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UNITED STATES

FORM 10-Q

(MARK ONE)

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2003

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 [  ]

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). YES  [   ]     NO  [X]

     There were 9,936,398 shares of the Company’s Common Stock, par value $.0001, outstanding on May 2, 2003.

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COSINE COMMUNICATIONS, INC.

FORM 10-Q

Quarter ended March 31, 2003

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

COSINE COMMUNICATIONS, INC.

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, 2002.

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COSINE COMMUNICATIONS, INC.

² Research and development expenses include $198 and $1,133 of non-cash charges related to equity issuances for the three months ended March 31, 2003 and 2002, respectively.

³ Sales and marketing expenses include $192 of non-cash benefits related to equity issuances for the three months ended March 31, 2003 and $918 of non-cash charges related to equity issuances for the three months ended March 31, 2002.

⁴ General and administrative expenses include $137 and $642 of non-cash charges related to equity issuances for the three months ended March 31, 2003 and 2002, respectively.

⁵ Interest expense includes $30 and $35 of non-cash charges related to equity issuances for the three months ended March 31, 2003 and 2002, respectively.

See accompanying notes.

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COSINE COMMUNICATIONS, INC.

See accompanying notes.

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COSINE COMMUNICATIONS, INC.

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 months ended March 31, 2003 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, 2002.

     In September 2002, CoSine implemented a 1-for-10 reverse stock split, which reduced the number of issued and outstanding shares of CoSine common stock from approximately 100 million to approximately 10 million. All share and per share data has been adjusted, as applicable, to reflect this reverse stock split.

Pro Forma Information

     CoSine has elected to continue to follow APB 25 to account for employee stock options because the alternative fair value method of accounting prescribed by SFAS 123 requires the use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, no compensation expense is recognized when the exercise price of employee stock options equals the market price of the underlying stock on the date of grant.

     The following table illustrates the effect on CoSine’s net loss and net loss per share if CoSine had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation (in thousands, except per share data):

     The fair value of CoSine’s options was estimated at the grant date using the Black-Scholes option pricing model with the following weighted average assumptions:

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     The estimated weighted-average fair value of shares granted under the Purchase Plan in 2002 was $1.60, using a volatility of 0.67, risk-free interest rate of 1% and an expected life of six months.

Guarantees

     The Company from time to time enters into certain types of contracts that contingently require the Company to indemnify parties against third party claims. These contracts primarily relate to: (i) certain real estate leases, under which the Company may be required to indemnify property owners for environmental and other liabilities, and other claims arising from the Company’s use of the applicable premises, (ii) certain agreements with the Company’s officers, directors and employees, under which the Company may be required to indemnify such persons for liabilities arising out of their employment relationship, (iii) contracts under which the Company may be required to indemnify customers against loss or damage to property or persons as a result of willful or negligent conduct by CoSine employees or sub-contractors, (iv) contracts under which the Company may be required to indemnify customers against third party claims that a CoSine product infringes a patent, copyright or other intellectual property right and (v) procurement or license agreements under which the Company may be required to indemnify licensors or vendors for certain claims that may be brought against them arising from the Company’s acts or omissions with respect to the supplied products or technology.

     Generally, a maximum obligation is not explicitly stated. Because the obligated amounts associated with this type of agreement are not explicitly stated, the overall maximum amount of the obligation cannot be reasonably estimated. Historically, CoSine has not been obligated to make payments for these obligations, and no liabilities have therefore been recorded for these obligations on its balance sheet as of March 31, 2003.

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 November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” — an Interpretation of FASB Statements No. 5, 57, and 107 and Rescission of FASB Interpretation No. 34. The Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. CoSine has not issued or modified any guarantees since December 31, 2002 and, accordingly, the adoption of FASB Interpretation No. 45 did not have a material impact on CoSine’s financial results.

     In December 2002, the FASB issued Statement Number 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” (SFAS 148). SFAS 148 amends SFAS 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition to the SFAS 123 fair value method of accounting for stock-based employee compensation. In addition, SFAS 148 requires disclosure of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. As permitted under SFAS 148, CoSine adopted the disclosure provisions of that accounting standard and, accordingly, has included such disclosures in the financial statements for the three months ended March 31, 2003.

4. COMMITMENTS AND CONTINGENCIES

     As of March 31, 2003, CoSine had commitments of approximately $1,950,000 relating to purchases of raw materials and semi-finished goods. Of that amount, $535,000 related to excess inventory was accrued at March 31, 2003.

     On November 15, 2001, CoSine and seven of its officers and directors were named as defendants in a securities class action lawsuit filed in the United States District Court, Southern District of New York. The complaint alleges that CoSine’s September 26, 2000 IPO prospectus failed to disclose certain alleged actions by the underwriters for the offering. The complaint alleges claims against CoSine and certain of its current and former officers and directors under

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Section 11 of the Securities Act of 1933. The complaint also alleges claims against the officers and directors under Section 15 of the 1933 Act and Section 20(a) of the Securities Exchange Act of 1934. CoSine and its officers and directors believe the allegations against them are without merit and intend to defend the action vigorously.

     The complaint generally alleges that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares in CoSine’s initial public offering. The complaint brings claims for the violation of several provisions of the federal securities laws against those underwriters, and also against the Company and certain of its directors and officers. Various plaintiffs have filed similar actions asserting virtually identical allegations against more than 250 other companies. The lawsuit and all other “IPO allocation” securities class actions currently pending in the Southern District of New York have been assigned to Judge Shira A. Scheindlin for coordinated pretrial proceedings. In October 2002, the individual defendants were dismissed without prejudice pursuant to a stipulation. The issuer defendants recently filed a coordinated motion to dismiss on common pleading issues, which the Court granted in part and denied in part in an order dated February 19, 2002. The Court’s order dismissed the Section 10(b) and Rule 10b-5 claims against the Company but did not dismiss the Section 11 claims against the Company. The Company believes that it has meritorious defenses to the claims against it and intends to defend itself vigorously.

     On December 27, 2002, CoSine and each of its five directors were named as defendants in a class action lawsuit filed in the San Mateo County Superior Court on behalf of CoSine stockholders. The complaint alleges that the CoSine directors breached their fiduciary duty to the corporation in rejecting a proposal offered by a private holding company, Wyndcrest Holdings LLC, to effect a merger of CoSine into a wholly owned subsidiary of Wyndcrest. Under the proposal, Wyndcrest would retain a 75% ownership interest in the assets of CoSine after distributing $95.5 million in cash to the existing CoSine shareholders, subject to adjustment. On January 23, 2003, a substantially similar class action lawsuit was filed in San Mateo County Superior Court. In March of 2003, the two plaintiffs agreed to consolidate the two actions. CoSine and its directors believe that the allegations are without merit and intend to defend the action vigorously.

     In the ordinary course of business, CoSine is involved in legal proceedings involving contractual obligations, employment relationships and other matters. Except as described above, CoSine does not believe there are any pending or threatened legal proceedings that will have a material impact on its financial position or results of operations.

5. BALANCE SHEET DETAILS

Inventory

     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 December 31, 2002 was $289,000 of goods used for customer evaluation purposes. At March 31, 2003, there was no net value in finished goods inventory for goods used for customer evaluation. During the three months ended March 31, 2003 and 2002, $336,000 and $409,000 of fully reserved inventory was sold, respectively.

Warranty

     CoSine provides a basic limited warranty, including repair or replacement of parts, and technical support. The specific terms and conditions of those warranties vary depending on the customer or region in which CoSine does business. CoSine estimates the costs that may be incurred under its basic limited warranty and records a liability in the

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amount of such costs at the time product revenue is recognized. CoSine’s warranty obligation is affected by the number of installed units, product failure rates, materials usage and service delivery costs incurred in correcting product failures. CoSine periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary.

     Changes in CoSine’s warranty liability were as follows, in thousands:

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 1,180,876 shares and 2,204,400 shares for the three months ended March 31, 2003 and 2002, respectively.

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

7. COMPREHENSIVE LOSS

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

8. SEGMENT REPORTING

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

     Revenues from customers by geographic region for the three months ended March 31, 2003 and 2002, respectively, were as follows, in thousands:

9. RESTRUCTURING CHARGES

March 2003 Restructuring

     In March 2003, CoSine’s senior management communicated an additional reduction in its workforce related to the closure of its sales office in Australia. The employees were notified in March 2003 that their job functions would be eliminated and that termination benefits would be paid to them. As a result of the workforce reduction, three employees were designated for termination. Amounts related to the workforce reduction and the other items are expected to be paid through June of 2003. The restructuring program was an extension of the October 2002 restructuring, which was implemented to reduce operating expenses and conserve cash.

     Details of the March 2003 restructuring charges for the quarter ended March 31, 2003 are as follows, unaudited (in thousands):

October 2002 Restructuring

     In October 2002, CoSine’s senior management approved a restructuring plan to reduce its worldwide workforce. Employees were notified in October 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, 73 employees were designated for termination in the restructuring program. Most of the terminations took place in the fourth quarter of 2002. The employees affected by the workforce reduction were from all functional groups and were located in offices in the United States, Europe and Asia. Amounts related to the worldwide workforce reduction are expected to be paid out through June of 2003. In addition, during the first quarter of 2003, CoSine concluded negotiations to settle obligations associated with Redwood City, California leased facilities it exited during 2002 and made a payment of $8,104,000. The restructuring program was implemented to reduce operating expenses and conserve cash.

     Activity in the October 2002 restructuring accrual for the quarter ended March 31, 2003 is as follows, unaudited (in thousands):

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May 2002 Restructuring and Impairment of Long-Lived Assets

     In May 2002, CoSine’s senior management approved a restructuring plan to reduce its worldwide workforce, close certain sales offices, exit certain facilities and dispose of or abandon certain property and equipment. Employees were notified in May 2002 that certain job functions would be eliminated and that particular termination benefits would be paid to affected employees. As a result of the workforce reduction, 146 employees were designated for termination in the restructuring program. Most of the terminations took place in the second quarter of 2002, with the remainder taken in the third quarter of 2002. The employees in the workforce reduction were from all functional groups and were located in offices in the United States, Europe and Asia. Amounts related to the worldwide workforce reduction were paid out through December of 2002, and lease commitments and non-cancelable commitments are being paid out over their respective 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.

     Activity in the May 2002 restructuring accrual for the quarter ended March 31, 2003 is as follows, unaudited (in thousands):

Impairment of Long-lived Assets

     As a result of CoSine’s assessment of market conditions and the related effect on its business plan, the Company concluded that indicators of impairment of its long-lived assets were present during the second and third quarters of 2002. 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 $15,512,000 to write the carrying value of its long-lived assets held for use down to their fair values in the second and third quarters of 2002. In addition, property and equipment that was idled or abandoned was written down by approximately $3,248,000 to its estimated net realizable value. The Company has concluded that no additional indicators of impairment were present in the first quarter of 2003.

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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, the continuation of the current downturn within the telecommunications industry, 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 directly and through support partners.

     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. Additionally, the audit committee of our board of directors reviews these critical accounting estimates at least annually. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. These estimates form the basis for certain judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

     The following accounting policies are significantly affected by the judgments and estimates we use in the preparation of our consolidated financial statements.

Revenue Recognition

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

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     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 greatly affect the timing of our revenue.

Allowance for Doubtful Accounts

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

Inventory Valuation

     In assessing the value of our inventory, we are required to make judgments as to future demand and then compare that demand with current inventory quantities and firm purchase commitments. If our inventories and firm purchase commitments are in excess of forecasted demand, we write down the value of our inventory. We generally use a 12-month forecast to assess future demand. Inventory write-downs are charged to cost of sales. During the three months ended March 31, 2003, we had no inventory write-downs. If actual demand for our products is less than our forecasts, additional inventory write-downs may be required.

Long-lived assets

     We evaluate the carrying value of long-lived assets, consisting primarily of property, plant and equipment, whenever certain events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. In assessing the recoverability of long-lived assets, we compare the carrying value to the undiscounted future cash flows the assets are expected to generate. If the total of the undiscounted future cash flows is less than the carrying amount of the assets, the assets will be written down to their estimated fair value. Fair value is generally determined by calculating the discounted future cash flows using a discount rate based upon our weighted average cost of capital or specific appraisal, as appropriate. Significant judgments and assumptions are required in the forecast of future operating results used in the preparation of the estimated future cash flows, including long-term forecasts of overall market conditions and our participation in the market. Changes in these estimates could have a material adverse effect on the assessment of the long-lived assets, thereby requiring us to record further asset write-downs in the future. During the second and third quarters of 2002, we charged $18.8 million to operating expenses as a result of impairments. We have concluded that no additional indicators of impairment were present in the first quarter of 2003.

Warranties

     We provide a basic limited warranty, including repair or replacement of parts, and technical support. The specific terms and conditions of those warranties vary depending on the customer or region in which we do business. We estimate the costs that may be incurred under its basic limited warranty and record a liability in the amount of such costs at the time product revenue is recognized. Our warranty obligation is affected by the number of installed units, product failure rates, materials usage and service delivery costs incurred in correcting product failures. We periodically assess the adequacy of our recorded warranty liabilities and adjust the amounts as necessary. In future periods, if actual product failure rates, materials usage or service delivery costs differ from our estimates, adjustments to cost of sales could result.

Impact of Equity Issuances on Operating Results

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     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 costs of goods sold and operating expenses are affected by charges related to warrants and options issued for services. Furthermore, some of our employee stock option transactions have resulted in deferred compensation, which is presented as a reduction of stockholders’ equity on our 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. The remeasurement at the end of each accounting period will result in unpredictable charges or credits in future periods, depending on future fluctuations in the market prices of our common stock:

	•		Non-recourse promissory notes receivable: During the fourth quarter of 2000, we converted full-recourse promissory notes received from employees upon the early exercise of unvested employee stock options to non-recourse obligations. Accordingly, we are required to remeasure the compensation associated with these shares until the earlier of the shares vesting or the note being repaid. Deferred compensation expense, which is recorded at each remeasurement, is amortized over the remaining vesting period of the underlying options.
	•		Repriced stock options: In November 2002, we repriced outstanding employee stock options to purchase 1,091,453 shares of our common stock with original exercise prices ranging from $5.45 per share to $159.38 per share. These options were repriced to $5.00 per share, which was higher than the fair market value of the underlying shares on the repricing date. The repricing requires that compensation be remeasured for these options until they are exercised or canceled, or expire.

     Some of the stock options granted to our employees have resulted in deferred compensation as a result of stock options having an exercise price below their fair value. Deferred compensation is presented as a reduction to stockholders’ equity on the balance sheet and is then amortized using an accelerated method over the vesting period of the applicable options. When an employee terminates, an expense credit is recorded for any amortization that has been previously recorded as an expense in excess of vesting.

RESULTS OF OPERATIONS

     For the three months ended March 31, 2003 and 2002, we reported basic and diluted net losses per common share of $0.91 and $2.31, respectively. The effect of equity issuances to suppliers, employees and consultants increased net loss per common share by $0.02 and $0.31 for the three months ended March 31, 2003 and 2002, respectively.

Revenue

     For the three months ended March 31, 2003, revenue was $2.2 million of which 74% was from hardware sales, 7% was from software sales and 19% was from sales of services. For the three months ended March 31, 2002, revenue was $7.1 million of which 77% was from hardware sales, 14% was from software sales and 9% was from sales of services. The $4.9 million decline in revenue was the result of sales to a fewer number of customers, delays in the receipt of certain purchase orders and continued weakness in capital spending in the telecommunications industry.

Non-Cash Charges Related to Equity Issuances

     During the three months ended March 31, 2003 and 2002, we recorded $0.2 million and $3.1 million, respectively, of non-cash charges related to equity issuances to cost of goods sold, operating expenses and interest expense.

     Below is a reconciliation of non-cash charges related to equity issuances for the three months ended March 31, 2003 and 2002, as presented in our statement of operations, in thousands:

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Cost of Goods Sold

     For the three months ended March 31, 2003, cost of goods sold was $0.7 million, of which $1.0 million represented materials, labor, production overhead, warranty and the costs of providing services, $0.3 million represented a benefit associated with fully reserved inventory sold and $47,000 represented amortization of deferred related to stock options granted to employees in manufacturing operations. For the three months ended March 31, 2002, cost of goods sold was $3.4 million, which represented materials, labor, production overhead, warranty and the costs of providing services, $0.4 million or 12% represented amortization of deferred compensation related to stock options granted to employees in manufacturing operations and a benefit of $0.4 million or 12% represented credits for fully reserved inventory sold.

Gross Profit

     For the three months ended March 31, 2003 and 2002, gross profit was $1.5 million and $3.7 million, respectively. The improvement in gross margin from 53% to 68% was the result of a greater percentage of fully reserved inventory sold relative to total cost of goods sold and a $0.1 million benefit associated with experience-based changes in the estimated warranty liability in the three months ended March 31, 2003.

Research and Development Expenses

     Research and development expenses were $5.3 million and $12.8 million for the three months ended March 31, 2003 and 2002, respectively. This represents a decrease of $7.5 million or 59%. This resulted partly from a $3.1 million reduction in payroll-related expense reflecting lower headcount in the current period. Depreciation expense and expense related to CoSine product used in labs declined $2.5 million due to the reduced carrying value of assets resulting from impairment charges recorded in the second and third quarters of 2002. Facilities and IT infrastructure expense declined $1.0 million as a result of reductions in workforce and square footage occupied. Non-cash charges related to equity issuances declined $.9 million due to the reversal of amortization of deferred compensation expense in excess of vesting for employees who were terminated and our use of an accelerated amortization method, which results in lower charges in each subsequent period.

Sales and Marketing Expenses

     Sales and marketing expenses were $3.3 million and $10.9 million for the three months ended March 31, 2003 and 2002, respectively. This represents a decrease of $7.6 million or 69%. This resulted partly from a $3.9 million reduction in payroll-related expense reflecting lower headcount in the current period in sales, marketing and services. Facilities and IT infrastructure expense declined $.9 million as a result of reductions in workforce and square footage occupied. Non-cash charges related to equity issuances declined $1.1 million due to the reversal of amortization of deferred compensation expense in excess of vesting for employees who were terminated and our use of an accelerated amortization method, which results in lower charges in each subsequent period. Depreciation expense declined $.7 million due to the reduced carrying value of assets resulting from impairment charges recorded in the second and third

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quarters of 2002. Travel expense declined by $.5 million due to cost saving measures and associated reductions in headcount. Marketing spending on events, collateral and public relations declined by $.5 million due to fewer tradeshows and cost saving measures. Expense related to CoSine product used in labs and evaluation unit amortization declined by $.4 million due to the reduced carrying value of assets resulting from impairment charges recorded in the second and third quarters of 2002 and a more selective evaluation process. Partially offsetting the expense reductions, service expense reclassified from operating expense to cost of sales and warranty declined by $.6 million due to lower revenue and a lower spending base.

General and Administrative Expenses

     General and administrative expenses were $1.7 million and $3.9 million for the three months ended March 31, 2003 and 2002, respectively. This represents a decrease of $2.2 million or 55%. This resulted partly from a $1.0 million reduction in payroll-related expense reflecting lower headcount in the current period. Non-cash charges related to equity issuances declined $.5 million due to the reversal of amortization of deferred compensation expense in excess of vesting for employees who were terminated and our use of an accelerated amortization method, which results in lower charges in each subsequent period. Depreciation expense declined $.3 million due to the reduced carrying value of assets resulting from impairment charges recorded in the second and third quarters of 2002. Outside services declined $.2 million due to cost saving measures.

Restructuring and Impairment

March 2003 Restructuring

     In March 2003, CoSine’s senior management communicated an additional reduction in its workforce related to the closure of its sales office in Australia. The employees were notified in March 2003 that their job functions would be eliminated and that termination benefits would be paid to them. As a result of the workforce reduction, three employees were designated for termination. Amounts related to the workforce reduction and the other items are expected to be paid through June of 2003. The restructuring program was an extension of the October 2002 restructuring, which was implemented to reduce operating expenses and conserve cash.

     Details of the March 2003 restructuring charges for the quarter ended March 31, 2003 are as follows, unaudited (in thousands):

October 2002 Restructuring

     In October 2002, CoSine’s senior management approved a restructuring plan to reduce its worldwide workforce. Employees were notified in October 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, 73 employees were designated for termination in the restructuring program. Most of the terminations took place in the fourth quarter of 2002. The employees affected by the workforce reduction were from all functional groups and were located in offices in the United States, Europe and Asia. Amounts related to the worldwide workforce reduction are expected to be paid out through June of 2003. In addition, during the first quarter of 2003, CoSine concluded negotiations to settle obligations associated with Redwood City, California leased facilities it exited during 2002 and made a payment of $8,104,000. The restructuring program was implemented to reduce operating expenses and conserve cash.

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     Activity in the October 2002 restructuring accrual for the quarter ended March 31, 2003 is as follows, unaudited (in thousands):

May 2002 Restructuring and Impairment Charges

     In May 2002, CoSine’s senior management approved a restructuring plan to reduce its worldwide workforce, close certain sales offices, exit certain facilities and dispose of or abandon certain property and equipment. Employees were notified in May 2002 that certain job functions would be eliminated and that particular termination benefits would be paid to affected employees. As a result of the workforce reduction, 146 employees were designated for termination in the restructuring program. Most of the terminations took place in the second quarter of 2002, with the remainder taken in the third quarter of 2002. The employees in the workforce reduction were from all functional groups and were located in offices in the United States, Europe and Asia. Amounts related to the worldwide workforce reduction were paid out through December of 2002, and lease commitments and non-cancelable commitments are being paid out over their respective 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.

     Activity in the May 2002 restructuring accrual for the quarter ended March 31, 2003 is as follows, unaudited (in thousands):

Impairment of Long-lived Assets

     As a result of CoSine’s assessment of market conditions and the related effect on its business plan, the Company concluded that indicators of impairment of its long-lived assets were present during the second and third quarters of 2002. 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 $15,512,000 to write the carrying value of its long-lived assets held for use down to their fair values in the second and third quarters of 2002. In addition, property and equipment that was idled or abandoned was written down by approximately $3,248,000 to its estimated net realizable value. We have concluded that no additional indicators of impairment were present in the first quarter of 2003.

Interest and Other Income

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     For the three months ended March 31, 2003, interest and other income was $0.4 million, $0.9 million less than the three months ended March 31, 2002. This reflects decreased interest income due to lower levels of cash and short-term investments and lower interest rates on invested amounts.

Interest Expense

     For the three months ended March 31, 2003, interest expense was $0.1 million, $0.2 million less than the three months ended March 31, 2002. The reduction reflects a decline in our debt.

Income Tax Provision

     The provision for income taxes was $42,000 for the three months ended March 31, 2003 and $161,000 for the three months ended March 31, 2002 and was comprised entirely of foreign corporate income taxes, which is a function of our operations of subsidiaries in various countries. The provision for income taxes is based on income taxes on minimum profits the foreign operations generated for services they provided to us.

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 696,000 shares of common stock.

     We have used approximately $158 million of the funds from the initial public offering to fund our operations.

     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.

Cash, Cash Equivalents and Short-Term Investments

     At March 31, 2003, cash, cash equivalents and short-term investments were $84.3 million. This compares with $101.5 million at December 31, 2002.

Operating Activities

     We used $15.6 million and $12.0 million of cash in operations for the three months ended March 31, 2003 and 2002, respectively. The increase in net cash used in operating activities was the result of the payment of $8.5 million in previously accrued restructuring expenses, including the payment for terminating one of our Redwood City, California leased facilities and $2.4 million in other unfavorable working capital changes, partially offset by a $6.5 million reduction in net loss (exclusive of non-cash charges related to equity issuances and depreciation).

Investing Activities

     For the three months ended March 31, 2003, we generated $20.1 million and for the three months ended March 31, 2002, we used $9.5 million in cash from investing activities. The change reflects an increase of $28.9 million for net proceeds from the sale of short-term investments and a decrease in capital expenditures of $.7 million.

Financing Activities

     For the three months ended March 31, 2003 and 2002, $1.4 million and $1.1 million, respectively, were used in financing activities. This primarily reflects reduced proceeds from the issuance of common stock and notes receivable from shareholders.

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OUTLOOK

     Beginning in the 2001 fiscal year and continuing through the first quarter of the 2003 fiscal year, the telecommunications industry has experienced a significant downturn. 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 within the industry as a whole. This reduction has had a direct impact on our operations. We believe that capital spending within 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 outlook for growth in the remainder of 2003 is not favorable and the outlook for 2004 cannot be determined with certainty at this time. 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 2003 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. Until capital spending levels within the telecommunications industry begin to recover, we will focus our efforts on controlling costs and increasing our market share. However, there can be no assurance that we will succeed in meeting these objectives.

RECENT ACCOUNTING PRONOUNCEMENTS

     In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” — an Interpretation of FASB Statements No. 5, 57, and 107 and Rescission of FASB Interpretation No. 34. The Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. We have not issued or modified any guarantees since December 31, 2002 and, accordingly, adoption of FASB Interpretation No. 45 did not have a material impact on our financial results.

     In December 2002, the FASB issued Statement Number 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” (SFAS 148). SFAS 148 amends Statement Number 123, “Accounting for Stock-Based Compensation,” (SFAS 123) to provide alternative methods of transition to the SFAS 123 fair value method of accounting for stock-based employee compensation. In addition, SFAS 148 requires disclosure of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. As permitted under SFAS 148, we adopted the disclosure provisions of that accounting standard and, accordingly, have included such disclosures in the financial statements for the three months ended March 31, 2003.

