our
operations. We believe that we have a technically strong product that can
deliver IP services at a lower cost than competing products. However, we must
increase our revenue in the near term in order to reduce our cash consumption
and remain a viable and competitive supplier. Managements overview of the Companys position is discussed in more
detail in the Outlook section on page 18 and the
Liquidity and Capital Resources section on page
17. CRITICAL ACCOUNTING POLICIES AND ESTIMATES General Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have
been prepared in accordance with accounting principles generally accepted in
the United States. The preparation of these financial statements requires us
to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities. On an ongoing basis, we evaluate our estimates, including
those related to revenue recognition, allowance for doubtful accounts,
inventory valuation, long-lived assets, warranties and equity issuances.
Additionally, the audit committee of PAGE 11 OF 35




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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. The following accounting policies are significantly affected by the
judgments and estimates we use in the preparation of our consolidated financial
statements. Revenue Recognition Most of our sales are generated from complex arrangements. Recognizing
revenue in these arrangements requires our making significant judgments,
particularly in the areas of customer acceptance and collectibility. Certain of our sales arrangements require formal acceptance by our
customers. In such cases, we do not recognize revenue until we have received
formal notification of acceptance. Although we work closely with our customers
to help them achieve satisfaction with our products prior to and after
acceptance, the timing of customer acceptance can greatly affect the timing of
our revenue. While the end users of our product are generally large network service
providers, we also sell product and services through small resellers and to
small network service providers in Asia, Europe and North America. To
recognize revenue before we receive payment, we are required to assess that
collection from the customer is probable. If we cannot satisfy ourselves that
collection is probable, we defer revenue recognition until we have collected
payment. Allowance for Doubtful Accounts Receivable We maintain allowances for doubtful accounts receivable in connection with
estimated losses resulting from the inability of our customers to pay our
invoices. In order to estimate the appropriate level of this allowance, we
analyze historical bad debts and write-offs, customer concentrations, current
customer credit-worthiness, current economic trends and changes in our customer
payment patterns. In future periods, if the financial condition of our
customers were to deteriorate and affect their ability to make payments,
additional allowances could be required. Inventory Valuation In assessing the value of our inventory, we are required to make judgments
as to future demand and then compare that demand with current inventory
quantities and firm purchase commitments. If our inventories and firm purchase
commitments are in excess of forecasted demand, we write down the value of our
inventory. We generally use a 12-month forecast to assess future demand.
Inventory write-downs are charged to cost of sales. During the three months
ended March 31, 2004, we wrote down $102,000 of inventory and we sold $60,000
of previously written-down inventory. If actual demand for our products is
less than our forecasts, additional inventory write-downs may be required. Long-lived Assets We evaluate the carrying value of long-lived assets, consisting primarily
of property, plant and equipment, whenever certain events or changes in
circumstances indicate that the carrying amount of these assets may not be
recoverable. In assessing the recoverability of long-lived assets, we compare
the carrying value to the undiscounted future cash flows the assets are
expected to generate. If the total of the undiscounted future cash flows is
less than the carrying amount of the assets, the assets will be written down to
their estimated fair value. Fair value is generally determined by calculating
the discounted future cash flows using a discount rate based upon our weighted
average cost of capital or specific appraisal, as appropriate. Significant
judgments and assumptions are required in the forecast of future operating
results used in the preparation of the estimated future cash flows, including
long-term forecasts of overall market conditions and our participation in the
market. Changes in these estimates could have a material adverse effect on the
assessment of the long-lived assets, thereby requiring us to record further
asset write-downs in the future. We have concluded that no indicators of
impairment were present in the first three months of 2004. PAGE 12 OF 35




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Warranties We provide a basic limited warranty, including repair or replacement of
parts, and technical support. The specific terms and conditions of those
warranties vary depending on the customer or region in which we do business.
We estimate the costs that may be incurred under our basic limited warranty and
record a liability in the amount of such costs at the time product revenue is
recognized. 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 sales may
result. Impact of Equity Issuances on Operating Results In 2004 and 2003, our operating results have been affected by stock
options previously granted to employees that were subsequently re-priced and by
the amortization of deferred compensation related to stock options
granted prior to September 2000 at
an exercise price below their estimated fair value.
These employee stock option transactions have resulted in deferred
compensation, which is presented as a reduction of stockholders equity on our
balance sheet and is amortized over the vesting period of the applicable
options using the graded vesting method. The re-priced stock options are also
required to be re-measured each quarter based on their fair market value,
resulting in additional charges or credits. In the first quarter of 2004, our
operating results were additionally affected by the grant of CoSine common
stock to employees based on the achievement of certain Company objectives. The compensation associated with shares and options relating to the
following transactions is required to be re-measured at the end of each
accounting period. The re-measurement at the end of each accounting period
will result in unpredictable charges or credits in future periods, depending on
future fluctuations in the market prices of our common stock:  
    
    Non-recourse promissory notes receivable: During the fourth quarter
of 2000, we converted full-recourse promissory notes received from
employees upon the early exercise of unvested employee stock options to
non-recourse obligations. Accordingly, we are required to re-measure
the compensation associated with the shares underlying the promissory
note until the earlier of repayment of the note or default. Deferred
compensation expense, which is recorded at each re-measurement date, is
amortized over the remaining vesting period of the underlying options.  
    
    Re-priced stock options: In November 2002, we re-priced outstanding
employee stock options to purchase 1,091,453 shares of our common stock
with original exercise prices ranging from $5.45 per share to $159.38
per share. These options were re-priced to $5.00 per share, which was
higher than the fair market value of the underlying shares on the
re-pricing date. Compensation will be re-measured for these options
until they are exercised, canceled, or expire. At March 31, 2004,
569,961 stock options re-priced in November 2002 were still outstanding.
Deferred compensation expense, which is recorded at each re-measurement
date, is amortized over the remaining vesting period of the underlying
options. Some of the stock options granted to our employees have generated deferred
compensation as a result of stock options having an exercise price below their
estimated fair value. Deferred compensation is presented as a reduction to
stockholders equity on the balance sheet and is then amortized using a graded
vesting method over the vesting period of the applicable options. When an
employee terminates, an expense credit is recorded for any amortization that
has been previously recorded as an expense in excess of vesting. In 2004, we began a program whereby we grant employees bonuses in shares
of CoSine common stock based on the achievement of certain Company objectives.
At the end of each quarter, we determine whether objectives have been achieved
and set the total value of the common stock grant. The number of shares to be
granted is calculated the following quarter based on the fixed value of the
common stock grant, as determined at quarter-end, divided by CoSines stock
price on the grant date. Compensation expense is accrued in full in the
quarter in which it is earned. RESULTS OF OPERATIONS For the three months ended March 31, 2004 and 2003, we reported basic and
diluted net losses per share of $0.74 and $0.91, respectively. The effect of
equity issuances to employees and suppliers decreased net loss per share by
$0.01 for PAGE 13 OF 35




