UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(MARK ONE)

FOR THE QUARTERLY PERIOD ENDED March 31, 2004

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 10,183,500 shares of the Company’s Common Stock, par value $.0001, outstanding on April 30, 2004.

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COSINE COMMUNICATIONS, INC.

FORM 10-Q

Quarter ended March 31, 2004

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

ITEM 1. CONDENSED 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, 2003.

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COSINE COMMUNICATIONS, INC.

² Research and development expenses include $41 and $198 for the three months ended March 31, 2004 and 2003, respectively, of non-cash charges related to equity issuances.

³ Sales and marketing expenses include ($39) and ($192) for the three months ended March 31, 2004 and 2003, respectively, of non-cash credits related to equity issuances.

⁴ General and administrative expenses include ($90) and $137 for the three months ended March 31, 2004 and 2003, respectively, of non-cash (credits) charges related to equity issuances.

⁵ Interest expense includes $0 and $30 for the three months ended March 31, 2004 and 2003, respectively, of non-cash charges related to equity issuances.

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COSINE COMMUNICATIONS, INC.

See accompanying notes.

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COSINE COMMUNICATIONS, INC.

1. BASIS OF PRESENTATION

     The unaudited condensed consolidated financial statements have been prepared by CoSine Communications, Inc. pursuant to instructions to Form 10-Q and Article 10 of Regulation S-X and include the accounts of CoSine Communications, Inc. and its wholly owned subsidiaries (“CoSine” or collectively, the “Company”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the Securities and Exchange Commission’s rules and regulations. In the opinion of management, all adjustments (consisting of normal recurring items) necessary for a fair presentation have been included. The results of operations for the three months ended March 31, 2004 are not necessarily indicative of the results to be expected for any subsequent quarter or for the entire year. The condensed consolidated balance sheet at December 31, 2003 has been derived from the audited financial statements as of that date. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes included in CoSine’s Annual Report filed on Form 10-K for the year ended December 31, 2003.

Pro Forma Information

     CoSine has elected to continue to follow Accounting Principles Board Opinion 25 (“APB 25”), “Accounting for Stock Issued to Employees,” and related interpretations to account for employee stock options because the alternative fair value method of accounting prescribed by Statement of Financial Accounting Standards (“SFAS”) 123, “Accounting for Stock-Based Compensation,” as amended by SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure” requires the use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, no compensation expense is recognized when the exercise price of employee stock options equals the market price of the underlying stock on the date of grant.

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

     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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     In the three months ended March 31, 2004, no shares were issued under the Employee Stock Purchase Plan. The estimated weighted-average fair value of shares issued under the Employee Stock Purchase Plan in 2003 was $2.22, using a volatility of 0.47, risk-free interest rate of 1.3% and an expected life of one year.

Guarantees

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

     Generally, a maximum obligation is not explicitly stated. Because the obligated amounts associated with this type of agreement are not explicitly stated, the overall maximum amount of the obligation cannot be reasonably estimated. Historically, CoSine has not been obligated to make payments for these obligations, and no liabilities have therefore been recorded for these obligations on its consolidated balance sheet as of March 31, 2004.

Use of Estimates

     The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and the accompanying notes. Actual results could differ from these estimates. Estimates are used in accounting for, but not limited to, revenue recognition, allowance for doubtful accounts, inventory valuations, long-lived asset valuations, accrued liabilities including warranties, and equity issuances. Estimates and assumptions are reviewed periodically and the effects of revisions are reflected in the consolidated financial statements in the period of determination.

2. COMMITMENTS AND CONTINGENCIES

     As of March 31, 2004, CoSine had commitments of approximately $990,000 relating to purchases of raw materials and semi-finished goods. Of that amount, $364,000 related to excess inventory was accrued at March 31, 2004.

     On November 15, 2001, CoSine and certain of its officers and directors were named as defendants in a securities class action lawsuit filed in the United States District Court, Southern District of New York. The complaint generally alleges that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares in CoSine’s initial public offering. The complaint brings claims for the violation of several provisions of the federal securities laws against those underwriters, and also against the Company and each of the directors and officers who signed the registration statement relating to the initial public offering. Various plaintiffs have filed similar actions asserting virtually identical allegations against more than 250 other companies. The lawsuit and all other “IPO allocation” securities class actions currently pending in the Southern District of New York have been assigned to Judge Shira A. Scheindlin for coordinated pretrial proceedings. In October 2002, the individual defendants were dismissed without prejudice pursuant to a stipulation. The issuer defendants filed a coordinated motion to dismiss on common pleading issues, which the Court granted in part and denied in part in an order dated February 19, 2003. The Court’s order dismissed the Section 10(b) and Rule 10b-5 claims against the Company but did not dismiss the Section 11 claims against the Company.