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.

          At March 31, 2003, we had an accumulated deficit of $452.4 million. We have incurred net losses since our incorporation. We cannot be certain that our revenue will grow or that we will generate sufficient revenue to become profitable. If we do not achieve profitability, we may cease operations.

Due to our losses, we could lose major opportunities with large service providers who are concerned with our long-term financial viability.

          Many large telecommunications service providers purchase capital equipment from vendors with a history of successful operations including positive cash flow. Our history of losses and use of cash in operations may cause certain service providers to decide not to purchase 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

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customers to purchase product from other larger, more established suppliers including Cisco Systems, Lucent Technologies, Nortel Networks, Alcatel, Ericsson, Siemens and Juniper Networks.

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

          Our business depends on capital expenditures within the telecommunications industry, which has experienced a significant downturn since 2001. Capital spending in the industry as a whole has slowed as a result of a lack of available capital for many emerging service providers and a generally cautious approach to capital spending within the industry.

          The ultimate severity and duration of this downturn is unknown. Due to reductions in capital spending plans by our customers and uncertainty within the telecommunications industry, we anticipate that this trend will continue to have a substantial, adverse effect on our revenue growth for at least the remainder of the current fiscal year. No assurance can be given that the Company’s net sales and operating results will not be further adversely affected by the current downturn or any future downturns

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. In addition, the long cycle for service providers to introduce new services made possible by our platform may cause our revenue and operating results to vary significantly from quarter to quarter.

          Our ability to generate future revenue also depends on whether network service providers successfully forecast market trends and identify customer demand for the services and features that our products would enable network service providers to offer their customers.

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

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property, plant and equipment is reviewed if the facts and circumstances suggest that property, plant and equipment may be impaired. An impairment review requires management to make certain estimates and judgments regarding future cash flows that management expects to be generated by groups of assets.

          We evaluate the carrying value of our long-lived assets, consisting primarily of property, plant and equipment, whenever certain events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. In assessing the recoverability of long-lived assets, we compare the carrying value to the undiscounted future cash flows the assets are expected to generate. If the total of the undiscounted future cash flows is less than the carrying amount of the assets, the assets will be written down to their estimated fair value. Significant judgments and assumptions are required in the forecast of future operating results used in the preparation of the estimated future cash flows, including long-term forecasts of overall market conditions and our participation in the market. 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 the loss of current customers, the inability to attract new customers 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.

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          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 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 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.

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If necessary licenses of third-party technology are terminated or become unavailable or too expensive, our competitive position and our product offering will suffer.

          We license from third-party suppliers certain software applications incorporated in our IP Service Delivery Platform. Also, we may need to license technology from other third-party suppliers to enable us to develop new products or features. Our inability to renew or obtain any third-party license that we need could require us to obtain substitute technology of lower quality or at greater cost. 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

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certain that the steps we have taken will prevent unauthorized use of our technology. If we are unable to protect our intellectual property rights, our ability to supply our products as they have been designed could suffer, and our ability to become profitable could be harmed.

If we become involved in an intellectual property dispute, we could be subject to significant liability, the time and attention of our management could be diverted and we could be prevented from selling our products.

          We may become a party to litigation in the future to protect our intellectual property or because others may allege infringement of their intellectual property. These claims and any resulting lawsuit could subject us to significant liability for damages or invalidate our proprietary rights. These lawsuits, regardless of their merits, likely would be time-consuming and expensive to resolve and would divert management time and attention. Any potential intellectual property litigation alleging our infringement of a third-party’s intellectual property also could force us to:

	-		stop selling products or services that use the challenged intellectual property;
	-		obtain from the owner of the infringed intellectual property right a license to sell the relevant technology, which license may not be available on reasonable terms, or at all; or
	-		redesign those products or services that use the infringed technology.

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

          If our stock price were to drop below $1.00, our common stock could be delisted from the Nasdaq National market.

          A low stock price could 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, the ensuing declaration of war on terrorism, and the war against Iraq 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.

We may have difficulty obtaining director and officer liability insurance in acceptable amounts for acceptable rates.

          Like most other public companies, we carry insurance protecting our officers and directors against claims relating to the conduct of our business. This insurance covers, among other things, the costs incurred by companies and their management to defend against and resolve claims relating to management conduct and results of operations, such as securities class action claims. These claims typically are expensive to defend against and resolve. We pay significant premiums to acquire and maintain this insurance, which is provided by third-party insurers, and we agree to underwrite a portion of such exposures under the terms of the insurance coverage. One consequence of the current economic downturn and decline in stock prices has been a substantial increase in the number of securities class actions and similar claims brought against public corporations and their management, including our company and certain of our current and former officers and directors. Consequently, insurers providing director and officer liability insurance have in recent periods sharply increased the premiums they charge for this insurance, raised retentions (that is, the amount of liability that a company is required to pay to defend and resolve a claim before any applicable insurance is provided), and limited the amount of insurance they will provide. Moreover, insurers typically provide only one-year policies. The insurance policies that may cover the current securities lawsuits against us have a $250,000 retention. As a result, the costs we incur in defending the current securities lawsuits against us will not be reimbursed until they exceed $250,000. The policies that would cover any future lawsuits may not provide any coverage to us and may cover the directors and officers only in the event we are unwilling or unable to cover their costs in defending against and resolving any future claims. As a result, our costs in defending any future lawsuits could increase significantly. Particularly in the current economic environment, we cannot assure you that in the future we will be able to obtain sufficient director and officer liability insurance coverage at acceptable rates and with acceptable deductibles and other limitations. Failure to obtain such insurance could materially harm our financial condition in the event that we are required to defend against and

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resolve any future or existing securities class actions or other claims made against us or our management arising from the conduct of our operations. Further, the inability to obtain such insurance in adequate amounts may impair our future ability to retain and recruit qualified officers and directors.

ITEM 3. 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, all of our sales and most of our expenses are denominated in United States dollars. Therefore, we have not engaged in any foreign exchange hedging activities to date.

ITEM 4. CONTROLS AND PROCEDURES

	(a)		Our President and Chief Executive Officer and our Executive Vice President and Chief Financial Officer have evaluated our disclosure controls and procedures as of a date (the “Evaluation Date”) within the 90 days prior to the filing date of this report on Form 10-Q, and have concluded that such controls and procedures are effective.
	(b)		There were no significant changes in our internal controls or in other factors that could significantly affect our internal controls subsequent to the Evaluation Date, including any corrective actions with regard to significant deficiencies or material weaknesses.

PART II. OTHER INFORMATION

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

	(a)		On September 25, 2000, in connection with our initial public offering, a Registration Statement on Form S-1 (File No. 333-35938) was declared effective by the Securities and Exchange Commission, pursuant to which 1,150,000 shares of our common stock were offered and sold for our account at a price of $230 per share, generating gross offering proceeds of $264.5 million. The managing underwriters were Goldman, Sachs & Co., Chase Securities Inc., Robertson Stephens, Inc. and JP Morgan Securities Inc. Our initial public offering closed on September 29, 2000. The net proceeds of the initial public offering were approximately $242.5 million after deducting approximately $18.5 million of underwriting discounts and approximately $3.5 million of other offering expenses.
			We did not pay directly or indirectly any of the underwriting discounts or other related expenses of the initial public offering to any of our directors or officers, any person owning 10% or more of any class of our equity securities, or any of our affiliates.
			We have used approximately $158 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.

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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

			(a) Exhibit Index on page 29.
			(b) Reports on Form 8-K.

On March 25, 2003, Stephen Goggiano, President and Chief Executive Officer of the Company, and Terry Gibson, Executive Vice President and Chief Financial Officer of the Company, each executed certifications in connection with the Annual Report on Form 10-K filed by the Company for the fiscal year ending December 31, 2002, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Copies of such certifications were included in a Form 8-K, filed by the Company on March 27, 2003, as Exhibits 99.1 and 99.2, respectively.

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SIGNATURE

     Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Dated: May 9, 2003

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CERTIFICATION

1.		I have reviewed this quarterly report on Form 10-Q of CoSine Communications, Inc.;
2.		Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
3.		Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
4.		The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

	a)		designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
	b)		evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
	c)		presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5.

The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

	a)		all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
	b)		any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6.

The registrant’s other certifying officer and I have indicated in this quarterly report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

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CERTIFICATION

1.		I have reviewed this quarterly report on Form 10-Q of CoSine Communications, Inc.;
2.		Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
3.		Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
4.		The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

	a)		designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
	b)		evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
	c)		presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;