Back to GetFilings.com

Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 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 Exchange Act).  Yes [  ]     No [X]

     There were 10,004,131 shares of the Company’s Common Stock, par value $.0001, outstanding on July 31, 2003.

Page 1 of 36

Table of Contents

COSINE COMMUNICATIONS, INC.

FORM 10-Q

Quarter ended June 30, 2003

TABLE OF CONTENTS

PAGE 2 OF 36

Table of Contents

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, 2002.

PAGE 3 OF 36

Table of Contents

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

See accompanying notes.

PAGE 4 OF 36

Table of Contents

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

See accompanying notes.

PAGE 5 OF 36

Table of Contents

COSINE COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

     The unaudited consolidated financial statements have been prepared by CoSine Communications, Inc. pursuant to the rules and regulations of the Securities and Exchange Commission and include the accounts of CoSine Communications, Inc. and its wholly owned subsidiaries (“CoSine” or collectively, the “Company”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, all adjustments (consisting of normal recurring items) necessary for a fair presentation have been included. The results of operations for the three and six months ended June 30, 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.

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:

PAGE 6 OF 36

Table of Contents

     The estimated weighted-average fair value of shares granted under the Purchase Plan in the three months ended June 30, 2003 was $1.39, using a volatility of 0.35, risk-free interest rate of 1% and an expected life of six months. 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

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

     Generally, a maximum obligation is not explicitly stated. Because the obligated amounts associated with this type of agreement are not explicitly stated, the overall maximum amount of the obligation cannot be reasonably estimated. Historically, the 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 June 30, 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 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, CoSine adopted the disclosure provisions of that accounting standard and, accordingly, has included such disclosures in the financial statements for the three and six months ended June 30, 2003.

     In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51,” which requires a company that has a controlling financial interest in a variable interest entity to consolidate the assets, liabilities and results of activities of the entity. A variable interest entity is an entity in which the equity investors do not have a controlling interest or the equity investment at risk is insufficient to finance the entity’s activities without receiving additional subordinated financial support from other parties. Interpretation No. 46 is applicable:(i) immediately for all variable interest entities created after January 31, 2003; or (ii) in the first fiscal year or

PAGE 7 OF 36

Table of Contents

interim period beginning after June 15, 2003 for those created before February 1, 2003. CoSine has not created any variable entities since January 31, 2003 and does not have any investments acquired prior to February 1, 2003 that are variable interest entities; accordingly, adoption of FASB Interpretation No. 46 will not have a material impact on its financial statements.

     In May 2003, the FASB issued Statement Number 150 “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (SFAS 150). This Statement establishes standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. SFAS 150 generally requires liability classification for two broad classes of financial instruments: (1) instruments that represent, or are indexed to, an obligation to buy back the issuer’s shares, and (2) obligations that can be settled in shares, but are subject to certain conditions. SFAS 150 applies to all financial instruments created or modified after May 31, 2003, and to other instruments at the beginning of the first interim period beginning after July 1, 2003. As CoSine has not created or modified any financial instruments since the effective date of SFAS 150, CoSine does not believe this Statement will have a material impact on its financial statements.

4. COMMITMENTS AND CONTINGENCIES

     As of June 30, 2003, CoSine had commitments of approximately $1,390,000 relating to purchases of raw materials and semi-finished goods. Of that amount, $314,000 related to purchase orders in excess of demand was accrued at June 30, 2003 in accrued other liabilities.

     On November 15, 2001, CoSine and certain of its officers and directors were named as defendants in a securities class action lawsuit filed in the United States District Court, Southern District of New York. The complaint generally alleges that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares in CoSine’s initial public offering. The complaint brings claims for the violation of several provisions of the federal securities laws against those underwriters, and also against the Company and each of the directors and officers who signed the registration statement relating to the initial public offering. Various plaintiffs have filed similar actions asserting virtually identical allegations against more than 250 other companies. The lawsuit and all other “IPO allocation” securities class actions currently pending in the Southern District of New York have been assigned to Judge Shira A. Scheindlin for coordinated pretrial proceedings. In October 2002, the individual defendants were dismissed without prejudice pursuant to a stipulation. The issuer defendants filed a coordinated motion to dismiss on common pleading issues, which the Court granted in part and denied in part in an order dated February 19, 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.

     In June 2003, the plaintiffs in all of the cases presented a settlement proposal to all of the issuer defendants. Under the proposed settlement, the plaintiffs will dismiss and release all claims against participating issuer defendants in exchange for a contingent payment guaranty by the insurance companies collectively responsible for insuring the issuer defendants in all of the related cases, and the assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. Under the guaranty, the insurers will be required to pay the amount, if any, by which $1 billion exceeds the aggregate amount ultimately collected by the plaintiffs from the underwriter defendants in all the cases, up to the limits of the applicable insurance policies. The Company will not be required to make any cash payments under the settlement, unless the Company’s insurer is required to pay on the Company’s behalf an amount that exceeds the Company’s insurance coverage. The Company does not believe that this circumstance will occur. In July 2003, a special committee of the Company’s Board of Directors approved the proposed settlement. The settlement is subject to acceptance by a substantial majority of the issuer defendants, and execution of a definitive settlement agreement. The settlement is also subject to approval of the court, which cannot be assured. If the settlement is not consummated, the Company intends to defend the lawsuit vigorously. However, the litigation is in the early stages, and we cannot predict its outcome with certainty.