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     In June 2003, the plaintiffs in all of the cases presented a settlement proposal to all of the issuer defendants. Under the proposed settlement, the plaintiffs will dismiss and release all claims against participating issuer defendants in exchange for a contingent payment guaranty by the insurance companies collectively responsible for insuring the issuer defendants in all of the related cases, and the assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. Under the guaranty, the insurers will be required to pay the amount, if any, by which $1 billion exceeds the aggregate amount ultimately collected by the plaintiffs from the underwriter defendants in all the cases, up to the limits of the applicable insurance policies. The Company will not be required to make any cash payments under the settlement, unless the Company’s insurer is required to pay on the Company’s behalf an amount that exceeds the Company’s insurance coverage. The Company does not believe that this circumstance will occur. In July 2003, a special committee of the Company’s Board of Directors approved the proposed settlement. The settlement is subject to acceptance by a substantial majority of the issuer defendants, and execution of a definitive settlement agreement. The settlement is also subject to approval of the court, which cannot be assured. If the settlement is not consummated, the Company intends to defend the lawsuit vigorously. However, the Company cannot predict its outcome with certainty. If the Company is not successful in its defense of this lawsuit, it could be forced to make significant payments to the plaintiffs and their lawyers, and such payments could have a material adverse effect on the Company’s business, financial condition and results of operations if not covered by the Company’s insurance carrier. Even if these claims are not successful, the litigation could result in substantial costs and divert management’s attention and resources, which could adversely affect the Company’s business, results of operations and financial position.

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

3. BALANCE SHEET DETAILS

Inventory

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

     Included in net finished goods at March 31, 2004 and December 31, 2003 was $190,000 and $160,000, respectively, of goods awaiting customer acceptance. Included in net finished goods at March 31, 2004 and December 31, 2003 were $66,000 and $126,000, respectively, of goods used for customer evaluation purposes.

     During the three months ended March 31, 2004, $60,000 of previously written-down inventory was sold and $102,000 of inventory was written down. During the three months ended March 31, 2003, $336,000 of previously written-down inventory was sold and no inventory was written down. In addition, charges of $35,000 were recorded in the three months ended March 31, 2004 in connection with excess purchase commitments at CoSine’s contract manufacturers. There were no charges in connection with excess purchase commitments at CoSine’s contract manufacturers in the three months ended March 31, 2003.

Warranty

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

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

4. NET LOSS PER COMMON SHARE

     Basic net loss per common share is calculated based on the weighted-average number of common shares outstanding during the periods presented, less weighted-average shares outstanding that are subject to CoSine’s right of repurchase. Common stock equivalents consisting of stock options and warrants (calculated using the treasury stock method), have been excluded from the diluted net loss per common share computations, as their inclusion would be antidilutive. These securities amounted to 1,258,000 shares and 1,181,000 shares for the three months ended March 31, 2004 and 2003, respectively.

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

5. COMPREHENSIVE LOSS

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

6. SEGMENT REPORTING

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

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     Revenues from customers by geographic region for the three months ended March 31, 2004 and 2003, respectively, were as follows, in thousands:

     For the three months ended March 31, 2004, Sprint, Lucent, Infranet (Korea) and Transpac accounted for 38%, 16%, 13% and 10% of CoSine’s revenue, respectively. For the three months ended March 31, 2003, Sprint, NEC, Equant and Transpac accounted for 33%, 17%, 12% and 11% of CoSine’s revenue, respectively. At March 31, 2004, Infranet (Korea), Sprint and Transpac accounted for 28%, 27% and 13% of CoSine’s accounts receivable, respectively. At December 31, 2003, Sprint and Lucent accounted for 52% and 19% of CoSine’s accounts receivable, respectively.