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the three months ended March 31, 2004 and increased net loss per share by
$0.02 for the three months ended March 31, 2003. Revenue For the three months ended March 31, 2004, revenue was $4.5 million of
which 73% was from hardware sales, 11% was from software sales and 16% was from
sales of services. For the three months ended March 31, 2003, revenue was $2.2
million of which 74% was from hardware sales, 7% was from software sales and
19% was from sales of services. Revenues from customers by geographic region for the three months ended
March 31, 2004 and 2003, respectively, were as follows, in thousands: Three Months EndedMarch 31,2004
    
    2003RegionUnited States
    
    $
    2,058
    
    
    $
    986Italy
    
    
    733
    
    
    
    France
    
    
    671
    
    
    
    499Korea
    
    
    613
    
    
    
    2Europe
    
    
    302
    
    
    
    195Japan
    
    
    67
    
    
    
    524Asia/Pacific
    
    
    11
    
    
    
    Total
    
    $
    4,455
    
    
    $
    2,206
 We have continued to focus our sales and engineering efforts on certain
large service providers. The increase in total revenue of $2.2 million in the
first three months of 2004 compared to the same period in 2003 resulted
primarily from higher sales to those customers, who expanded network capacity
or increased the capability of their networks. Because the market for network-based IP services is in the early stages of
development, service provider demand for our products may fluctuate until
service providers are able to further develop enterprise demand for such
services and accelerate revenue growth from the sale of such services. See
Outlook section on page 18 and Risk Factors section on pages 19 to 24. Non-Cash Charges Related to Equity Issuances 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 goods sold, operating expenses and interest expense. Below is a reconciliation of non-cash charges related to equity issuances
for the three months ended March 31, 2004 and 2003, as presented in our
statement of operations, in thousands: 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
    
    $
    65
    
    
    $
    581Credits related to the reversal of deferred
stock compensation amortization in excess of
vesting for terminated employees
    
    
    (115
    )
    
    
    (405
    )Amortization of deferred compensation associated
with non-recourse promissory notes
    
    
    
    
    
    
    
 PAGE 14 OF 35




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Three Months EndedMarch 31,2004
    
    2003Reversal of amortization of deferred
compensation associated with re-pricing
    
    
    (315
    )
    
    
    Accrual for bonus to be awarded in shares of
common stock
    
    
    236
    
    
    
    Amortization of charges related to warrants or
stock options issued to non-employees in
conjunction with lease and debt agreements
    
    
    15
    
    
    
    44Net non-cash charges related to equity issuances
    
    
    ($114
    )
    
    $
    220
 Under
the stock bonus program for which we issued $236,000 at March 31,
2004, we issued 43,300 shares of CoSine common stock in the second quarter of
2004, based on CoSines stock price on the issuance date. Cost of Goods Sold For the three months ended March 31, 2004, cost of goods sold 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, $0.1 million represented scrap and other adjustments, off-set by
a $0.1 million benefit associated with previously written-down inventory sold.
For the three months ended March 31, 2003, cost of goods sold was $0.7 million,
of which $1.0 million represented materials, labor, production overhead,
warranty and the costs of providing services, off-set by $0.3 million
representing a benefit associated with previously written-down inventory sold. Gross Profit For the three months ended March 31, 2004 and 2003, gross profit was $3.0
million and $1.5 million, respectively. Gross margin declined from 68% to 66%.
Lower sales of previously written-down inventory accounted for a 14 percentage
point decrease in gross margin. Higher charges for inventory written-down
accounted for a two percentage point decrease in gross margin. Higher warranty
expenses additionally decreased gross margin by six percentage points primarily
due to a $97,000 credit taken in the three months ended March 31, 2003.
Partially offsetting those unfavorable changes, a reduction in materials, labor
and product overhead costs as a percentage of sales accounted for a 21
percentage point improvement in gross margin. Primarily accounting for the
reduction in materials, labor and overhead cost as a percentage of sales were
an increase in average selling price due to the regional mix of sales, more
favorable product configurations, including higher software sales, and
reductions in maintenance contract support costs due to headcount and overhead
reductions. We expect our gross margin to continue to be primarily affected by
regional product mix and configurations, the volume of product sold and pricing
pressures, the amount of excess inventory reserve charges and the amount of
previously written-down inventory sold. The mix of products that our customers
purchase is unpredictable and, because of lead times required to buy certain
components and the timing of our customers orders, we purchase inventory based
on forecasted demand. The amount of excess inventory purchase commitments and
excess inventory charges related to on-hand inventory is dependent on us
purchasing the correct mix of inventory. In addition, if our unit sales
volumes are significantly lower than forecasted demand, excess inventory
charges will result. Research and Development Expenses Research and development expenses were $5.3 million for both the three
months ended March 31, 2004 and 2003, respectively. There were several
offsetting items. Outside engineering services increased $0.5 million due to
the transition of our sustaining engineering and certain software development
functions to outside engineering firms. Non-cash equity charges declined $0.2
million primarily due to credits related to the reversal of amortization of
deferred compensation expense in excess of vesting for employees who were
terminated during the first quarter of 2004 and to an expense credit for
re-priced options as our stock price declined $.80 from December 31, 2003 to
March 31, 2004. Depreciation expense declined $0.1 million due primarily to
certain property and equipment becoming fully depreciated. PAGE 15 OF 35




