##### Table of Contents



---

---

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549



---



FORM 10-Q



---



(MARK ONE)

|    |  |                                                                                        
|--- |  | ---------------------------------------------------------------------------------------
|[X] |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2002

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)
|                                                                             
|3200 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 [   ]

There were 101,564,769 shares of the Companys Common Stock, par value
$.0001, outstanding on July 31, 2002.



---

---

Page 1 of 25



---

TABLE OF CONTENTS



|                              |                                                                                               |                                            |  |  |  |  |  | 
|----------------------------- | --------------------------------------------------------------------------------------------- | ------------------------------------------ |  |  |  |  |  | 
|PART I. FINANCIAL INFORMATION
|                              | ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS                                                    
|                              |                                                                                               | CONSOLIDATED BALANCE SHEETS               
|                              |                                                                                               | CONSOLIDATED STATEMENTS OF OPERATIONS     
|                              |                                                                                               | CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                              |                                                                                               | NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
|                              | ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|                              | ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK                           
|PART II. OTHER INFORMATION   
|                              | ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS                                            
|                              | ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS                                    
|                              | ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K                                                     
|SIGNATURE                    



---



##### Table of Contents



COSINE COMMUNICATIONS, INC.

FORM 10-Q

Quarter ended June 30, 2002

TABLE OF CONTENTS

|                                                                                              |                                                                                                          |  |      |   | 
|--------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------- |  | ---- | - | 
|                                                                                              |                                                                                                          |  | Page
|                                                                                              |                                                                                                          |  |     
|PART I                                                                                        |                                                                                                          |  |      |  
|                                                                                             
|Item 1. Consolidated Financial Statements:                                                    |                                                                                                          |  |      |  
|                                                                                              | Consolidated Balance Sheets as of June 30, 2002 and December 31, 2001                                    |  |      | 3 | 
|                                                                                              | Consolidated Statements of Operations for the Three and Six Months Ended June
30, 2002 and June 30, 2001 |  |      | 4 | 
|                                                                                              | Consolidated Statements of Cash Flows for the Three and Six Months Ended June
30, 2002 and June 30, 2001 |  |      | 5 | 
|                                                                                              | Notes to Consolidated Financial Statements                                                               |  |      | 6 | 
|Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations |                                                                                                          |  | 10   |  
|Item 3. Quantitative and Qualitative Disclosures About Market Risk                            |                                                                                                          |  | 23   |  
|                                                                                             
|PART II                                                                                       |                                                                                                          |  |      |  
|Item 2. Changes in Securities and Use of Proceeds                                             |                                                                                                          |  | 23   |  
|Item 4. Submission of Matters to Vote of Security Holders                                     |                                                                                                          |  | 23   |  
|Item 6. Exhibits and Reports on Form 8-K                                                      |                                                                                                          |  | 24   |  
|                                                                                             
|Signature                                                                                     |                                                                                                          |  | 25   |  

Page 2 of 25



---



##### Table of Contents






PART I. FINANCIAL INFORMATION




ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS




COSINE COMMUNICATIONS, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except for share data)

|                                                         |                                                                                                                                                                               |                                                                                                                      |                            |          |       |             |         |              |        |         |  | 
|-------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------- | -------------------------- | -------- | ----- | ----------- | ------- | ------------ | ------ | ------- |  | 
|                                                         |                                                                                                                                                                               |                                                                                                                      |                            |          |       | June 30,    |         | December 31,
|                                                         |                                                                                                                                                                               |                                                                                                                      |                            |          |       | 2002        |         | 2001        
|                                                         |                                                                                                                                                                               |                                                                                                                      |                            |          |       |             |         |             
|                                                         |                                                                                                                                                                               |                                                                                                                      |                            |          |       | (Unaudited) |         | (1)         
|ASSETS                                                   |                                                                                                                                                                               |                                                                                                                      |                            |          |       |             |         |             
|Current assets:                                          |                                                                                                                                                                               |                                                                                                                      |                            |          |       |             |         |             
|                                                         | Cash and cash equivalents                                                                                                                                                     |                                                                                                                      | $                          | 22,895   |       |             | $       | 73,868       |       
|                                                         | Short-term investments                                                                                                                                                        |                                                                                                                      |                            | 104,653  |       |             |         | 91,010       |       
|                                                         | Accounts receivable:                                                                                                                                                          |                                                                                                                      |                            |          |       |             |         |              |       
|                                                         |                                                                                                                                                                               | Trade (net of allowance for doubtful accounts of $233 and $700
at June 30, 2002 and December 31, 2001, respectively) |                            |          | 4,681 |             |         |              | 13,978 |        
|                                                         |                                                                                                                                                                               | Other                                                                                                                |                            |          | 987   |             |         |              | 1,277  |        
|                                                         | Inventory                                                                                                                                                                     |                                                                                                                      |                            | 4,906    |       |             |         | 5,229        |       
|                                                         | Prepaid expenses and other current assets                                                                                                                                     |                                                                                                                      |                            | 5,600    |       |             |         | 5,736        |       
|                                                         |                                                                                                                                                                               |                                                                                                                      |                            |          |       |             |         |             
|                                                         |                                                                                                                                                                               |                                                                                                                      | Total current assets       |          |       | 143,722     |         |              |        | 191,098 | 
|                                                         | Property and equipment, net                                                                                                                                                   |                                                                                                                      |                            | 4,150    |       |             |         | 28,724       |       
|                                                         | Long-term deposits                                                                                                                                                            |                                                                                                                      |                            | 1,115    |       |             |         | 1,136        |       
|                                                         | Other assets                                                                                                                                                                  |                                                                                                                      |                            | 73       |       |             |         | 245          |       
|                                                         |                                                                                                                                                                               |                                                                                                                      |                            |          |       |             |         |             
|                                                         |                                                                                                                                                                               | $                                                                                                                    | 149,060                    |          |       | $           | 221,203 |             
|                                                         |                                                                                                                                                                               |                                                                                                                      |                            |          |       |             |         |             
|LIABILITIES AND STOCKHOLDERS EQUITY                     |                                                                                                                                                                               |                                                                                                                      |                            |          |       |             |         |             
|Current liabilities:                                     |                                                                                                                                                                               |                                                                                                                      |                            |          |       |             |         |             
|                                                         | Accounts payable                                                                                                                                                              |                                                                                                                      | $                          | 1,598    |       |             | $       | 3,210        |       
|                                                         | Provision for warranty claims                                                                                                                                                 |                                                                                                                      |                            | 1,666    |       |             |         | 2,505        |       
|                                                         | Accrued other liabilities                                                                                                                                                     |                                                                                                                      |                            | 7,857    |       |             |         | 8,989        |       
|                                                         | Accrued compensation                                                                                                                                                          |                                                                                                                      |                            | 2,835    |       |             |         | 4,221        |       
|                                                         | Deferred revenue                                                                                                                                                              |                                                                                                                      |                            | 1,800    |       |             |         | 2,713        |       
|                                                         | Current portion of equipment and working capital loans                                                                                                                        |                                                                                                                      |                            | 2,303    |       |             |         | 2,549        |       
|                                                         | Current portion of obligations under capital lease                                                                                                                            |                                                                                                                      |                            | 3,473    |       |             |         | 3,487        |       
|                                                         |                                                                                                                                                                               |                                                                                                                      |                            |          |       |             |         |             
|                                                         |                                                                                                                                                                               |                                                                                                                      | Total current liabilities  |          |       | 21,532      |         |              |        | 27,674  | 
|Long-term portion of equipment and working capital loans |                                                                                                                                                                               |                                                                                                                      | 838                        |          |       |             | 1,992   |             
|Long-term portion of obligations under capital lease     |                                                                                                                                                                               |                                                                                                                      | 218                        |          |       |             | 1,905   |             
|Accrued rent                                             |                                                                                                                                                                               |                                                                                                                      | 2,712                      |          |       |             | 2,556   |             
|Other long-term liabilities                              |                                                                                                                                                                               |                                                                                                                      | 13                         |          |       |             | 11      |             
|                                                        
|Commitments and contingencies                            |                                                                                                                                                                               |                                                                                                                      |                            |          |       |             |         |             
|                                                        
|Stockholders equity:                                    |                                                                                                                                                                               |                                                                                                                      |                            |          |       |             |         |             
|                                                         | Preferred stock, 3,000,000 authorized, none issued and outstanding                                                                                                            |                                                                                                                      |                            |         |       |             |         |             |       
|                                                         | Common stock, $.0001 par value, 300,000,000 shares authorized;
101,564,769 and 102,020,060 shares issued and outstanding at
June 30, 2002 and December 31, 2001, respectively |                                                                                                                      |                            | 10       |       |             |         | 10           |       
|                                                         | Additional paid-in capital                                                                                                                                                    |                                                                                                                      |                            | 565,252  |       |             |         | 575,885      |       
|                                                         | Notes receivable from stockholders                                                                                                                                            |                                                                                                                      |                            | (18,700  | )     |             |         | (25,466      | )     
|                                                         | Accumulated other comprehensive income                                                                                                                                        |                                                                                                                      |                            | 535      |       |             |         | 481          |       
|                                                         | Deferred compensation                                                                                                                                                         |                                                                                                                      |                            | (6,123   | )     |             |         | (14,321      | )     
|                                                         | Accumulated deficit                                                                                                                                                           |                                                                                                                      |                            | (417,227 | )     |             |         | (349,524     | )     
|                                                         |                                                                                                                                                                               |                                                                                                                      |                            |          |       |             |         |             
|                                                         |                                                                                                                                                                               |                                                                                                                      | Total stockholders equity |          |       | 123,747     |         |              |        | 187,065 | 
|                                                         |                                                                                                                                                                               |                                                                                                                      |                            |          |       |             |         |             
|                                                         |                                                                                                                                                                               | $                                                                                                                    | 149,060                    |          |       | $           | 221,203 |             
|                                                         |                                                                                                                                                                               |                                                                                                                      |                            |          |       |             |         |             

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, 2001.