7. RESTRUCTURING CHARGES

March 2003 and May 2002 Restructuring

     In March 2003, CoSine’s senior management communicated reductions in its workforce related to the closure of a sales office in the Asia/Pacific Rim region. The employees were notified in March 2003 that their job functions would be eliminated and that termination benefits would be paid to them. As a result of the workforce reduction, five employees were designated for termination.

     In May 2002, CoSine’s senior management approved a restructuring program to reduce its worldwide workforce, close certain sales offices, exit certain facilities and dispose of or abandon certain property and equipment. Employees were notified in May 2002 that certain job functions would be eliminated and that particular termination benefits would be paid to affected employees. As a result of the workforce reduction, 146 employees were designated for termination in the restructuring program. Most of the terminations took place in the second quarter of 2002, with the remainder taking place in the third quarter of 2002. The employees in the workforce reduction were from all functional groups and were located in offices in the United States, Europe and Asia. The Company also wrote down certain property and equipment to its expected realizable value as the assets have been either sold, disposed of or otherwise abandoned. The final $153,000 related to the restructuring program was paid in the three months ended March 31, 2004.

     Activity related to the March 2003 and May 2002 restructurings for the three months ended March 31, 2004 was as follows, (in thousands):

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     CoSine expects to pay the remaining $48,000 related to the workforce reduction in 2004.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements. We use words such as “anticipate,” “believe,” “plan,” “expect,” “future,” “intend” and similar expressions to identify forward-looking statements. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, failure to achieve revenue growth and profitability, the loss of business opportunities with large service providers due to our financial losses, the continued downturn in the telecommunications industry and slow development of the market for network-based IP services, failure to develop and maintain distribution partnerships, product development, commercialization and technology difficulties, manufacturing costs, the impact of competitive products, pricing, changing customer requirements, timely availability and acceptance of new products, and changes in economic conditions in the various markets that we serve, all as are discussed in more detail in the section entitled “Risk Factors” on pages 19 through 24 of this report, as well as the other risk factors discussed in that section. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s opinions only as of the date hereof. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Readers should carefully review the risk factors described in other documents that we file from time to time with the Securities and Exchange Commission, including the Quarterly Reports on Form 10-Q that we will file in the remainder of fiscal year 2004.

OVERVIEW

     We develop, market and sell a communications platform that we refer to as our IP Service Delivery Platform. Our product is designed to enable network service providers to rapidly deliver a portfolio of communication services to business and consumer customers. We market our IP Service Delivery Platform through our direct sales force and through resellers to network service providers in Asia, Europe and North America. We provide customer service and support for our products directly and through support partners.

     The market for our IP Service Delivery Platform is still in the early stages of development, and the volume and timing of orders are difficult to predict. A customer’s decision to purchase our platform typically involves a significant commitment of its resources and a lengthy evaluation, testing and product qualification process. The long sales cycle and the timing of our customers’ rollout of services made possible by our platform, which affects repeat business, may cause our revenue and operating results to vary significantly and unexpectedly from quarter to quarter and may also constrain our ability to secure new customers. While we believe that the market for network-based IP services will continue to grow and represents a significant opportunity, we have not generated sufficient revenue to fund our operations. We believe that we have a technically strong product that can deliver IP services at a lower cost than competing products. However, we must increase our revenue in the near term in order to reduce our cash consumption and remain a viable and competitive supplier.

     Management’s overview of the Company’s position is discussed in more detail in the “Outlook” section on page 18 and the “Liquidity and Capital Resources” section on page 17.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

General

     Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, allowance for doubtful accounts, inventory valuation, long-lived assets, warranties and equity issuances. Additionally, the audit committee of

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

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

Revenue Recognition

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

     Certain of our sales arrangements require formal acceptance by our customers. In such cases, we do not recognize revenue until we have received formal notification of acceptance. Although we work closely with our customers to help them achieve satisfaction with our products prior to and after acceptance, the timing of customer acceptance can greatly affect the timing of our revenue.

     While the end users of our product are generally large network service providers, we also sell product and services through small resellers and to small network service providers in Asia, Europe and North America. To recognize revenue before we receive payment, we are required to assess that collection from the customer is probable. If we cannot satisfy ourselves that collection is probable, we defer revenue recognition until we have collected payment.