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Facilities and information technology infrastructure expense declined $0.1
million as a result of reductions in property taxes and in depreciation of
information technology infrastructure. Finally, $0.3 million of savings
related to a 15-employee reduction over the year were offset by $0.2 million of
severance costs for eight of those employees who terminated in the first
quarter of 2004. As a result of the engineering headcount reductions, we will see a savings
in payroll-related expense. Those savings, however, will be largely offset by
the increased outsourcing of sustaining engineering and certain software
development functions. The timing of prototyping, certification
testing, customer-specific testing and equity-related charges (benefits),
including the effect of bonuses awarded in shares of common stock, can cause
expenses to fluctuate from quarter-to-quarter. We expect research and development expenses in the quarter ending June 30,
2004 to be essentially consistent with the levels in the quarter ended March
31, 2004. Sales and Marketing Expenses Sales and marketing expenses were $3.4 million and $3.3 million for the
three months ended March 31, 2004 and 2003, respectively. Payroll-related
expense increased $0.3 million primarily due to commission expense on $2.3
million higher sales in the first quarter of 2004 compared to the first quarter
of 2003. Non-cash charges related to equity issuances increased $0.2 million
due primarily to credits for the reversal of amortization of deferred
compensation expense in excess of vesting for employees who terminated during
the first quarter of 2003. Absorption to cost of goods sold of spending to
support maintenance contracts and warranty declined $0.1 million. Such support
costs are initially charged to Sales and Marketing expense and subsequently
reclassified to either cost of sales or the provision for warranty claims based
on associated activity such as product return levels and technical support case
data. Due primarily to a smaller customer installed base, activity associated
with maintenance and warranty was less than the prior year. Offsetting those
increases in expense, facilities rent expense decreased by $0.2 million due to
reductions in square footage and re-negotiation of rents at certain offices and
the elimination of others. Travel expense declined $0.1 million due to
continued cost saving measures. Depreciation expense declined $0.1 million due
primarily to some assets becoming fully depreciated. We expect sales and marketing expenses in the quarter ending June 30, 2004
to be essentially consistent with the levels in the quarter ended March 31,
2004. General and Administrative Expenses General and administrative expenses were $1.7 million for both the three
months ended March 31, 2004 and 2003, respectively. Outside legal and
accounting expense increased $0.3 million due to tax and structural changes
related to international subsidiaries and audit-related matters. Other outside
services increased $0.1 million primarily as a result of fees paid to an
outside firm to assist us in finding partnership opportunities. Offsetting
those increases, stock-based compensation expense declined $0.2 million
primarily due to an expense credit for re-priced options as our stock
price declined $.80 from December 31, 2003 to March 31, 2004. Payroll-related
expense declined $0.1 million primarily due to reduced headcount and related
benefits. Director and officer insurance expense declined $0.1 million as we
were able to obtain better rates than in the prior year. General and administrative expenses in the second half of 2004 may
significantly increase due to cost related to the implementation of Section 404
of the Sarbanes-Oxley Act of 2002, which requires management to report on, and
our auditors to attest to, our internal controls. Restructuring and Impairment March 2003 and May 2002 Restructuring In March 2003, our senior management communicated reductions in our
workforce related to the closure of a sales office in the Asia/Pacific Rim
region. The employees were notified in March 2003 that their job functions
would be PAGE 16 OF 35




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eliminated and that termination benefits would be paid to them. As a
result of the workforce reduction, five employees were designated for
termination. In May 2002, our senior management approved a restructuring program to
reduce our worldwide workforce, close certain sales offices, exit certain
facilities and dispose of or abandon certain property and equipment. Employees
were notified in May 2002 that certain job functions would be eliminated and
that particular termination benefits would be paid to affected employees. As a
result of the workforce reduction, 146 employees were designated for
termination in the restructuring program. Most of the terminations took place
in the second quarter of 2002, with the remainder taking place in the third
quarter of 2002. The employees in the workforce reduction were from all
functional groups and were located in offices in the United States, Europe and
Asia. We also wrote down certain property and equipment to its expected
realizable value as the assets have been either sold, disposed of or otherwise
abandoned. The final $153,000 related to the restructuring program was paid in
the three months ended March 31, 2004. Activity related to the March 2003 and May 2002 restructurings for the
three months ended March 31, 2004 was as follows (in thousands): Worldwide workforce
    
    Lease terminationreduction
    
    and other
    
    TotalProvision balance at December 31, 2003
    
    $
    48
    
    
    $
    118
    
    
    $
    166Cash payments
    
    
    
    
    
    
    (153
    )
    
    
    (153
    )Accrual adjustment
    
    
    
    
    
    
    35
    
    
    
    35Provision balance at March 31, 2004
    
    $
    48
    
    
    $
    
    
    
    $
    48
 CoSine expects to pay the remaining $48,000 related to the workforce
reduction in 2004. Interest and Other Income For the three months ended March 31, 2004 and 2003, interest and other
income was $0.1 million and $0.4 million, respectively. This reflects
decreased interest income due to lower levels of cash and short-term
investments and lower interest rates on invested amounts. Interest Expense For the three months ended March 31, 2004 and 2003, interest expense was
$2,000 and $128,000, respectively. The reduction reflects a decline in our
debt. Income Tax Provision For the three months ended March 31, 2004 and 2003, the provisions for
income taxes were $43,000 and $42,000, respectively, and were comprised
entirely of foreign corporate income taxes, which are a function of our
operation of subsidiaries in various countries. LIQUIDITY AND CAPITAL RESOURCES Currently, we are not generating sufficient revenue to fund our
operations. We expect our operating losses and net operating cash outflows to
continue unless we are able to significantly increase our revenue. In 2001 and
2002 and, to a lesser extent, in March and May 2003, we announced that we had
adopted business plans to reduce our operating expenses to reflect the then
current and expected business conditions. As of the filing date of this report,
we believe that we cannot make further significant reductions in our operating
expenses and still remain a viable and competitive supplier. Based on our rate of quarterly cash consumption in the last four quarters
of approximately $8.5 million, we believe that we possess sufficient liquidity
and capital resources to fund our operations and working capital requirements
for at least the next 12 months. However, because of our history of losses and
use of cash in operations, certain of our existing PAGE 17 OF 35