Page 3 of 25



---



##### Table of Contents






COSINE COMMUNICATIONS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except for per share data)
(Unaudited)

|                                            |                                      |                               |         |                    |        |                  |         |        |        |      |         |        |        |   |         |        |        | 
|------------------------------------------- | ------------------------------------ | ----------------------------- | ------- | ------------------ | ------ | ---------------- | ------- | ------ | ------ | ---- | ------- | ------ | ------ | - | ------- | ------ | ------ | 
|                                            |                                      |                               |         | Three Months Ended |        | Six Months Ended
|                                            |                                      |                               |         | June 30,           |        | June 30,        
|                                            |                                      |                               |         |                    |        |                 
|                                            |                                      |                               |         | 2002               |        | 2001             |         | 2002   |        | 2001
|                                            |                                      |                               |         |                    |        |                  |         |        |        |     
|Revenue                                     |                                      | $                             | 6,066   |                    |        | $                | 7,127   |        |        | $    | 13,159  |        |        | $ | 13,182  |       
|                                            | Cost of goods sold1                  |                               |         | 5,988              |        |                  |         | 4,442  |        |      |         | 9,355  |        |   |         | 13,287 |       
|                                            |                                      |                               |         |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|Gross profit (loss)                         |                                      |                               | 78      |                    |        |                  | 2,685   |        |        |      | 3,804   |        |        |   | (105    | )     
|                                            |                                      |                               |         |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|Operating expenses:                         |                                      |                               |         |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|                                            | Research and development2            |                               |         | 10,304             |        |                  |         | 17,348 |        |      |         | 23,135 |        |   |         | 36,045 |       
|                                            | Sales and marketing3                 |                               |         | 7,749              |        |                  |         | 18,404 |        |      |         | 18,628 |        |   |         | 34,774 |       
|                                            | General and administrative4          |                               |         | 3,210              |        |                  |         | 6,596  |        |      |         | 7,060  |        |   |         | 13,579 |       
|                                            | Restructuring and impairment charges |                               |         | 24,046             |        |                  |         | 1,989  |        |      |         | 24,046 |        |   |         | 1,989  |       
|                                            |                                      |                               |         |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|                                            |                                      | Total operating expenses      |         |                    | 45,309 |                  |         |        | 44,337 |      |         |        | 72,869 |   |         |        | 86,387 | 
|                                            |                                      |                               |         |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|Loss from operations                        |                                      |                               | (45,231 | )                  |        |                  | (41,652 | )      |        |      | (69,065 | )      |        |   | (86,492 | )     
|                                            |                                      |                               |         |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|Other income (expenses):                    |                                      |                               |         |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|                                            | Interest income and other            |                               |         | 885                |        |                  |         | 3,206  |        |      |         | 2,228  |        |   |         | 7,001  |       
|                                            | Interest expense5                    |                               |         | (264               | )      |                  |         | (450   | )      |      |         | (567   | )      |   |         | (938   | )     
|                                            |                                      |                               |         |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|                                            |                                      | Total other income (expenses) |         |                    | 621    |                  |         |        | 2,756  |      |         |        | 1,661  |   |         |        | 6,063  | 
|                                            |                                      |                               |         |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|Loss before income tax provision            |                                      |                               | (44,610 | )                  |        |                  | (38,896 | )      |        |      | (67,404 | )      |        |   | (80,429 | )     
|                                            | Income tax provision                 |                               |         | 138                |        |                  |         | 198    |        |      |         | 299    |        |   |         | 511    |       
|                                            |                                      |                               |         |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|Net loss                                    |                                      | $                             | (44,748 | )                  |        | $                | (39,094 | )      |        | $    | (67,703 | )      |        | $ | (80,940 | )     
|                                            |                                      |                               |         |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|Basic and diluted net loss per common share |                                      | $                             | (0.46   | )                  |        | $                | (0.41   | )      |        | $    | (0.70   | )      |        | $ | (0.85   | )     
|                                            |                                      |                               |         |                    |        |                  |         |        |        |      |         |        |        |   |         |       
|Shares used in computing per share amounts  |                                      |                               | 96,731  |                    |        |                  | 96,355  |        |        |      | 96,467  |        |        |   | 95,667  |       
|                                            |                                      |                               |         |                    |        |                  |         |        |        |      |         |        |        |   |         |       



---

| |  | 1 Cost of goods sold includes $280 and $384 for the three months ended June 30,
2002 and 2001, respectively, and $630 and $1,265 for the six months ended 2002
and 2001, respectively, of non-cash charges related to equity issuances.                       
| |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
|
|
|
| |  | 2 Research and development expenses include $507 and $1,775 for the three
months ended June 30, 2002 and 2001, respectively, and $1,640 and $7,020 for
the six months ended 2002 and 2001, respectively, of non-cash charges related
to equity issuances.     
|
|
|
|
| |  | 3 Sales and marketing expenses include $(588) and $5,738 for the three months
ended June 30, 2002 and 2001, respectively, and $330 and $9,468 for the six
months ended 2002 and 2001, respectively, of non-cash (credits) charges related
to equity issuances.
|
|
|
|
| |  | 4 General and administrative expenses include $348 and $1,298 for the three
months ended June 30, 2002 and 2001, respectively, and $990 and $3,597 for the
six months ended 2002 and 2001, respectively, of non-cash charges related to
equity issuances.     
|
|
|
|
| |  | 5 Interest expense includes $35 and $41 for the three months ended June 30,
2002 and 2001, respectively, and $70 and $83 for the six months ended 2002 and
2001, respectively, of non-cash charges related to equity issuances.                               

See accompanying notes.