Allowance for Doubtful Accounts Receivable

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

Inventory Valuation

     In assessing the value of our inventory, we are required to make judgments as to future demand and then compare that demand with current inventory quantities and firm purchase commitments. If our inventories and firm purchase commitments are in excess of forecasted demand, we write down the value of our inventory. We generally use a 12-month forecast to assess future demand. Inventory write-downs are charged to cost of sales. During the three months ended March 31, 2004, we wrote down $102,000 of inventory and we sold $60,000 of previously written-down inventory. If actual demand for our products is less than our forecasts, additional inventory write-downs may be required.

Long-lived Assets

     We evaluate the carrying value of long-lived assets, consisting primarily of property, plant and equipment, whenever certain events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. In assessing the recoverability of long-lived assets, we compare the carrying value to the undiscounted future cash flows the assets are expected to generate. If the total of the undiscounted future cash flows is less than the carrying amount of the assets, the assets will be written down to their estimated fair value. Fair value is generally determined by calculating the discounted future cash flows using a discount rate based upon our weighted average cost of capital or specific appraisal, as appropriate. Significant judgments and assumptions are required in the forecast of future operating results used in the preparation of the estimated future cash flows, including long-term forecasts of overall market conditions and our participation in the market. Changes in these estimates could have a material adverse effect on the assessment of the long-lived assets, thereby requiring us to record further asset write-downs in the future. We have concluded that no indicators of impairment were present in the first three months of 2004.

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Warranties

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

Impact of Equity Issuances on Operating Results

     In 2004 and 2003, our operating results have been affected by stock options previously granted to employees that were subsequently re-priced and by the amortization of deferred compensation related to stock options granted prior to September 2000 at an exercise price below their estimated fair value. These employee stock option transactions have resulted in deferred compensation, which is presented as a reduction of stockholders’ equity on our balance sheet and is amortized over the vesting period of the applicable options using the graded vesting method. The re-priced stock options are also required to be re-measured each quarter based on their fair market value, resulting in additional charges or credits. In the first quarter of 2004, our operating results were additionally affected by the grant of CoSine common stock to employees based on the achievement of certain Company objectives.

     The compensation associated with shares and options relating to the following transactions is required to be re-measured at the end of each accounting period. The re-measurement at the end of each accounting period will result in unpredictable charges or credits in future periods, depending on future fluctuations in the market prices of our common stock:

•

Non-recourse promissory notes receivable: During the fourth quarter of 2000, we converted full-recourse promissory notes received from employees upon the early exercise of unvested employee stock options to non-recourse obligations. Accordingly, we are required to re-measure the compensation associated with the shares underlying the promissory note until the earlier of repayment of the note or default. Deferred compensation expense, which is recorded at each re-measurement date, is amortized over the remaining vesting period of the underlying options.

•

Re-priced stock options: In November 2002, we re-priced outstanding employee stock options to purchase 1,091,453 shares of our common stock with original exercise prices ranging from $5.45 per share to $159.38 per share. These options were re-priced to $5.00 per share, which was higher than the fair market value of the underlying shares on the re-pricing date. Compensation will be re-measured for these options until they are exercised, canceled, or expire. At March 31, 2004, 569,961 stock options re-priced in November 2002 were still outstanding. Deferred compensation expense, which is recorded at each re-measurement date, is amortized over the remaining vesting period of the underlying options.

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

     In 2004, we began a program whereby we grant employees bonuses in shares of CoSine common stock based on the achievement of certain Company objectives. At the end of each quarter, we determine whether objectives have been achieved and set the total value of the common stock grant. The number of shares to be granted is calculated the following quarter based on the fixed value of the common stock grant, as determined at quarter-end, divided by CoSine’s stock price on the grant date. Compensation expense is accrued in full in the quarter in which it is earned.

RESULTS OF OPERATIONS

     For the three months ended March 31, 2004 and 2003, we reported basic and diluted net losses per share of $0.74 and $0.91, respectively. The effect of equity issuances to employees and suppliers decreased net loss per share by $0.01 for

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the three months ended March 31, 2004 and increased net loss per share by $0.02 for the three months ended March 31, 2003.

Revenue

     For the three months ended March 31, 2004, revenue was $4.5 million of which 73% was from hardware sales, 11% was from software sales and 16% was from sales of services. For the three months ended March 31, 2003, revenue was $2.2 million of which 74% was from hardware sales, 7% was from software sales and 19% was from sales of services.