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and prospective customers may have concerns regarding our long-term
financial viability and our ability to support their businesses, and as a
result may choose to purchase equipment from other larger and more established
suppliers. See Risk Factors on pages 19 - 24. We may seek to raise additional funds through debt or equity financing, or
from other sources. There can be no assurances that additional funding will be
available at all, or that if available, such financing will be obtainable on
terms favorable to us. Cash, Cash Equivalents and Short-Term Investments At March 31, 2004, cash, cash equivalents and short-term investments were
$50.2 million. This compares with $57.8 million at December 31, 2003. Operating Activities We used $7.0 million and $15.6 million of cash in operations for the three
months ended March 31, 2004 and 2003, respectively. The decrease in net cash
used in operating activities was primarily the result of the payment of $8.4
million of restructuring expenses in the first quarter of 2003. Investing Activities For the three months ended March 31, 2004, investing activities used $0.6
million in cash while for the three months ended March 31, 2003, investing
activities provided $20.1 million in cash. The change reflects a decrease of
$20.5 million for net proceeds from the sale of short-term investments and an
increase in capital expenditures of $0.2 million. Financing Activities For the three months ended March 31, 2004 and 2003, $9,000 and $1.4
million, respectively, were used in financing activities. The decrease
primarily reflects lower principal payments on working capital loans and
capital leases, all of which have expired as of March 31, 2004. OUTLOOK Although capital spending in the telecommunications industry has begun to
recover, the market for network-based IP services continues to develop slowly.
While we believe that this market represents a significant opportunity, we
recognize that we must significantly reduce our cash consumption in the near
term by significantly increasing revenues or we will not be able to survive.
At March 31, 2004, we had $50.2 million in cash and short-term investments.
Cash consumption during the quarter ending March 31, 2004 was $7.6 million.
As of the filing of this report, we believe that we cannot make further
significant reductions in our operating expenses, and at the same time continue
with the research and development and marketing and sales activity necessary to compete effectively in our
market. Therefore, we must achieve revenue growth in the near term by winning
repeat business as our customers expand their network-based IP service
offerings and by winning new customers as they seek to enter this market.
There can be no assurance, however, that we will succeed in meeting these
objectives. Our ability to pursue new customers is constrained by the relatively small
size of our sales and support forces and the long sales cycle involved in the
purchase of our products. Accordingly, the establishment of strategic reseller
relationships is an important part of our strategy for 2004. By establishing
those relationships, we can leverage the sales and support capabilities of
these partners and thereby expand our potential market. Finally, we have evaluated a variety of different business scenarios and
possible means to enhance CoSines chances of success. We have explored, and
will continue to explore, OEM relationships, strategic partner relationships,
mergers and acquisitions, and other corporate transactions and strategies as possible
ways to maximize shareholder value, and we use industry and financial experts
to assist us in seeking and evaluating such opportunities. PAGE 18 OF 35




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RISK FACTORS The following discussion describes certain risk factors related to our
business as well as to our industry in general. We have a history of losses that we expect will continue, and if we do not
achieve profitability we may cease operations. At March 31, 2004, we had an accumulated deficit of $485.8 million. We
have incurred net losses since our incorporation. We cannot be certain that
our revenue will grow or that we will generate sufficient revenue to become
profitable. At March 31, 2004, we had $50.2 million in cash and short-term
investments. Cash consumption during the quarter ending March 31, 2004 was
$7.6 million. If we do not achieve profitability and are unable to obtain
additional financing, we may run out of cash and cease operations. Due to our losses, we could lose major opportunities with large service
providers who are concerned with our long-term financial viability. Many large telecommunications service providers purchase capital equipment
from vendors with a history of successful operations including positive cash
flow. Our history of losses and use of cash in operations may cause certain
service providers to decide not to purchase equipment from us because of
concerns regarding our long-term financial viability and our ability to support
their businesses. Unless we can generate positive cash flows by increasing
revenues, concerns regarding our long-term financial viability may cause some
potential customers to purchase product from other larger, more established
suppliers including Cisco Systems, Lucent Technologies, Nortel Networks,
Alcatel, Ericsson, Siemens, and Juniper Networks. The market for managed network-based IP services is still in the early stages
of growth. As a result, demand may fluctuate. The market for managed network-based IP services is still in the early
stages of growth. We believe that the market for these services will grow, but
the timing of this growth is linked to the development of this market by
service providers and the growth of enterprise demand. Until the market
develops further, demand may not increase significantly and may continue to
fluctuate. If our quarterly or annual operating results do not meet the
expectations of securities analysts or investors, the trading price of our
common stock could decline. Our ability to sustain or grow our business may be harmed if we are unable to
develop and maintain certain strategic relationships with third parties to
market and sell our products. Because we are a relatively small company with correspondingly small sales
and support groups, our success will depend in part upon our ability to form
and maintain distribution partnerships, including agreements under which we
sell our products to certain service provider customers through distribution
partners. We may not be able to establish sufficient reseller relationships to
enable us to expand our potential market and achieve revenue growth. The amount
and timing of resources that our distribution partners devote to our business,
if any, is not within our control. Our distribution partners may not perform
their obligations as expected. In some cases, agreements with our distribution
partners may be relatively new, and we cannot be certain that we will be able
to achieve expected revenues from such partners or sustain the level of revenue
generated thus far under similar arrangements. If any of our distribution
partners chooses not to renew, breaches or terminates its agreement or fails to
perform its obligations under its agreement, we may not be able to sustain or
grow our business. In the event that such relationships are terminated, we may
not be able to continue to maintain or develop similar relationships or to
replace distribution partners. In addition, any such agreements we enter into
in the future may not be successful. The outlook for capital spending in the telecommunications industry directly
impacts our business. Our business depends on capital expenditures within the telecommunications
industry, which has experienced a significant downturn since 2001. Capital
spending in the industry as a whole has slowed as a result of a lack of
available capital for many emerging service providers and a generally cautious
approach to capital spending within the industry. PAGE 19 OF 35




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While the industry in general appears to be recovering, the ultimate
duration of this downturn is unknown. Due to reductions in capital spending
plans by our customers and uncertainty within the telecommunications industry,
we anticipate that this trend will continue to have a substantial, adverse
effect on our revenue growth for at least the remainder of the current fiscal
year. No assurance can be given that the Companys net revenue and operating
results will not be further adversely affected by the current downturn or any
future downturns. If we fail to retain key personnel, our operations could suffer and our stock
price could be negatively impacted. Maintaining key personnel may be difficult for a number of reasons,
including but not limited to market demand, stock price, growth opportunities,
management philosophy, company performance and competitive activity. If we
lose key personnel we may find it difficult and costly to recruit new
management and other personnel and this may have a negative affect on our
performance and in turn on our stock price. The long sales cycle for our platform may cause our revenue and operating
results to vary significantly from quarter to quarter, and the price of our
stock to decline. A customers decision to purchase our IP Service Delivery Platform
involves a significant commitment of its resources and a lengthy evaluation,
testing and product qualification process that may run from three to twelve
months. Network service providers and other customers with complex networks
usually expand their networks in increments on a periodic basis. We may
receive purchase orders for significant dollar amounts on an irregular and
unpredictable basis. These events may cause our revenue and operating results
to vary significantly and unexpectedly from quarter to quarter, which could
cause our stock price to decline. We participate in a competitive marketplace, and our failure to compete
successfully would limit our ability to increase our market share and harm our
business. Competition in the network infrastructure market is intense, and we expect
that competition in the market for IP networking services will also be intense.
If we are unable to compete effectively, our revenue and market share will be
negatively affected. We face competition from companies in the network infrastructure market,
including Cisco Systems, Lucent Technologies, Nortel Networks, Alcatel,
Ericsson, Siemens, and Juniper Networks. Many of our competitors are larger
companies with significantly greater resources than we have, and we expect to
face increased competition from larger companies in the future. Some of these
larger competitors have pre-existing relationships involving a range of product
lines with the network service providers who are the principal potential
customers for our IP Service Delivery Platform. These competitors may offer
vendor financing, which we generally do not offer, undercut our prices or use
their pre-existing relationships with our customers to induce them not to use
our IP Service Delivery Platform. Future consolidation in the telecommunications equipment industry may increase
competition that could harm our business. The markets in which we compete are characterized by increasing
consolidation both within the data communications sector and by companies
combining or acquiring data communications assets and assets for delivering
voice-related services. We cannot predict with certainty how industry
consolidation will affect our competitors. We may not be able to compete
successfully in an increasingly consolidated industry. Increased competition
and consolidation in our industry could require that we reduce the prices of
our products and result in our loss of market share, which would materially
adversely affect our business, financial condition and results of operations.
Because we may be dependent on certain strategic relationships with third
parties in our industry, any additional consolidation involving these parties
could reduce the demand for our products and otherwise harm our business
prospects. If our customers are unable to generate sales of services using our products
and to manage delivery of these services to their customers, we may be unable
to sell our products. PAGE 20 OF 35




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Our future success depends on network service providers, who are our
customers, generating revenue from the sale of services delivered using our
products. Sales of our products may decline or be delayed if our customers do
not successfully introduce commercial services derived from our IP Service
Delivery Platform or if our customers do not generate revenue from these
services sufficient to realize an attractive return on their investment in our
IP Service Delivery Platform. In addition, the long cycle for service
providers to introduce new services made possible by our platform may cause our
revenue and operating results to vary significantly from quarter to quarter. Our ability to generate future revenue also depends on whether network
service providers successfully forecast market trends and identify customer
demand for the services and features that our products would enable network
service providers to offer their customers. If our IP Service Delivery Platform does not achieve market acceptance, we may
be unable to achieve profitability. Our products offer a new approach for delivering services by network
service providers, who may perceive our products as being more expensive than
the other technologies and products they purchase. If network service
providers do not accept our IP Service Delivery Platform as a method for
delivering services to their customers, our ability to increase our revenue,
achieve profitability and continue operations would be harmed. Our IP Service Delivery Platform is our only product line, and our future
revenue depends on its commercial success. Our IP Service Delivery Platform, which is comprised of hardware and
software, is the only product line that we currently offer to our customers.
Our future revenue depends on the commercial success of our IP Service Delivery
Platform. If customers do not adopt, purchase and successfully implement our
IP Service Delivery Platform in large numbers, our revenue will not grow. If our products contain defects, we may be subject to significant liability
claims from our customers, distribution partners and the end-users of our
products and incur significant unexpected expenses and lost sales. Our products are technically complex and can be adequately tested only
when put to full use in large and diverse networks with high amounts of
traffic. They have in the past contained, and may in the future contain,
undetected or unresolved errors or defects. Despite extensive testing, errors,
defects or failures may be found in our current or future products or
enhancements after commencement of commercial shipments. If this happens, we
may experience delay in or loss of market acceptance and sales, product
returns, diversion of development resources, injury to our reputation,
inability to attract new customers, or increased service and warranty costs,
any of which could have a material adverse effect on our business, financial
condition and results of operations. Moreover, because our products are
designed to provide critical communications services, we may receive
significant liability claims. We attempt to include in our agreements with
customers and distribution partners provisions intended to limit our exposure
to liability claims. However, our customers and distribution partners may not
be willing to agree to such provisions, and in any event such provisions may
not be effective in any or all cases or under any or all scenarios, and they
may not preclude all potential claims resulting from a defect in one of our
products or from a defect related to the installation or operation of one of
our products. Although we maintain product liability and errors and omissions
insurance covering certain damages arising from implementation and use of our
products, our insurance may not cover all claims sought against us. Liability
claims could require us to spend significant time and money in litigation or to
pay significant damages. As a result, any such claims, whether or not
successful, could seriously damage our reputation and our business. If we fail to develop and market new products or features, we will have
difficulty attracting customers. Based on our prior experience, we expect that our customers will require
product features that our current IP Service Delivery Platform does not have.
Our products are technically complex, and the development of new products or
features is an uncertain, time-consuming and labor-intensive process. We may
experience design, manufacturing or marketing problems with our new products.
If we fail to develop new or enhanced products that meet customer requirements,
our ability to attract and retain customers will be hindered. If we fail to introduce new products in a timely manner we may experience
erratic revenue growth, which could negatively affect profitability and in turn
have a negative impact on our stock price. In addition, such a failure could
result in additional costs such as excess inventory, customer conversion costs,
higher than expected product costs and higher than expected operating expenses
in research and development and in sales and marketing. PAGE 21 OF 35