Page 4 of 25



---



##### Table of Contents






COSINE COMMUNICATIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

|                                                                             |                                                     |   |                                           |         |                  |        |         |        |   |        |  
|---------------------------------------------------------------------------- | --------------------------------------------------- | - | ----------------------------------------- | ------- | ---------------- | ------ | ------- | ------ | - | ------ | -
|                                                                             |                                                     |   |                                           |         | Six Months Ended
|                                                                             |                                                     |   |                                           |         | June 30,        
|                                                                             |                                                     |   |                                           |         |                 
|                                                                             |                                                     |   |                                           |         | 2002             |        | 2001   
|                                                                             |                                                     |   |                                           |         |                  |        |        
|Operating activities:                                                        |                                                     |   |                                           |         |                  |        |         |       
|Net loss                                                                     |                                                     | $ | (67,703                                   | )       |                  | $      | (80,940 | )     
|Adjustments to reconcile net loss to net cash used in operating
activities:  |                                                     |   |                                           |         |                  |        |         |       
|                                                                             | Depreciation                                        |   |                                           | 8,724   |                  |        |         | 6,412  |  
|                                                                             | Allowance for doubtful accounts                     |   |                                           | 296     |                  |        |         | 724    |  
|                                                                             | Non-cash charges related to inventory write-down    |   |                                           | 1,692   |                  |        |         | 7,032  |  
|                                                                             | Write-down
of property and capital equipment        |   |                                           | 18,068  |                  |        |         |       |  
|                                                                             | Amortization of warrants issued for services        |   |                                           | 102     |                  |        |         | 5,146  |  
|                                                                             | Amortization of deferred stock compensation         |   |                                           | 3,558   |                  |        |         | 18,577 |  
|                                                                             | Other, net                                          |   |                                           | 159     |                  |        |         | 675    |  
|                                                                             | Change in operating assets and liabilities:         |   |                                           |         |                  |        |         |        |  
|                                                                             |                                                     |   | Accounts receivable, trade                |         |                  | 9,001  |         |        |   | (5,597 | )
|                                                                             |                                                     |   | Other receivables                         |         |                  | 290    |         |        |   | (220   | )
|                                                                             |                                                     |   | Inventory                                 |         |                  | (1,369 | )       |        |   | (7,554 | )
|                                                                             |                                                     |   | Prepaid expenses and other current assets |         |                  | 116    |         |        |   | 1,410  |  
|                                                                             |                                                     |   | Long-term deposits                        |         |                  | 21     |         |        |   | 66     |  
|                                                                             |                                                     |   | Other assets                              |         |                  | 172    |         |        |   | (82    | )
|                                                                             |                                                     |   | Accounts payable                          |         |                  | (1,612 | )       |        |   | (3,654 | )
|                                                                             |                                                     |   | Provision for warranty claims             |         |                  | (839   | )       |        |   | (1,647 | )
|                                                                             |                                                     |   | Accrued other liabilities                 |         |                  | (1,132 | )       |        |   | 3,195  |  
|                                                                             |                                                     |   | Accrued compensation                      |         |                  | (1,386 | )       |        |   | 416    |  
|                                                                             |                                                     |   | Note payable                              |         |                  |       |         |        |   | (223   | )
|                                                                             |                                                     |   | Deferred revenue                          |         |                  | (913   | )       |        |   | (1,747 | )
|                                                                             |                                                     |   | Accrued rent                              |         |                  | 156    |         |        |   | 216    |  
|                                                                             |                                                     |   | Other liabilities                         |         |                  | 2      |         |        |   | 90     |  
|                                                                             |                                                     |   |                                           |         |                  |        |         |       
|Net cash used in operating activities                                        |                                                     |   | (32,597                                   | )       |                  |        | (57,705 | )     
|                                                                             |                                                     |   |                                           |         |                  |        |         |       
|Investing activities:                                                        |                                                     |   |                                           |         |                  |        |         |       
|Capital expenditures                                                         |                                                     |   | (2,303                                    | )       |                  |        | (10,332 | )     
|Purchase of short-term investments                                           |                                                     |   | (57,553                                   | )       |                  |        | (74,093 | )     
|Proceeds from sales and maturities of short-term investments                 |                                                     |   | 43,808                                    |         |                  |        | 101,655 |       
|                                                                             |                                                     |   |                                           |         |                  |        |         |       
|                                                                             | Net cash (used in) provided by investing activities |   |                                           | (16,048 | )                |        |         | 17,230 |  
|                                                                             |                                                     |   |                                           |         |                  |        |         |       
|Financing activities:                                                        |                                                     |   |                                           |         |                  |        |         |       
|Principal payments of equipment and working capital loans and
capital leases |                                                     |   | (3,101                                    | )       |                  |        | (2,945  | )     
|Proceeds from issuance of common stock, net                                  |                                                     |   | 623                                       |         |                  |        | 410     |       
|Proceeds from notes receivable from stockholders                             |                                                     |   | 234                                       |         |                  |        | 296     |       
|Repurchase of common stock                                                   |                                                     |   | (84                                       | )       |                  |        | (303    | )     
|                                                                             |                                                     |   |                                           |         |                  |        |         |       
|                                                                             | Net cash used in financing activities               |   |                                           | (2,328  | )                |        |         | (2,542 | )
|                                                                             |                                                     |   |                                           |         |                  |        |         |       
|Net decrease in cash and cash equivalents                                    |                                                     |   | (50,973                                   | )       |                  |        | (43,017 | )     
|Cash and cash equivalents at the beginning of the period                     |                                                     |   | 73,868                                    |         |                  |        | 126,139 |       
|                                                                             |                                                     |   |                                           |         |                  |        |         |       
|Cash and cash equivalents at the end of the period                           |                                                     | $ | 22,895                                    |         |                  | $      | 83,122  |       
|                                                                             |                                                     |   |                                           |         |                  |        |         |       
|Supplemental information:                                                    |                                                     |   |                                           |         |                  |        |         |       
|Cash paid for interest                                                       |                                                     | $ | 497                                       |         |                  | $      | 855     |       
|                                                                             |                                                     |   |                                           |         |                  |        |         |       
|Income taxes paid                                                            |                                                     | $ | 299                                       |         |                  | $      | 511     |       
|                                                                             |                                                     |   |                                           |         |                  |        |         |       
|Cancellation of notes receivable due to repurchase of unvested stock         |                                                     | $ | 6,532                                     |         |                  | $      | 4,503   |       
|                                                                             |                                                     |   |                                           |         |                  |        |         |       

See accompanying notes.

Page 5 of 25



---



##### Table of Contents






COSINE COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

The unaudited consolidated financial statements have been prepared by
CoSine Communications, Inc. pursuant to the rules and regulations of the
Securities and Exchange Commission 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 such
rules and regulations. In the opinion of management, all adjustments
(consisting of normal recurring items) necessary for a fair presentation have
been included. The results of operations for the three and six months ended
June 30, 2002 are not necessarily indicative of the results to be expected for
the entire year. These unaudited 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, 2001.

During 2000, CoSine issued warrants to its initial customers, which
significantly affected revenue through December 31, 2001. These warrants were
issued upon receipt of substantial purchase orders, which were preceded by a
period of cooperation with marketing, development and refinement of the
Companys products. Customer revenue consists of receipts from sales,
including equity issued in connection with sales, less receipts for equity
issued in connection with sales. As of December 31, 2001, the value of the
warrants granted to our first three customers was fully amortized and as a
result, our revenue in 2002 is no longer affected by the value of warrants
granted to customers.

Below is a reconciliation of revenue for the three and six months ended
June 30, 2002 and 2001 as presented in our statement of operations to show the
separate components as indicated (in thousands):

|                                                                      |  |                    |       |                  |  |             |       |      |  |   |        |  |  |   |        | 
|--------------------------------------------------------------------- |  | ------------------ | ----- | ---------------- |  | ----------- | ----- | ---- |  | - | ------ |  |  | - | ------ | 
|                                                                      |  | Three Months Ended |       | Six Months Ended
|                                                                      |  | June 30,           |       | June 30,        
|                                                                      |  |                    |       |                 
|                                                                      |  | 2002               |       | 2001             |  | 2002        |       | 2001
|                                                                      |  |                    |       |                  |  |             |       |     
|                                                                      |  |                    |       |                  |  | (unaudited) |       |      |  |  
|Receipts from sales, including equity issued
in connection with sales |  | $                  | 6,066 |                  |  | $           | 8,465 |      |  | $ | 13,159 |  |  | $ | 15,476 | 
|Less: Receipts for equity issued in
connection with sales             |  |                    |      |                  |  |             | 1,338 |      |  |   |       |  |  |   | 2,294  | 
|                                                                      |  |                    |       |                  |  |             |       |      |  |   |        |  |  |   |        | 
|Revenue                                                               |  | $                  | 6,066 |                  |  | $           | 7,127 |      |  | $ | 13,159 |  |  | $ | 13,182 | 
|                                                                      |  |                    |       |                  |  |             |       |      |  |   |        |  |  |   |        | 

2. 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.

3. RECENT ACCOUNTING PRONOUNCEMENTS

In October 2001, the FASB issued Statement of Financial Accounting
Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived
Assets (SFAS 144), which was effective January 1, 2002. SFAS No. 144
supercedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets to be Disposed Of, and the accounting reporting
provisions relating to the disposal of a segment of a business of Accounting
Principles Board Opinion No. 30. The adoption of SFAS No. 144 did not
materially impact the Companys financial statements.

In June 2002, the FASB issued Statement of Financial Accounting Standards
No. 146, Accounting for Costs Associated with Exit or Disposal Activities
(SFAS 146). SFAS 146 nullifies Emerging Issues Task Force Issue No. 94-3,
Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring) (EITF 94-3). The principle difference between SFAS 146 and
EITF 94-3

Page 6 of 25



---



##### Table of Contents



relates to its requirement for recognition of a liability for a cost
associated with an exit or disposal activity. This statement requires that a
liability for a cost associated with an exit or disposal activity be recognized
when the liability is incurred. Under EITF 94-3, a liability for an exit cost
as defined in EITF 94-3 was recognized at the date of an entitys commitment to
an exit plan. This statement also establishes that fair value is the objective
for initial measurement of the liability. SFAS 146 is effective for exit or
disposal activities that are initiated after December 31, 2002.
The Company does not
expect adoption of SFAS 146 to have a material impact on its financial
statements.

4. COMMITMENTS AND CONTINGENCIES

On September 25, 2000, a technology company initiated correspondence with
CoSine asserting that CoSine had used that companys patented technology
without a licensing arrangement. During the first quarter of 2002, the parties
resolved this matter by agreeing to a 5-year license agreement under which
CoSine agreed to make certain royalty payments. The terms of the license
agreement are subject to a confidentiality provision. However, the Company
does not believe that these payments will have a material effect on
its results of operations.

5. INVENTORIES

Net inventories, stated at the lower of cost (first-in, first-out) or
market, consisted of the following, in thousands:

|                    |  |             |       |              |  |   |       | 
|------------------- |  | ----------- | ----- | ------------ |  | - | ----- | 
|                    |  | June 30,    |       | December 31,
|                    |  | 2002        |       | 2001        
|                    |  |             |       |             
|                    |  | (unaudited) |       |              |  |  
|Raw materials       |  | $           | 1,247 |              |  | $ | 1,170 | 
|Semi-finished goods |  |             | 2,928 |              |  |   | 2,952 | 
|Finished goods      |  |             | 731   |              |  |   | 1,107 | 
|                    |  |             |       |              |  |   |       | 
|                    |  | $           | 4,906 |              |  | $ | 5,229 | 
|                    |  |             |       |              |  |   |       | 

Included in net finished goods at June 30, 2002 and December 31, 2001 were
$52,000 and $516,000, respectively, of goods awaiting customer acceptance and
$365,000 and $591,000, respectively, of goods used for customer evaluation
purposes. During the six months ended June 30, 2002, $409,000 of fully
reserved inventory was sold and $1,692,000 of inventory was written down.
During the six months ended June 30, 2001, inventory was written down by
$7,032,000.