     In December 2002 and January 2003, two lawsuits were filed against the Company and its directors in state court in California. The lawsuits alleged that the Company and the other defendants violated their fiduciary duties by failing to approve an acquisition of the Company by Wyndcrest Holdings, LLC in December 2002. After only minimal prosecution of the lawsuits, the plaintiffs agreed to dismiss them without prejudice to plaintiffs’ right to re-file at a later date. The dismissals became effective on June 6, 2003. Neither lawsuit is currently pending.

PAGE 8 OF 36

Table of Contents

     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 June 30, 2003 was $386,000 of goods awaiting customer acceptance. There were no goods awaiting customer acceptance at December 31, 2002. Included in net finished goods at June 30, 2003 and December 31, 2002 were $263,000 and $289,000, respectively, of goods used for customer evaluation purposes.

     During the six months ended June 30, 2003, $612,000 of fully reserved inventory was sold and no inventory was written down. During the six months ended June 30, 2002, $701,000 of fully reserved inventory was sold and inventory was written down by $1,692,000.

     CoSine periodically reviews the rates used to determine overhead capitalization applied to inventory. As a result of restructuring activity and refinements in its business model, the Company adjusted the overhead absorption rate for raw materials and semi-finished goods downward during the three months ended June 30, 2003. This increased cost of goods sold by $369,000 for the three and six months ended June 30, 2003.

Warranty

     CoSine provides a basic limited warranty, including repair or replacement of parts, and technical support. The specific terms and conditions of those warranties vary depending on the customer or region in which CoSine does business. CoSine estimates the costs that may be incurred under its basic limited warranty and records a liability in the amount of such costs at the time product revenue is recognized. CoSine’s warranty obligation is affected by the number of installed units, product failure rates, materials usage and service delivery costs incurred in correcting product failures. CoSine periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary.

     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

PAGE 9 OF 36

Table of Contents

been excluded from the diluted net loss per common share computations, as their inclusion would be antidilutive. These securities amounted to 1,580,837 shares and 2,057,100 shares for the six months ended June 30, 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

     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, 2003 and 2002, respectively, were as follows, in thousands:

PAGE 10 OF 36

Table of Contents

9. RESTRUCTURING CHARGES

May 2003 Restructuring

     In May 2003, CoSine’s senior management communicated an additional reduction in its workforce related to employees in its European region. The employees were notified in May 2003 that their job functions would be eliminated and that termination benefits would be paid to them. As a result of the workforce reduction, two employees were designated for termination. Amounts related to the workforce reduction are expected to be paid through July 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 May 2003 restructuring charges for the six months ended June 30, 2003 are as follows, unaudited (in thousands):

March 2003 Restructuring

     In March 2003, CoSine’s senior management communicated an additional reduction in its workforce related to the closure of a sales office in the Asia/Pacific Rim region. The employees were notified in March 2003 that their job functions would be eliminated and that termination benefits would be paid to them. As a result of the workforce reduction, three employees were designated for termination. Amounts related to the workforce reduction and the other items are expected to be paid through December 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 six months ended June 30, 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 September of 2003. In addition, during the first quarter of 2003, CoSine concluded negotiations to settle

PAGE 11 OF 36

Table of Contents

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 six months ended June 30, 2003 is as follows, unaudited (in thousands):

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 six months ended June 30, 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

PAGE 12 OF 36

Table of Contents

estimated net realizable value. The Company has concluded that no indicators of impairment were present in the first or second quarters of 2003.

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.

PAGE 13 OF 36

Table of Contents

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.

     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 and six months ended June 30, 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 six months 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.

PAGE 14 OF 36

Table of Contents

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 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 June 30, 2003 and 2002, we reported basic and diluted net losses per common share of $0.79 and $4.63, respectively. The effect of equity issuances to customers, suppliers, employees and consultants increased net loss per common share by $0.03 and $0.06 per share for the three months ended June 30, 2003 and 2002, respectively.

     For the six months ended June 30, 2003 and 2002, we reported basic and diluted net losses per common share of $1.70 and $7.02, respectively. The effect of equity issuances to customers, suppliers, employees and consultants increased net loss per common share by $0.05 and $0.38 per share for the six months ended June 30, 2003 and 2002, respectively.

Revenue

     For the three months ended June 30, 2003, revenue was $6.0 million of which 84% was from hardware sales, 1% was from software sales and 15% was from sales of services. 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 six months ended June 30, 2003, revenue was $8.2 million of which 81% was from hardware sales, 2% was from software sales and 17% was from sales of services. 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. Revenue in the first six months of 2003 was the result of continued weakness in capital spending in the

PAGE 15 OF 36

Table of Contents

telecommunications industry. Additionally, in Europe and the Asia/Pacific Rim regions, slower-than-expected follow-on orders, some of which was related to the timing of orders, contributed to the revenue decline.

Non-Cash Charges Related to Equity Issuances

     During the three months ended June 30, 2003 and 2002, we recorded $0.3 million and $0.6 million, respectively, of non-cash charges related to equity issuances to cost of goods sold, operating expenses and interest expense. During the six months ended June 30, 2003 and 2002, we recorded $0.5 million and $3.7 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 and six months ended June 30, 2003 and 2002, as presented in our statement of operations, in thousands: