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

FORM 10-Q

(MARK ONE)

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2002

OR

For the transition period from ____________ to ____________.

Commission File Number 000-30715

COSINE COMMUNICATIONS, INC.

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.

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COSINE COMMUNICATIONS, INC.

FORM 10-Q

Quarter ended June 30, 2002

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

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

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.

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

See accompanying notes.

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

See accompanying notes.

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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):

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

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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:

     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:

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7. COMPREHENSIVE LOSS

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

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:

9. RESTRUCTURING AND IMPAIRMENT CHARGES

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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):

     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.

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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

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     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

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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.

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     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):

     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,

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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.

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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):

     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

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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.

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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.

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