6. 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 20,571,000 shares and 15,648,000 shares for the six months ended
June 30, 2002 and 2001, respectively.

The calculations of basic and diluted net loss per share are shown below,
in thousands, except per share data:

|                                              |                                                                             |   |                    |         |                  |   |             |         |      |   |         |         |  |   |         |         | 
|--------------------------------------------- | --------------------------------------------------------------------------- | - | ------------------ | ------- | ---------------- | - | ----------- | ------- | ---- | - | ------- | ------- |  | - | ------- | ------- | 
|                                              |                                                                             |   | Three Months Ended |         | Six Months Ended
|                                              |                                                                             |   | June 30,           |         | June 30,        
|                                              |                                                                             |   |                    |         |                 
|                                              |                                                                             |   | 2002               |         | 2001             |   | 2002        |         | 2001
|                                              |                                                                             |   |                    |         |                  |   |             |         |     
|                                              |                                                                             |   |                    |         |                  |   | (unaudited) |         |      |   |        
|Net loss                                      |                                                                             | $ | (44,748            | )       |                  | $ | (39,094     | )       |      | $ | (67,703 | )       |  | $ | (80,940 | )      
|                                              |                                                                             |   |                    |         |                  |   |             |         |      |   |         |         |  |   |         |        
|Basic and diluted:                            |                                                                             |   |                    |         |                  |   |             |         |      |   |         |         |  |   |         |        
|                                              | Weighted-average shares of common stock
outstanding                         |   |                    | 101,591 |                  |   |             | 102,849 |      |   |         | 101,679 |  |   |         | 103,208 | 
|Weighted-average shares subject to repurchase |                                                                             |   | (4,860             | )       |                  |   | (6,494      | )       |      |   | (5,212  | )       |  |   | (7,541  | )      
|                                              |                                                                             |   |                    |         |                  |   |             |         |      |   |         |         |  |   |         |        
|                                              | Weighted-average shares used in basic and
diluted net loss per common share |   |                    | 96,731  |                  |   |             | 96,355  |      |   |         | 96,467  |  |   |         | 95,667  | 
|                                              |                                                                             |   |                    |         |                  |   |             |         |      |   |         |         |  |   |         |        
|Basic and diluted net loss per common share   |                                                                             | $ | (0.46              | )       |                  | $ | (0.41       | )       |      | $ | (0.70   | )       |  | $ | (0.85   | )      
|                                              |                                                                             |   |                    |         |                  |   |             |         |      |   |         |         |  |   |         |        

Page 7 of 25



---



##### Table of Contents



7. COMPREHENSIVE LOSS

The components of comprehensive loss are shown below, in thousands:

|                          |                                          |                                       |         |                    |     |                  |         |             |      |      |         |      |    |   |         |        |        |  
|------------------------- | ---------------------------------------- | ------------------------------------- | ------- | ------------------ | --- | ---------------- | ------- | ----------- | ---- | ---- | ------- | ---- | -- | - | ------- | ------ | ------ | -
|                          |                                          |                                       |         | Three Months Ended |     | Six Months Ended
|                          |                                          |                                       |         | June 30,           |     | June 30,        
|                          |                                          |                                       |         |                    |     |                 
|                          |                                          |                                       |         | 2002               |     | 2001             |         | 2002        |      | 2001
|                          |                                          |                                       |         |                    |     |                  |         |             |      |     
|                          |                                          |                                       |         |                    |     |                  |         | (unaudited) |      |      |         |     
|Net loss                  |                                          | $                                     | (44,748 | )                  |     | $                | (39,094 | )           |      | $    | (67,703 | )    |    | $ | (80,940 | )     
|Other comprehensive loss: |                                          |                                       |         |                    |     |                  |         |             |      |      |         |      |    |   |         |       
|                          | Unrealized gains (losses) on investments |                                       |         | 198                |     |                  |         | (69         | )    |      |         | (102 | )  |   |         | (1,485 | )     
|                          | Translation adjustment                   |                                       |         | 173                |     |                  |         | (105        | )    |      |         | 156  |    |   |         | (193   | )     
|                          |                                          |                                       |         |                    |     |                  |         |             |      |      |         |      |    |   |         |       
|                          |                                          | Total other comprehensive gain (loss) |         |                    | 371 |                  |         |             | (174 | )    |         |      | 54 |   |         |        | (1,678 | )
|                          |                                          |                                       |         |                    |     |                  |         |             |      |      |         |      |    |   |         |       
|Comprehensive loss        |                                          | $                                     | (44,377 | )                  |     | $                | (39,268 | )           |      | $    | (67,649 | )    |    | $ | (82,618 | )     
|                          |                                          |                                       |         |                    |     |                  |         |             |      |      |         |      |    |   |         |       

8. SEGMENT REPORTING

CoSine operates in only one operating segment, and substantially all of
CoSines assets are located in the United States.

Revenues from customers by geographic region for the three and six months
ended June 30, 2002 and 2001, respectively, were as follows, in thousands:

|                                             |       |                       |                            |            |                      |         |       |       |  |   |       |        | 
|-------------------------------------------- | ----- | --------------------- | -------------------------- | ---------- | -------------------- | ------- | ----- | ----- |  | - | ----- | ------ | 
|                                             |       |                       | Receipts from sales,       |            | Receipts for equity  |         |       |       | 
|                                             |       |                       | including equity issued in |            | issued in connection |         |       |       | 
|Region                                       |       | connection with sales |                            | with sales |                      | Revenue
|                                             |       |                       |                            |            |                      |        
|Three Months Ended
June 30, 2002
(unaudited) |       |                       |                            |            |                      |         |       |       |  |   |       |       
|United States                                |       | $                     | 2,262                      |            |                      | $       |      |       |  | $ | 2,262 |       
|Asia/Pacific                                 |       |                       | 1,921                      |            |                      |         |      |       |  |   | 1,921 |       
|Europe                                       |       |                       | 1,883                      |            |                      |         |      |       |  |   | 1,883 |       
|                                             |       |                       |                            |            |                      |         |       |       |  |   |       |       
|                                             | Total |                       | $                          | 6,066      |                      |         | $     |      |  |   | $     | 6,066  | 
|                                             |       |                       |                            |            |                      |         |       |       |  |   |       |       
|Three Months Ended
June 30, 2001
(unaudited) |       |                       |                            |            |                      |         |       |       |  |   |       |       
|United States                                |       | $                     | 1,026                      |            |                      | $       | 1,314 |       |  | $ | (288  | )     
|Asia/Pacific                                 |       |                       | 1,723                      |            |                      |         |      |       |  |   | 1,723 |       
|Europe                                       |       |                       | 5,716                      |            |                      |         | 24    |       |  |   | 5,692 |       
|                                             |       |                       |                            |            |                      |         |       |       |  |   |       |       
|                                             | Total |                       | $                          | 8,465      |                      |         | $     | 1,338 |  |   | $     | 7,127  | 
|                                             |       |                       |                            |            |                      |         |       |       |  |   |       |       
|Six Months Ended
June 30, 2002
(unaudited)   |       |                       |                            |            |                      |         |       |       |  |   |       |       
|United States                                |       | $                     | 5,702                      |            |                      | $       |      |       |  | $ | 5,702 |       
|Asia/Pacific                                 |       |                       | 3,795                      |            |                      |         |      |       |  |   | 3,795 |       
|Europe                                       |       |                       | 3,662                      |            |                      |         |      |       |  |   | 3,662 |       
|                                             |       |                       |                            |            |                      |         |       |       |  |   |       |       
|                                             | Total |                       | $                          | 13,159     |                      |         | $     |      |  |   | $     | 13,159 | 
|                                             |       |                       |                            |            |                      |         |       |       |  |   |       |       
|Six Months Ended
June 30, 2001
(unaudited)   |       |                       |                            |            |                      |         |       |       |  |   |       |       
|United States                                |       | $                     | 3,842                      |            |                      | $       | 2,112 |       |  | $ | 1,730 |       
|Asia/Pacific                                 |       |                       | 4,871                      |            |                      |         |      |       |  |   | 4,871 |       
|Europe                                       |       |                       | 6,763                      |            |                      |         | 182   |       |  |   | 6,581 |       
|                                             |       |                       |                            |            |                      |         |       |       |  |   |       |       
|                                             | Total |                       | $                          | 15,476     |                      |         | $     | 2,294 |  |   | $     | 13,182 | 
|                                             |       |                       |                            |            |                      |         |       |       |  |   |       |       

9. RESTRUCTURING AND IMPAIRMENT CHARGES

Page 8 of 25



---



##### Table of Contents



Restructuring

In May 2002, CoSines senior management approved a restructuring plan to
reduce the Company's 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 plan. Most of the terminations took place in
the second quarter of 2002, and the remainder will take place in the third
quarter of 2002. The employees in the workforce reduction were from all
functional groups and were located in CoSines offices in the United States,
Europe and Asia. Amounts related to the worldwide workforce reduction will be
paid out through September of 2002, and lease commitments will also be paid out
over the respective lease terms through 2003. 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 restructuring
program was implemented to reduce operating expenses and conserve cash. The
Company also anticipates taking additional charges upon reaching an agreement
to exit a facilities lease for one of its office buildings in Redwood City,
California.

Details of the May 2002 restructuring for the three months ended June 30,
2002 are as follows (in thousands):

|                                   |  |           |        |             |  |             |        |       |  |   |       |   |  |   |        |  
|---------------------------------- |  | --------- | ------ | ----------- |  | ----------- | ------ | ----- |  | - | ----- | - |  | - | ------ | -
|                                   |  |           |        |             |  | Write-down  |        |       |  |   |       |   |  |  
|                                   |  | Worldwide |        | of property |  | Lease       |        |       |  |  
|                                   |  | workforce |        | and         |  | commitments |        |       |  |  
|(unaudited)                        |  | reduction |        | equipment   |  | and other   |        | Total
|                                   |  |           |        |             |  |             |        |      
|Charges                            |  | $         | 3,660  |             |  | $           | 3,248  |       |  | $ | 2,318 |   |  | $ | 9,226  |  
|Cash payments                      |  |           | (2,466 | )           |  |             |       |       |  |   | (50   | ) |  |   | (2,516 | )
|Non-cash charges                   |  |           |       |             |  |             | (3,248 | )     |  |   |      |   |  |   | (3,248 | )
|                                   |  |           |        |             |  |             |        |       |  |   |       |   |  |   |        |  
|Provision balance at June 30, 2002 |  | $         | 1,194  |             |  | $           |       |       |  | $ | 2,268 |   |  | $ | 3,462  |  
|                                   |  |           |        |             |  |             |        |       |  |   |       |   |  |   |        |  

In September 2001, CoSines senior management approved a restructuring
plan to reduce its worldwide workforce, close certain sales offices, exit
certain facilities and idle certain property and equipment. Notification was
given to employees on September 28, 2001 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, approximately 50 employees
were designated for termination in the restructuring plan and were then
terminated in the fourth quarter of 2001. The employees in the workforce
reduction were from all functional groups and were primarily located in
CoSines Redwood City, California offices. In the fourth quarter of 2001, the
Company also wrote down certain property and equipment to its expected
realizable value. Amounts related to the worldwide workforce reduction will be
paid out by the end of 2002, and lease commitments will be paid out over the
respective lease terms through the end of 2002. The restructuring program was
implemented to reduce operating expenses and conserve cash. During the three
months ended June 30, 2002, the Company paid $0.2 million for lease commitments
and other. During the six months ended June 30, 2002, the Company paid $0.4
million in severance costs and $0.6 million for lease commitments and other.
The provision balance at June 30, 2002 amounted to $0.2 million.

For the three months ended June 30, 2001 restructuring charges were $2.0
million reflecting a reclassification of $0.7 million from research and
development expenses, $0.2 million from sales and marketing expenses and $1.1
million from general and administrative expenses to restructuring expenses in
the Statement of Operations.

Impairment of long-lived assets

As a result of CoSines assessment of current market conditions and
related effect on its business plan, the Company concluded that indicators of
impairment of its long-lived assets were present. Accordingly, the Company
performed an impairment test of the carrying value of its long-lived assets,
consisting primarily of property and equipment in accordance with SFAS No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets. Based on an
undiscounted cash flow analysis, the cash flows expected to be generated by
CoSines long-lived assets during their estimated remaining useful lives are
not sufficient to recover the net book value of the assets. Consequently, the
Company obtained a valuation report outlining the estimated fair value of the
assets, based on quoted market prices, from an independent appraiser and recorded an impairment charge of $14.8
million to write the carrying value of its long-lived assets held for use down
to their fair values in the second quarter of 2002.

Page 9 of 25



---



##### Table of Contents






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. These
forward-looking statements are subject to certain risks and uncertainties that
could cause actual results to differ materially from those reflected in these
forward-looking statements. We use words such as anticipate, believe, plan,
expect, future, intend and similar expressions to identify forward-looking
statements. Factors that might cause such a difference include, but are not
limited to, product development, commercialization and technology difficulties,
manufacturing costs, the impact of competitive products, pricing pressures,
changing customer requirements, timely availability and acceptance of new
products, changes in economic conditions in the various markets we serve and
those factors discussed in the section entitled Managements Discussion and
Analysis of Financial Condition and Results of Operations  Risk Factors.
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.

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 computer applications and communications
services from within their networks. 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.

The market for our IP Service Delivery Platform is new and evolving, 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. Long sales and implementation cycles for our platform may cause our
revenue and operating results to vary significantly and unexpectedly from
quarter to quarter.

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, inventory valuation, warranties and
allowances for doubtful accounts. 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 our
judgments and estimates in the preparation of our consolidated financial
statements.

Revenue Recognition

Page 10 of 25



---



##### Table of Contents



Most of our sales are generated from complex arrangements. Recognizing
revenue in these arrangements requires our making significant judgments,
particularly in the areas of collectibility and customer acceptance.

Assessing the collectibility of amounts invoiced to customers is
particularly critical. 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 recognizing revenue
until we have collected payment.

Certain of our sales arrangements require formal acceptance by the
customer. 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 affect the timing of our
revenue.

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. Inventory write-downs are charged to cost of sales. During the
second quarter of 2002, we charged significant inventory write-downs to cost of
sales as the result of reduced forecasted demand for our product. In future
periods, if actual demand for our products is less than our forecasts,
additional inventory write-downs may be required.

Long-lived assets

The Company evaluates 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, the Company
compares 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 the Companys participation in the market. Changes in
these estimates could have a material adverse effect on the assessment of the
long-lived assets, thereby requiring the Company to record further asset
write-downs in the future.

Warranties

When we recognize revenue from each sale, we include estimated warranty
costs in cost of sales. Our warranty obligation is affected by product failure
rates, materials usage and service delivery costs incurred in correcting
product failures. 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.

Allowance for Doubtful Accounts

We maintain allowances for doubtful accounts for estimated losses
resulting from the inability of our customers to pay our invoices. In order to
estimate the appropriate level of this allowance, we analyze historical bad
debts, customer concentrations, current customer credit-worthiness, current
economic trends and changes in our customer payment patterns. In future
periods, if the financial condition of our customers were to deteriorate and
affect their ability to make payments, additional allowances could be required.

Impact of Equity Issuances on Operating Results

Equity issuances have a material impact on our operating results. The
equity issuances that have affected operating results to date include warrants
granted to customers and suppliers, stock options granted to employees and
consultants and stock issued in lieu of cash compensation to suppliers.

Our revenue in 2001 was affected significantly by warrants issued to our
first three customers: Qwest Communications International, Inc., AduroNet
Limited and Broadband Office, Inc. These warrants were issued upon

Page 11 of 25



---



##### Table of Contents



receipt of
substantial purchase orders that were preceded by a period of cooperation with
us in the marketing, development and refinement of our products. Our revenue
from these customers consisted of receipts from sales, including equity issued
in connection with sales, less receipts for equity issued in connection with
sales. As of December 31, 2001, the value of the warrants granted to these
customers was fully amortized and as a result, our revenue in 2002 is no longer
affected by the value of warrants granted to customers.

Our costs of goods sold and operating expenses are also affected
significantly by charges related to warrants
and options issued for services. Furthermore, some of our employee stock
option transactions have resulted in deferred compensation, which is presented
as a reduction to stockholders equity on our balance sheet and is amortized
over the vesting period of the applicable options using the graded vesting
method.

The compensation associated with shares and options relating to the
following transactions is required to be remeasured at the end of each
accounting period. Each remeasurement will result in unpredictable charges or
credits, to be recorded as non-cash charges related to equity issuances in
future periods, depending on future fluctuations in the market price 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 remeasure the compensation
associated with these shares each quarter until the earlier of the vesting
of the shares or the repayment of the amounts owed under the note.
Deferred compensation expense, which is recorded at each remeasurement, is
amortized over the remaining vesting period of the underlying options.

| |                                                                                                                                                                                                                                                                                                                                                            
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Repriced stock options: During the third quarter of 2001, we repriced
7,220,710 unexercised employee stock options to $1.55 per share. These
options had previously been granted at prices ranging from $4.00 to $40.00
per share. The repricing requires that compensation be remeasured for
these options until they expire or are exercised or canceled.

RESULTS OF OPERATIONS

For the three months ended June 30, 2002 and 2001, we reported basic and
diluted net losses per common share of $0.46 and $0.41, respectively. The
effect of equity issuances to customers, suppliers, employees and consultants
increased net loss per common share by $0.01 and $0.11 per share for the three
months ended June 30, 2002 and 2001, respectively.

For the six months ended June 30, 2002 and 2001, we reported basic and
diluted net losses per common share of $0.70 and $0.85, respectively. The
effect of equity issuances to customers, suppliers, employees and consultants
increased net loss per common share by $0.04 and $0.25 per share for the six
months ended June 30, 2002 and 2001, respectively.