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If our products do not work the way our customers expect, orders for our
products may be cancelled and the market perception of our products could be
harmed. If our products do not work with our customers or their end-users
networks, the market perception of our products could be harmed and orders for
our products could be cancelled. In particular, if an actual or perceived
breach of network security occurs in a customers or its end-users network
that uses our products, we may be subject to lawsuits for losses suffered by
customers or their end-users. If we have to redesign or modify our products to make them compatible with
a customers or end-users network, our sales cycle could be extended, our
research and development costs may increase and profit margins on our products
may decline. Because the markets in which we compete are prone to rapid technological change
and the adoption of standards different from those that we use, our products
could become obsolete, and we could be required to incur substantial costs to
modify our products to remain competitive. The market for our IP Service Delivery Platform is prone to rapid
technological change, the adoption of new standards, frequent new product
introductions and changes in customer and end-user requirements. We may be
unable to respond quickly or effectively to these developments. We may
experience difficulties that could prevent our development of new products and
features. The introduction of new products or technologies by competitors, or
the emergence of new industry standards, could render our products obsolete or
could require us to incur costs to redesign our products. We rely upon a limited number of customers, and any decrease in revenue from
these customers or failure to increase our customer base could harm our
operating results. The loss of one or more of our customers, a reduction in purchases of our
products by certain of our customers or the decline of a key customers
business may limit our revenue growth and harm our operating results. Our
customers may reduce or discontinue purchases of our products at any time. In
the first quarter of 2004, we generated 77 percent of our revenue from four
customers. Our future success will depend on attracting additional customers.
Failure to increase our customer base would hinder our growth and harm our
operating results. A failure of our contract manufacturers or our sole source and limited source
suppliers to meet our needs would seriously harm our ability to timely fill
customer orders. If any of our manufacturers terminates its relationship with us or is
unable to produce sufficient quantities of our products in a timely manner and
at satisfactory quality levels, our ability to fill customer orders on time,
our reputation and our operating results will suffer. Our contract
manufacturers do not have a long-term obligation to supply products to us.
Qualifying new contract manufacturers and starting volume production is
expensive and time consuming and would disrupt our business. We purchase several key components, including field programmable gate
arrays, some integrated circuits and memory devices, and power supplies from a
single source or a limited number of sources. We do not have long-term supply
contracts for these components. If our supply of these components is
interrupted, we may be unable to locate an alternate source in a timely manner
or at favorable prices. Interruption or delay in the supply of these
components could cause us to lose sales to existing and potential customers. If any of our significant suppliers were to terminate their relationships with
us or compete against us, our revenue and market share would likely be reduced. Many of our suppliers also have significant development and marketing
relationships with our competitors and have significantly greater financial and
marketing resources than we do. If they develop and market products in the
future in competition with us, or form or strengthen arrangements with our
competitors, our revenue and market share will likely be reduced. PAGE 22 OF 35




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If we fail to predict our manufacturing requirements accurately, we could incur
additional costs or manufacturing delays. We provide forecasts of our demand to our contract manufacturers up to
twelve months before scheduled delivery of products to our customers. If we
overestimate our manufacturing requirements, we may have excess or obsolete
inventory, which could harm our operating results. If we underestimate our
requirements, our contract manufacturers may have an insufficient inventory,
which could interrupt manufacturing of our products and result in delays in
shipments and revenue. If we do not accurately anticipate lead times for
components, we may experience component shortages. If necessary licenses of third-party technology are terminated or become
unavailable or too expensive, our competitive position and our product offering
will suffer. We license from third-party suppliers certain software applications
incorporated in our IP Service Delivery Platform. Also, we may need to license
technology from other third-party suppliers to enable us to develop new
products or features. Our inability to renew or obtain any third-party license
that we need could require us to obtain substitute technology of lower quality
or at greater cost. These outcomes could seriously impair our ability to sell
our products and could harm our operating results. We rely on our intellectual property rights to be competitive, and if we are
unable to protect these rights, we may never become profitable. We rely on a combination of copyright, trademark, patent and trade secret
laws and restrictions on disclosure to protect our intellectual property
rights. Monitoring unauthorized use of our products is difficult, and we
cannot be certain that the steps we have taken will prevent unauthorized use of
our technology. If we are unable to protect our intellectual property rights,
our ability to supply our products as they have been designed could suffer, and
our ability to become profitable could be harmed. If we become involved in an intellectual property dispute, we could be subject
to significant liability, the time and attention of our management could be
diverted and we could be prevented from selling our products. We may become a party to litigation in the future to protect our
intellectual property or because others may allege infringement of their
intellectual property. These claims and any resulting lawsuit could subject us
to significant liability for damages or invalidate our proprietary rights.
These lawsuits, regardless of their merits, likely would be time-consuming and
expensive to resolve and would divert management time and attention. Any
potential intellectual property litigation alleging our infringement of a
third-partys intellectual property also could force us to:  
    
    stop selling products or services that use the challenged
intellectual property;
    
    obtain from the owner of the infringed intellectual property
right a license to sell the relevant technology, which license may
not be available on reasonable terms, or at all; or
    
    redesign those products or services that use the infringed
technology. If we become subject to unfair hiring claims, we could be prevented from hiring
needed personnel, or from pursuing or implementing our research, and could
incur substantial liabilities or costs. Companies in our industry whose employees accept positions with
competitors frequently claim that these competitors have engaged in unfair
hiring practices or that the employment of these persons would involve the
disclosure or use of trade secrets or information subject to an obligation of
confidentiality. We have been threatened with claims like these in the past
and may receive claims of this kind in the future. These claims could prevent
us from hiring personnel or from using the knowledge and experience brought to
us by the personnel whom we hire. We could also incur substantial costs and
damages in defending against these claims, regardless of their merits.
Defending ourselves against such claims could divert the attention of our
management away from our operations. Insiders continue to have substantial control over us and they could delay or
prevent a change in our corporate control even if our other stockholders wanted
it to occur. PAGE 23 OF 35