Revenue

During 2000, CoSine issued warrants to its first three customers, which
significantly affected revenue through December 31, 2001. These warrants were
issued upon receipt of substantial purchase orders, which were preceded by a
period of cooperation with marketing, development and refinement of the
Companys products. Customer revenue consists of receipts from sales,
including equity issued in connection with sales, less receipts for equity
issued in connection with sales. As of December 31, 2001, the value of the
warrants granted to our first three customers was fully amortized and excluded
from the determination of revenue. As a result, our revenue in 2002 is no
longer affected by the value of warrants granted to customers.

For the three months ended June 30, 2002, revenue was $6.1 million of
which 77% was from hardware sales, 10% was from software sales and 13% was from
sales of services. For the three months ended June 30, 2001, revenue was $7.1
million of which 64% was from hardware sales, 10% was from software sales and
26% was from sales of services. Receipts from sales, including equity issued
in connection with sales, were $8.5 million for the three months ended June 30,
2001. Revenue in the second quarter of 2002 reflected sales to a higher number
of customers; however, order amounts by each customer were lower. The higher
percentage of revenue from sales of services in 2001 was due to sales
agreements to our initial customers that contained larger service elements.

Page 12 of 25



---



##### Table of Contents



For the six months ended June 30, 2002, revenue was $13.2 million of which
77% was from hardware sales, 12% was from software sales and 11% was from sales
of services. For the six months ended June 30, 2001, revenue was $13.2 million
of which 54% was from hardware sales, 11% was from software sales and 35% was
from sales of services. Receipts from sales, including equity issued in
connection with sales, were $15.5 million for the six months ended June 30,
2001. Revenue in the first six months of 2002 reflected sales to a higher
number of customers; however, order
amounts by each customer where lower. The higher percentage of revenue
from sales of services in 2001 was due to sales agreements to our initial
customers that contained larger service elements.

Below is a reconciliation of revenue for the three and six months ended
June 30, 2002 and 2001, as presented in our statement of operations to show the
separate components as indicated (in thousands):

|                                                                      |  |                    |       |                  |  |             |       |      |  |   |        |  |  |   |        | 
|--------------------------------------------------------------------- |  | ------------------ | ----- | ---------------- |  | ----------- | ----- | ---- |  | - | ------ |  |  | - | ------ | 
|                                                                      |  | Three Months Ended |       | Six Months Ended
|                                                                      |  | June 30,           |       | June 30,        
|                                                                      |  |                    |       |                 
|                                                                      |  | 2002               |       | 2001             |  | 2002        |       | 2001
|                                                                      |  |                    |       |                  |  |             |       |     
|                                                                      |  |                    |       |                  |  | (unaudited) |       |      |  |  
|Receipts from sales, including equity issued in
connection with sales |  | $                  | 6,066 |                  |  | $           | 8,465 |      |  | $ | 13,159 |  |  | $ | 15,476 | 
|Less: Receipts for equity issued in connection with
sales             |  |                    |      |                  |  |             | 1,338 |      |  |   |       |  |  |   | 2,294  | 
|                                                                      |  |                    |       |                  |  |             |       |      |  |   |        |  |  |   |        | 
|Revenue                                                               |  | $                  | 6,066 |                  |  | $           | 7,127 |      |  | $ | 13,159 |  |  | $ | 13,182 | 
|                                                                      |  |                    |       |                  |  |             |       |      |  |   |        |  |  |   |        | 

During the year ended December 31, 2000 we issued the following warrants
to customers:

A warrant exercisable for 1,233,499 shares of our series C preferred stock
at an exercise price of $0.81 per share issued to Qwest Communications upon
receipt of a purchase order from Qwest for $18.3 million of our products and
services;

A warrant exercisable for 200,000 shares of our common stock at an
exercise price of $4.00 per share issued to AduroNet Ltd. upon receipt of a
purchase order from AduroNet for $20.7 million of our products and services;
and

A warrant exercisable for 468,849 shares of our common stock at an
exercise price of $3.73 per share issued to BroadBand Office upon receipt of a
purchase order from BroadBand Office for $20.0 million of our products and
services. BroadBand filed for bankruptcy in the second quarter of 2001 and
subsequently CoSine wrote off the remaining unamortized portion of this
warrant.

We calculated the fair value of these customer-related warrants to be
$16.3 million ($10.3 million in the case of Qwest, $1.9 million in the case of
AduroNet and $4.1 million in the case of BroadBand Office). These values were
calculated using the Black-Scholes option pricing model, using volatility of
0.6, a risk-free interest rate of 5% and an expected life of four years. Of
this amount, $1.3 million and $2.3 million was excluded from revenue for the
three and six months ended June 30, 2001, respectively.

Non-Cash Charges Related to Equity Issuances

During the three months ended June 30, 2002 and 2001, we amortized $0.6
million and $9.2 million, respectively, of non-cash charges related to equity
issuances to cost of goods sold and operating expenses. During the six months
ended June 30, 2002 and 2001, we amortized $3.7 million and $21.4 million,
respectively, of non-cash charges related to equity issuances to cost of goods
sold and operating expenses.

Cost of Goods Sold

For the three months ended June 30, 2002, cost of goods sold was $6.0
million, of which $4.0 million or 67% represented materials, labor, production
overhead, warranty and the costs of providing services, $1.7 million or 28%
represented inventory reserve provisions and $0.3 million or 5% represented
amortization of deferred compensation related to stock options granted to
employees in manufacturing operations. For the three months ended June 30,
2001, cost of goods sold was $4.4 million, of which $2.3 million or 51%
represented materials, labor, production overhead,

Page 13 of 25



---



##### Table of Contents



warranty and the costs of
providing services, $1.7 million or 40% represented inventory reserve
provisions and $0.4 million or 9% represented amortization of deferred
compensation related to stock options granted to employees in manufacturing
operations.

For the six months ended June 30, 2002, cost of goods sold was $9.4
million, of which $7.5 million or 79% represented materials, labor, production
overhead, warranty and the costs of providing services, $1.3 million or 14%
represented inventory reserve provisions and $0.6 million or 7%
represented amortization of deferred compensation related to stock options
granted to employees in manufacturing operations. For the six months ended
June 30, 2001, cost of goods sold was $13.3 million, of which $5.0 million or
38% represented materials, labor, production overhead,
warranty and the costs
of providing services, $7.0 million or 53% represented inventory reserve
provisions and $1.3 million or 9% represented amortization of deferred
compensation.

Gross Profit (Loss)

For the three months ended June 30, 2002, gross loss was nil and for the
three months ended June 30, 2001, gross profit was $2.7 million. In the second
quarter of 2002, reserves for warranty expense were higher by $1.2 million.

For the six months ended June 30, 2002, gross profit was $3.8 million and
for the six months ended June 30, 2001, gross loss was $0.1 million. In the
first six months of 2002, there were inventory write-downs of $1.7 million and
a benefit of $0.4 million for inventory sold that had previously been written
down. In the first six months of 2001, there were inventory write-downs of
$7.0 million.

Research and Development Expenses

Research and development expenses were $10.3 million and $17.3 million for
the three months ended June 30, 2002 and 2001, respectively. This represents a
decrease of $7.0 million or 41%. This primarily resulted from reduced salary
and employee-related expenses reflecting lower headcount in the current period.
Additionally, non-cash charges related to equity issuances were lower due
primarily to our use of an accelerated amortization method for employee stock
compensation, which results in lower charges in each subsequent period.
Non-cash charges related to equity issuances were $0.5 million and $1.8 million
for the three months ended June 30, 2002 and 2001, respectively.

Research and development expenses were $23.1 million and $36.0 million for
the six months ended June 30, 2002 and 2001, respectively. This represents a
decrease of $12.9 million or 36%. This primarily resulted from reduced salary
and employee-related expenses reflecting lower headcount in the current period.
Additionally, non-cash charges related to equity issuances were lower due to
our use of an accelerated amortization method for employee stock compensation,
which results in lower charges in each subsequent period. Non-cash charges
related to equity issuances were $1.6 million and $7.0 million for the six
months ended June 30, 2002 and 2001, respectively.

Sales and Marketing Expenses

Sales and marketing expenses were $7.7 million and $18.4 million for the
three months ended June 30, 2002 and 2001, respectively. This represents a
decrease of $10.7 million or 58%. This primarily resulted from decreased
non-cash charges related to equity issuances due to our use of an accelerated
amortization method for employee stock compensation, which results in lower
charges in each subsequent period. Additionally, salary and employee-related
expenses were reduced reflecting lower headcount in the current period, reduced
spending on various marketing programs and trade shows, and lower travel
expenses due to the implementation of cost saving policies. Non-cash credits
related to equity issuances were $0.6 million for the three months ended June
30, 2002 and non-cash charges related to equity issuances were $5.7 million for
the three months ended June 30, 2001.

Sales and marketing expenses were $18.6 million and $34.8 million for the
six months ended June 30, 2002 and 2001, respectively. This represents a
decrease of $16.1 million or 46%. This primarily resulted from decreased
non-cash charges related to equity issuances due to our use of an accelerated
amortization method for employee stock compensation, which results in lower
charges in each subsequent period. Additionally, salary and employee-related
expenses were reduced reflecting lower headcount in the current period and
travel expenses declined due to the implementation of cost saving measures.
Non-cash charges related to equity issuances were $0.3 million and $9.5 million
for the six months ended June 30, 2002 and 2001, respectively.

Page 14 of 25



---



##### Table of Contents



General and Administrative Expenses

General and administrative expenses were $3.2 million and $6.6 million for
the three months ended June 30, 2002 and 2001, respectively. This represents a
decrease of $3.4 million or 51%. Salary and recruiting expenses declined,
reflecting lower headcount in the current period. Additionally, there were
decreased non-cash charges related
to equity issuances due to our use of an accelerated amortization method
for employee stock compensation, which results in lower charges in each
subsequent period. Non-cash charges related to equity issuances were $0.3
million and $1.3 million for the three months ended June 30, 2002 and 2001,
respectively.

General and administrative expenses were $7.1 million and $13.6 million
for the six months ended June 30, 2002 and 2001, respectively. This represents
a decrease of $6.5 million or 48%. This resulted from decreased non-cash
charges related to equity issuances, decreased professional services and
decreased salary and recruiting expenses. Non-cash charges related to equity
issuances were $1.0 million and $3.6 million for the six months ended June 30,
2002 and 2001, respectively.

Restructuring and Impairment

Restructuring

In May 2002, our senior management approved a restructuring plan 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 plan. Most of the terminations took place in
the second quarter of 2002, and the remainder will take place in the third
quarter of 2002. The employees in the workforce reduction were from all
functional groups and were located in our offices in the United States, Europe
and Asia. Amounts related to the worldwide workforce reduction will be paid
out through September of 2002, and lease commitments will also be paid out over
the respective lease terms through 2003. 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 restructuring program was
implemented to reduce operating expenses and conserve cash. The Company also
anticipates taking additional charges upon reaching an agreement to exit a
facilities lease for one of its office buildings in Redwood City, California.
We expect this restructuring plan will reduce quarterly operating expenses by
approximately $9.0 million by the fourth quarter of 2002, a 36% reduction as
compared with the first quarter of 2002.

Details of the May 2002 restructuring for the three months ended June 30,
2002 are as follows (in thousands):

|                                   |  |           |        |             |  |             |        |       |  |   |       |   |  |   |        |  
|---------------------------------- |  | --------- | ------ | ----------- |  | ----------- | ------ | ----- |  | - | ----- | - |  | - | ------ | -
|                                   |  |           |        |             |  | Write-down  |        |       |  |   |       |   |  |  
|                                   |  | Worldwide |        | of property |  | Lease       |        |       |  |  
|                                   |  | workforce |        | and         |  | commitments |        |       |  |  
|(unaudited)                        |  | reduction |        | equipment   |  | and other   |        | Total
|                                   |  |           |        |             |  |             |        |      
|Charges                            |  | $         | 3,660  |             |  | $           | 3,248  |       |  | $ | 2,318 |   |  | $ | 9,226  |  
|Cash payments                      |  |           | (2,466 | )           |  |             |       |       |  |   | (50   | ) |  |   | (2,516 | )
|Non-cash charges                   |  |           |       |             |  |             | (3,248 | )     |  |   |      |   |  |   | (3,248 | )
|                                   |  |           |        |             |  |             |        |       |  |   |       |   |  |   |        |  
|Provision balance at June 30, 2002 |  | $         | 1,194  |             |  | $           |       |       |  | $ | 2,268 |   |  | $ | 3,462  |  
|                                   |  |           |        |             |  |             |        |       |  |   |       |   |  |   |        |  

In September 2001, our senior management approved a restructuring plan to
reduce our worldwide workforce, close certain sales offices, exit certain
facilities and idle certain property and equipment. Notification was given to
employees on September 28, 2001 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, approximately 50 employees were
designated for termination in the restructuring plan and were then terminated
in the fourth quarter of 2001. The employees in the workforce reduction were
from all functional groups and were primarily located in our Redwood City,
California offices. In the fourth quarter of 2001, we also wrote down certain
property and equipment to its expected realizable value. Amounts related to
the worldwide workforce reduction will be paid out by the end of 2002, and
lease commitments will be paid out over the respective lease terms through the
end of 2002. The restructuring program was implemented to reduce operating
expenses and conserve cash. During the three months ended June 30, 2002, the

Page 15 of 25



---



##### Table of Contents



Company paid $0.2 million for lease commitments and other. During the six
months ended June 30, 2002, the Company paid $0.4 million in severance costs
and $0.6 million for lease commitments and other. The provision balance at
June 30, 2002 amounted to $0.2 million.

For the three months ended June 30, 2001 restructuring charges were $2.0
million reflecting a reclassification of $0.7 million from research and
development expenses, $0.2 million from sales and marketing expenses and $1.1
million
from general and administrative expenses to restructuring expenses in the
Statement of Operations.

Impairment of long-lived assets

As a result of our assessment of current market conditions and related
effect on our business plan, we concluded that indicators of
impairment of our
long-lived assets were present. Accordingly, we performed an impairment test
of the carrying value of our long-lived assets, consisting primarily of
property and equipment in accordance with SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. Based on an undiscounted cash
flow analysis, the cash flows expected to be generated by our long-lived assets
during their estimated remaining useful lives are not sufficient to recover the
net book value of the assets. Consequently, we obtained a valuation report
outlining the estimated fair value of the assets, based on quoted market prices, from an independent appraiser
and recorded an impairment charge of $14.8 million to write the carrying value
of our long-lived assets held for use down to their fair values in the second
quarter of 2002.

Interest and Other Income

For the three and six months ended June 30, 2002, interest and other
income was $0.9 million and $2.2 million, respectively, down from $3.2 million
and $7.0 million for the three and six months ended June 30, 2001,
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 and six months ended June 30, 2002, interest expense was
$0.3 million and $0.6 million, respectively, down from $0.5 million and $0.9
million for the three and six months ended June 30, 2001, respectively. The
reduction reflects a decline in our debt.

Income Tax Provision

The provisions for income taxes were $0.1 million and $0.2 million for the
three months ended June 30, 2002 and 2001, respectively, and $0.3 million and
$0.5 million for the six months ended June 30, 2002 and 2001, 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

Prior to our initial public offering in September 2000, we financed our
operations primarily through sales of convertible preferred stock for net
proceeds of $166.6 million, plus equipment and working capital loans and
capital leases. Upon the closing of our initial public offering on September
29, 2000, we received cash proceeds, net of underwriters discounts and
offering expenses, totaling $242.5 million, and all of our convertible
preferred stock was converted into 69.6 million shares of common stock.

We believe that we possess sufficient liquidity and capital resources to
fund our operating and working capital requirements for at least the next 12
months. We may require additional funds to support other purposes and may seek
to raise these 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.

Page 16 of 25



---



##### Table of Contents



Cash, Cash Equivalents and Short-Term Investments

At June 30, 2002, cash, cash equivalents and short-term investments were
$127.5 million. This compares with $164.9 million at December 31, 2001.

Operating Activities

We used $32.6 million and $57.7 million of cash in operations for the six
months ended June 30, 2002 and 2001, respectively. The decrease in net cash
used in operating activities was the result of a lower net loss and an
improvement in working capital. The working capital improvement was due
to cash provided by accounts receivable and inventory.

Investing Activities

For the six months ended June 30, 2002 and 2001, we used $16.0 million and
provided $17.2 million, respectively, in cash from investing activities. The
change reflects a decrease of $41.3 million for net proceeds from the sale of
short-term investments offset by a decrease in capital expenditures of $8.0
million.

Financing Activities

For the six months ended June 30, 2002 and 2001, $2.3 million and $2.5
million, respectively, were used in financing activities. This primarily
reflects principal payments on working capital loans and capital leases.

OUTLOOK

We believe that capital spending in the telecommunications industry will
recover in the long-term (two to five years). However, due to reductions in
capital spending plans by our customers and uncertainty within the
telecommunications industry, the current and short-term outlook (up to two
years) for growth is not favorable. The lack of capital availability for many
emerging service providers combined with the emphasis of larger service
providers on reducing operating expenses, has caused a significant reduction in
capital spending in the industry as a whole. While we believe this is a
short-term (up to two years) phenomenon, it has had a direct impact on our
operations. We anticipate that this capital spending trend will continue to
have a substantial, adverse effect on our revenue growth for at least the
remainder of the current fiscal year. Because capital continues to be scarce,
we believe that pricing will continue to be under pressure as each potential
customer attempts to improve returns on invested capital.

In October 2001, the
FASB issued Statement of Financial Accounting Standards No. 144,
Accounting for the Impairment or Disposal of Long-Lived
Assets (SFAS 144), which was effective January 1,
2002. SFAS No. 144 supercedes SFAS No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be
Disposed Of, and the accounting reporting provisions relating
to the disposal of a segment of a business of Accounting Principles
Board Opinion No. 30. The adoption of SFAS No. 144 did not materially
impact our financial statements.