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Our executive officers, directors and principal stockholders who hold 5%
or more of the outstanding common stock and their affiliates beneficially own a
significant portion of our outstanding common stock. These stockholders will
be able to exercise significant control over all matters requiring stockholder
approval, including the election of directors and approval of significant
corporate transactions. This could delay or prevent an outside party from
acquiring or merging with us even if our other stockholders wanted it to occur. If we cannot obtain director and officer liability insurance in acceptable
amounts for acceptable rates, we may have difficulty recruiting and retaining
qualified directors and officers. Like most other public companies, we carry insurance protecting our
officers and directors against claims relating to the conduct of our business.
This insurance covers, among other things, the costs incurred by companies and
their management to defend against and resolve claims relating to management
conduct and results of operations, such as securities class action claims.
These claims typically are expensive to defend against and resolve. We pay
significant premiums to acquire and maintain this insurance, which is provided
by third-party insurers, and we agree to underwrite a portion of such exposures
under the terms of the insurance coverage. One consequence of the current
economic downturn and decline in stock prices has been a substantial increase
in the number of securities class actions and similar claims brought against
public corporations and their management, including our company and certain of
our current and former officers and directors. Consequently, insurers providing
director and officer liability insurance have in recent periods sharply
increased the premiums they charge for this insurance, raised retentions (that
is, the amount of liability that a company is required to pay to defend and
resolve a claim before any applicable insurance is provided), and limited the
amount of insurance they will provide. Moreover, insurers typically provide
only one-year policies. The insurance policies that may cover the current
securities lawsuit against us have a $250,000 retention. As a result, the costs
we incur in defending this lawsuit will not be reimbursed until they exceed
$250,000. The policies that would cover any future lawsuits may not provide any
coverage to us and may cover the directors and officers only in the event we
are unwilling or unable to cover their costs in defending against and resolving
any future claims. As a result, our costs in defending any future lawsuits
could increase significantly. Particularly in the current economic environment,
we cannot assure you that in the future we will be able to obtain sufficient
director and officer liability insurance coverage at acceptable rates and with
acceptable deductibles and other limitations. Failure to obtain such insurance
could materially harm our financial condition in the event that we are required
to defend against and resolve any future or existing securities class actions
or other claims made against us or our management arising from the conduct of
our operations. Further, the inability to obtain such insurance in adequate
amounts may impair our future ability to retain and recruit qualified officers
and directors. Fluctuations in demand can lead to impairment of the value of our long-lived
assets. Fluctuations in demand can also lead to the consideration of asset
impairment charges. The carrying value of property, plant and equipment is
reviewed if the facts and circumstances suggest that property, plant and
equipment may be impaired. An impairment review requires management to make
certain estimates and judgments regarding future cash flows that management
expects to be generated by groups of assets. We evaluate the carrying value of our long-lived assets, consisting
primarily of property, plant and equipment, whenever certain events or changes
in circumstances indicate that the carrying amount of these assets may not be
recoverable. In assessing the recoverability of long-lived assets, we compare
the carrying value to the undiscounted future cash flows the assets are
expected to generate. If the total of the undiscounted future cash flows is
less than the carrying amount of the assets, the assets will be written down to
their estimated fair value. 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. For example, we recorded a
write-down of $15.5 million in fiscal year 2002. Changes in these estimates
could have a material adverse effect on the assessment of the long-lived
assets, thereby requiring us to record further asset write-downs in the future. 
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Interest Rate Sensitivity PAGE 24 OF 35




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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, 2004 based on a modeling technique that measures hypothetical fair
market value changes that would result from a parallel shift in the yield curve
of plus or minus 100 basis points. Based on this analysis, a hypothetical 100
basis point increase or decrease in interest rates would result in a $106,000
decrease or increase, respectively, in the fair value of our investments in
debt securities as of March 31, 2004. Exchange Rate Sensitivity Currently, all of our revenue and most of our expenses are denominated in
U.S. dollars. However, since a portion of our operations sales and service
activities are outside of the U.S., we have entered into transactions in other
currencies. We are primarily exposed to changes in exchange rates for the Euro,
Japanese Yen, and British Pound. Because we transact expenses only in foreign
currency, we are adversely affected by a weaker U.S. dollar relative to major
currencies worldwide. Additionally, because some of our obligations are
denominated in foreign currencies, a weaker U.S. dollar creates foreign
exchange losses. We have not engaged in any foreign exchange hedging
activities to date. 
 ITEM 4. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures. The Securities and Exchange
Commission defines the term disclosure controls and procedures to mean a
companys controls and other procedures that are designed to ensure that
information required to be disclosed in the reports that it files or submits
under the Securities Exchange Act of 1934 is recorded, processed, summarized
and reported, within the time periods specified in the Commissions rules and
forms. While our disclosure controls and procedures are designed to provide
reasonable assurance of achieving their objectives, the design of any system of
controls is based in part upon certain assumptions about the likelihood of
future events, and there can be no assurance that any design will succeed in
achieving its stated goals under all potential future conditions regardless of
how remote. Our president and chief executive officer and our executive vice
president and chief financial officer have concluded, based on the evaluation
of the effectiveness of the disclosure controls and procedures by our
management, as of the end of the period covered by this report, that our
disclosure controls and procedures were generally effective for this purpose. Changes in Internal Controls.There were no changes in our internal control
over financial reporting during the fiscal quarter ending March 31, 2004 that
have materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting. In connection with the audit of our financial statements for the fiscal
year ended December 31, 2003, our management and our independent auditors
reported to our Audit Committee two matters involving internal controls that
our independent auditors considered to be reportable conditions, but that were
not material weaknesses, under standards established by the American Institute
of Certified Public Accountants.  
    
    The first matter related to revenue recognition control processes.
The annual audit process identified instances of a lack of timely
communication between the sales and finance departments for certain
contractual terms and an instance of incorrect interpretation of the
accounting literature for a certain type of transaction.
    
    The second matter related to the financial close process. Certain
adjustments were identified in the annual audit process, related to
stock-based compensation amortization, a balance sheet adjustment for
a specific fixed asset PAGE 25 OF 35




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capitalization, foreign income tax accruals and inventory reserves. In
addition, there were instances where accounting analyses did not include
evidence of a timely review of the accounting entries by our finance
department. In response to these observations, we instituted additional processes and
procedures in the first quarter of 2004 to improve internal control over
revenue recognition and the financial close processes. With respect to the
revenue recognition process, we have reviewed our key procedures and have
realigned those procedures to improve communications between the sales, finance
and legal departments, updated documentation requirements, and ensured that key
sales and finance staff members have completed updated formal revenue
recognition-related training. With respect to the financial close process, we
have also reviewed key procedures and have realigned those procedures to
improve the accuracy of the process as well as provide enhanced evidence of
timely review. While our president and chief executive officer and our executive vice
president and chief financial officer believe that we have taken the necessary
steps to resolve the reportable conditions discussed above, we intend to
continue to refine our internal control processes on an ongoing basis. 
 PART II. OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS On November 15, 2001, CoSine and certain of its officers and directors
were named as defendants in a securities class action lawsuit filed in the
United States District Court, Southern District of New York. The complaint
generally alleges that various investment bank underwriters engaged in improper
and undisclosed activities related to the allocation of shares in CoSines
initial public offering. The complaint brings claims for the violation of
several provisions of the federal securities laws against those underwriters,
and also against the Company and each of the directors and officers who signed
the registration statement relating to the initial public offering. Various
plaintiffs have filed similar actions asserting virtually identical allegations
against more than 250 other companies. The lawsuit and all other IPO
allocation securities class actions currently pending in the Southern District
of New York have been assigned to Judge Shira A. Scheindlin for coordinated
pretrial proceedings. In October 2002, the individual defendants were dismissed
without prejudice pursuant to a stipulation. The issuer defendants filed a

coordinated motion to dismiss on common pleading issues, which the Court
granted in part and denied in part in an order dated February 19, 2003. The
Courts order dismissed the Section 10(b) and Rule 10b-5 claims against the
Company but did not dismiss the Section 11 claims against the Company. In June 2003, the plaintiffs in all of the cases presented a settlement
proposal to all of the issuer defendants. Under the proposed settlement, the
plaintiffs will dismiss and release all claims against participating issuer
defendants in exchange for a contingent payment guaranty by the insurance
companies collectively responsible for insuring the issuer defendants in all of
the related cases, and the assignment or surrender to the plaintiffs of certain
claims the issuer defendants may have against the underwriters. Under the
guaranty, the insurers will be required to pay the amount, if any, by which $1
billion exceeds the aggregate amount ultimately collected by the plaintiffs
from the underwriter defendants in all the cases, up to the limits of the
applicable insurance policies. The Company will not be required to make any
cash payments under the settlement, unless the Companys insurer is required to
pay on the Companys behalf an amount that exceeds the Companys insurance
coverage. The Company does not believe that this circumstance will occur. In
July 2003, a special committee of the Companys Board of Directors approved the
proposed settlement. The settlement is subject to acceptance by a substantial
majority of the issuer defendants, and execution of a definitive settlement
agreement. The settlement is also subject to approval of the court, which
cannot be assured. If the settlement is not consummated, the Company intends 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. In the ordinary course of business, CoSine is involved in legal
proceedings involving contractual obligations, employment relationships and
other matters. Except as described above, CoSine does not believe there are
any pending or threatened legal proceedings that will have a material impact on
its financial position or results of operations. PAGE 26 OF 35




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ITEM 2. CHANGES IN SECURITIES; USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY
SECURITIES  (a)
    
    On September 25, 2000, in connection with our initial public
offering, a Registration Statement on Form S-1 (File No. 333-35938)
was declared effective by the Securities and Exchange Commission,
pursuant to which 1,150,000 shares of our common stock were offered
and sold for our account at a price of $230 per share, generating
gross offering proceeds of $264.5 million. The managing underwriters
were Goldman, Sachs & Co., Chase Securities Inc., Robertson Stephens,
Inc. and JP Morgan Securities Inc. Our initial public offering closed
on September 29, 2000. The net proceeds of the initial public
offering were approximately $242.5 million after deducting
approximately $18.5 million of underwriting discounts and
approximately $3.5 million of other offering expenses.We did not pay directly or indirectly any of the underwriting discounts
or other related expenses of the initial public offering to any of our
directors or officers, any person owning 10% or more of any class of
our equity securities, or any of our affiliates.We have used approximately $192 million of the funds from the initial
public offering to fund our operations. We expect to use the remaining
net proceeds for general corporate purposes, to fund our operations,
working capital and capital expenditures. Pending further use of the
net proceeds, we have invested them in short-term, interest-bearing,
investment-grade securities.(e)
    
    The following table provides information about purchases by the
Company during the quarter ended March 31, 2004 of equity securities
that are registered by the Company pursuant to Section 12 of the
Exchange Act: ISSUER PURCHASES OF EQUITY SECURITIES Total number ofShares that
    
    Maximum Number ofPurchased as Part
    
    Shares that May YetTotal Number of
    
    Average Price Paid
    
    of Publicly
    
    be Purchased UnderShares Purchased
    
    per Share
    
    Announced Plans
    
    the PlansJanuary 1, 2004  January 31,
2004
    
    
    11,549
    
    
    $
    43.44
    
    
    not applicable
    
    not applicableFebruary 1, 2004  February 29,
2004
    
    
    
    
    
    
    
    
    
    not applicable
    
    not applicableMarch 1, 2004  March 31,
2004
    
    
    9,600
    
    
    $
    45.39
    
    
    not applicable
    
    not applicableTotal
    
    
    21,149
    
    
    $
    44.51
 Under our 1997 Plan, we are authorized to repurchase shares of our common
stock that were previously issued pursuant to the exercise of stock options
granted under the 1997 Plan. Such common stock is reacquired by us privately
pursuant to repurchase rights contained in restricted stock purchase agreements
or pursuant to optionee defaults on promissory notes issued in connection with
the exercise of such options. All shares repurchased in the first quarter of
2004 were reacquired pursuant to optionee defaults on promissory notes and were
therefore non-cash. As of the date of this report, 160,850 outstanding shares
remain subject to the foregoing repurchase right 
 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K  (a)
    
    Exhibit Index on page 32.(b)
    
    Reports on Form 8-K.On February 17, 2004, the Company issued a press release in which it
reported earnings for the quarter and year ended December 31, 2003. A
copy of such press release was furnished by the Company with a Form 8-K
on February 17, 2004 as Exhibit 99.1. PAGE 27 OF 35




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SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized. COSINE COMMUNICATIONS, INC.By:
    
    /s/ Terry GibsonTerry Gibson
Executive Vice President and Chief
Financial Officer
(Principal Financial and Accounting Officer)
 Dated: May 13, 2004 PAGE 28 OF 35




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EXHIBIT INDEX Exhibit Number
    
    Description31.1
    
    Certification of Stephen Goggiano, President and Chief
Executive Officer of CoSine Communications, Inc., pursuant
to 15 U.S.C. Section 7241, as adopted pursuant to Section
302 of the Sarbanes-Oxley Act of 200231.2
    
    Certification of Terry Gibson, Executive Vice President and
Chief Financial Officer of CoSine Communications, Inc.,
pursuant to 15 U.S.C. Section 7241, as adopted pursuant to
Section 302 of the Sarbanes-Oxley Act of 200232.1
    
    Certification of Stephen Goggiano, President and Chief
Executive Officer of CoSine Communications, Inc., pursuant
to 18 U.S.C. Section 1350, as adopted pursuant to Section
906 of the Sarbanes-Oxley Act of 200232.2
    
    Certification of Terry Gibson, Executive Vice President and
Chief Financial Officer of CoSine Communications, Inc.,
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
 PAGE 29 OF 35