In June 2002, the
FASB issued Statement of Financial Accounting Standards No. 146,
Accounting for Costs Associated with Exit or Disposal
Activities (SFAS 146). SFAS 146 nullifies Emerging
Issues Task Force Issue No. 94-3, Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an
Activity (including Certain Costs Incurred in a Restructuring)
(EITF 94-3). The principle difference between SFAS 146
and EITF 94-3 relates to its requirement for recognition of a
liability for a cost associated with an exit or disposal activity.
This statement requires that a liability for a cost associated with an
exit or disposal activity be recognized when the liability is
incurred. Under EITF 94-3, a liability for an exit cost as defined in
EITF 94-3 was recognized at the date of an entity's commitment to an
exit plan. This statement also establishes that fair value is the
objective for initial measurement of the liability. SFAS 146 is
effective for exit or disposal activities that are initiated after
December 31, 2002. We do not expect adoption of SFAS 146 will have a
material impact on our financial statements.

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 never
achieve profitability we may cease operations.

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. If we do not achieve profitability, we may cease
operations.

Due to our loss-making activity 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 our equipment because of concerns
regarding our long-term financial viability and our ability to support their
businesses. Unless we can generate positive cash flows by either increasing
revenues and/or decreasing costs, 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.

Page 17 of 25



---



##### Table of Contents



The outlook for capital spending in the telecommunications industry directly
impacts our business.

Due to reductions in capital spending plans by our customers and
uncertainty within the telecommunications industry, the current and short-term
outlook (up to two years) for growth is not favorable. Capital spending in the
industry as a whole has slowed as a result of a lack of available capital for
many emerging service providers and a generally cautious approach to capital
spending within the industry.
While we believe this is a short-term (up to two years) phenomenon, 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.

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.

We believe that there is likely to be consolidation in our industry. We
expect to face increased competition from larger companies with significantly
greater resources than we have.

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.

The limited sales history of our IP Service Delivery Platform makes forecasting
our revenue difficult, which may impair our ability to manage our business.

We were founded in April 1997, shipped our first test IP Service Delivery
Platform product in March 1999 and sold our first IP Service Delivery Platform
product in March 2000. We have limited meaningful historical financial data
upon which to forecast our revenue.

If our customers are unable to generate sales of services using our products
and to manage delivery of these services to their customers, we may be unable
to sell our products.

Our future success depends on network service providers, who are our
customers, generating revenue from the sale of services delivered using our
products. Sales of our products may decline or be delayed if our customers do
not successfully introduce commercial services derived from our IP Service
Delivery Platform or if our customers do not generate revenue from these
services sufficient to realize an attractive return on their investment in our
IP Service Delivery Platform.

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.

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

Page 18 of 25



---



##### Table of Contents



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. 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.

If our IP Service Delivery Platform does not rapidly 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 success
also depends on third-party software providers recognizing the advantages of
our service delivery method and on our ability to effectively support their
software development efforts.

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 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.

Our products are technically complex and may contain errors or defects that are
not found until our customers put our products to full use. Errors or defects
in our products could seriously harm our reputation and our ability to sell our
products.

Our products are more complicated than most networking products. They can
be adequately tested only when put to full use in large and diverse networks
with high amounts of traffic. Errors or defects in our products could result
in:



| |  | loss of current customers and failure to attract new customers or
achieve market acceptance; and
|- |  | ------------------------------------------------------------------------------------------------
| 
| |  | increased service and warranty costs.                                                           

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. 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.

If we fail to develop 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 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 execute new product introductions 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

Page 19 of 25



---



##### Table of Contents



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.

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 our customers or the decline of our customers business may limit
our revenue growth and harm our operating results. Our customers may reduce or
discontinue purchases of our products at any time.

Our future success will depend on attracting additional customers.
Failure to increase our customer base would hinder our growth and harm our
operating results.

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
company performance and in turn on our stock price.

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.

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.

Page 20 of 25



---



##### Table of Contents



We license from third-party suppliers several key 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. Either of these outcomes could seriously impair our
ability to sell our products and could harm our operating results.

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.

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 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 ourselves or our employees against these claims,
regardless of their merits. Defending ourselves against such claims could
divert the attention of our management away from our operations.

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 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.

Page 21 of 25



---



##### Table of Contents



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; and
| 
| |  | redesign those products or services that use the infringed
technology.                                                                                                              

If our stock price remains below $1.00, we could be delisted from the Nasdaq.

Our stock price was below $1.00 as the date on which we filed this Report
on Form 10-Q with the Securities and Exchange Commission. On June 24, 2002, we
received a letter from Nasdaq advising us that our Common Stock had not met
Nasdaqs minimum bid price requirement for 30 consecutive trading days and
that, if we were unable to demonstrate compliance with this requirement for ten
consecutive trading days during the 90 calendar days ending September 23, 2002,
our Common Stock would be delisted from the Nasdaq. In response to this
notice, the Board of Directors has called a special meeting of stockholders, to
be held on September 17, 2002, for the purpose of obtaining stockholder
approval of a proposal that would authorize the Board to effect a reverse stock
split. We anticipate that such a reverse stock split, if approved by our
stockholders and implemented by the Board, would cause the bid price of the
Common Stock to exceed $1.00 and thereby avoid delisting.

We believe that delisting our stock would have negative effects on
liquidity and on the value of the stock. For additional information concerning
the proposed reverse stock split, refer to our Definitive Proxy Materials filed
with the Securities and Exchange Commission on August 7, 2002.

Our low stock price may also cause some of our potential customers to be
reluctant to purchase our products.

Acts of war, terrorist activity, and bio-terrorism can have a negative effect
on the demand for our products.

The terrorist activity on September 11, 2001 and the ensuing declaration
of war on terrorism may result in reduced demand for networking products.
Capital spending in the telecommunications industry was already depressed prior
to the tragedy, and additional news regarding war and terrorism may negatively
impact the demand for our products. These circumstances may result in delayed
purchases, cancelled orders and new technology requirements, which could lead
to reduced revenues or increased costs, which in turn could negatively affect
our stock price.

Page 22 of 25



---



##### Table of Contents






ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Sensitivity

We do not currently use derivative financial instruments for speculative
trading or hedging purposes. In addition, we maintain our cash equivalents in
government and agency securities, debt instruments of financial institutions
and corporations and money market funds. Our exposure to market risks from
changes in interest rates relates primarily to corporate debt securities. We
place our investments with high credit quality issuers and, by policy, limit
the amount of the credit exposure to any one issuer.

Our general policy is to limit the risk of principal loss and ensure the
safety of invested funds by limiting market and credit risk. All highly liquid
investments with a maturity of less than three months at the date of purchase
are considered to be cash equivalents, and all investments with maturities of
three months or greater are classified as available-for-sale and considered to
be short-term investments.

Exchange Rate Sensitivity

Currently, most of our sales and expenses are denominated in United States
dollars. As a consequence, we have not engaged in any foreign exchange hedging
activities to date. However, we expect to conduct transactions in foreign
currencies in increasing volumes in the future, and as a result we may engage
in foreign exchange hedging activities.




PART II. OTHER INFORMATION




ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(a) | On September 25, 2001, 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 11,500,000 shares of our common stock were offered
and sold for our account at a price of $23 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, 2001. 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 $115 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.




ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS

|    |                                                                     
|--- | --------------------------------------------------------------------
|(a) | The annual meeting of CoSines stockholders was held on May 7, 2002.

|    |                                                                                                                                                                                                                                                                                                                                                                                               
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(b) | Charles J. Abbe was elected as a Class II director for a term
of three years. The Companys Class I and Class III directors did
not stand for reelection at the annual meeting. The terms of the
Companys Class III directors, Vinton G. Cerf and Donald Green, will
expire in 2003. The terms of the Companys Class I directors, R.
David Spreng and Stephen Goggiano, will expire in 2004.

|    |                                                                                                                                                                      
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(c) | The only other matter voted upon at the annual meeting was the
ratification of Ernst & Young LLP as the independent auditors of the
Company for the 2002 fiscal year.

Page 23 of 25



---



##### Table of Contents



The following sets forth the number of votes cast or withheld, as well
as the number of abstentions and broker non-votes, with respect to the
nominee for election as a director and the ratification of Ernst &
Young LLP:

|                                                 |  |     |            |          |  |  |         | 
|------------------------------------------------ |  | --- | ---------- | -------- |  |  | ------- | 
|                                                 |  | For |            | Withheld
|                                                 |  |     |            |         
|Election of Charles J. Abbe as Class II director |  |     | 72,210,943 |          |  |  | 881,979 | 

|                                                                    |  |     |            |         |  |         |         |  |  |  |        | 
|------------------------------------------------------------------- |  | --- | ---------- | ------- |  | ------- | ------- |  |  |  | ------ | 
|                                                                    |  | For |            | Against |  | Abstain
|                                                                    |  |     |            |         |  |        
|Ratify the appointment of Ernst & Young LLP
as independent auditors |  |     | 72,477,112 |         |  |         | 580,366 |  |  |  | 35,443 | 




ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

|    |          
|--- | ---------
|(a) | Exhibits.
|   
|    | None.    

|    |                     
|--- | --------------------
|(b) | Reports on Form 8-K.
|   
|    | None.               

Page 24 of 25



---



##### Table of Contents






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 Gibson
Terry Gibson
Executive Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)

Dated: August 14, 2002

Page 25 of 25