     Revenues from customers by geographic region for the three months ended March 31, 2004 and 2003, respectively, were as follows, in thousands:

     We have continued to focus our sales and engineering efforts on certain large service providers. The increase in total revenue of $2.2 million in the first three months of 2004 compared to the same period in 2003 resulted primarily from higher sales to those customers, who expanded network capacity or increased the capability of their networks.

     Because the market for network-based IP services is in the early stages of development, service provider demand for our products may fluctuate until service providers are able to further develop enterprise demand for such services and accelerate revenue growth from the sale of such services. See “Outlook” section on page 18 and “Risk Factors” section on pages 19 to 24.

Non-Cash Charges Related to Equity Issuances

     During the three months ended March 31, 2004, we recorded ($0.1) million and $0.2 million of non-cash (credits) charges related to equity issuances to cost of goods sold, operating expenses and interest expense.

     Below is a reconciliation of non-cash charges related to equity issuances for the three months ended March 31, 2004 and 2003, as presented in our statement of operations, in thousands:

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     Under the stock bonus program for which we issued $236,000 at March 31, 2004, we issued 43,300 shares of CoSine common stock in the second quarter of 2004, based on CoSine’s stock price on the issuance date.

Cost of Goods Sold

     For the three months ended March 31, 2004, cost of goods sold was $1.5 million, of which $1.2 million represented materials, labor, production overhead, warranty and the costs of providing services, $0.2 million represented software royalty expense, $0.1 million represented inventory written down, $0.1 million represented scrap and other adjustments, off-set by a $0.1 million benefit associated with previously written-down inventory sold. For the three months ended March 31, 2003, cost of goods sold was $0.7 million, of which $1.0 million represented materials, labor, production overhead, warranty and the costs of providing services, off-set by $0.3 million representing a benefit associated with previously written-down inventory sold.

Gross Profit

     For the three months ended March 31, 2004 and 2003, gross profit was $3.0 million and $1.5 million, respectively. Gross margin declined from 68% to 66%. Lower sales of previously written-down inventory accounted for a 14 percentage point decrease in gross margin. Higher charges for inventory written-down accounted for a two percentage point decrease in gross margin. Higher warranty expenses additionally decreased gross margin by six percentage points primarily due to a $97,000 credit taken in the three months ended March 31, 2003. Partially offsetting those unfavorable changes, a reduction in materials, labor and product overhead costs as a percentage of sales accounted for a 21 percentage point improvement in gross margin. Primarily accounting for the reduction in materials, labor and overhead cost as a percentage of sales were an increase in average selling price due to the regional mix of sales, more favorable product configurations, including higher software sales, and reductions in maintenance contract support costs due to headcount and overhead reductions.

     We expect our gross margin to continue to be primarily affected by regional product mix and configurations, the volume of product sold and pricing pressures, the amount of excess inventory reserve charges and the amount of previously written-down inventory sold. The mix of products that our customers purchase is unpredictable and, because of lead times required to buy certain components and the timing of our customers’ orders, we purchase inventory based on forecasted demand. The amount of excess inventory purchase commitments and excess inventory charges related to on-hand inventory is dependent on us purchasing the correct mix of inventory. In addition, if our unit sales volumes are significantly lower than forecasted demand, excess inventory charges will result.

Research and Development Expenses

     Research and development expenses were $5.3 million for both the three months ended March 31, 2004 and 2003, respectively. There were several offsetting items. Outside engineering services increased $0.5 million due to the transition of our sustaining engineering and certain software development functions to outside engineering firms. Non-cash equity charges declined $0.2 million primarily due to credits related to the reversal of amortization of deferred compensation expense in excess of vesting for employees who were terminated during the first quarter of 2004 and to an expense credit for re-priced options as our stock price declined $.80 from December 31, 2003 to March 31, 2004. Depreciation expense declined $0.1 million due primarily to certain property and equipment becoming fully depreciated.

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Facilities and information technology infrastructure expense declined $0.1 million as a result of reductions in property taxes and in depreciation of information technology infrastructure. Finally, $0.3 million of savings related to a 15-employee reduction over the year were offset by $0.2 million of severance costs for eight of those employees who terminated in the first quarter of 2004.

     As a result of the engineering headcount reductions, we will see a savings in payroll-related expense. Those savings, however, will be largely offset by the increased outsourcing of sustaining engineering and certain software development functions. The timing of prototyping, certification testing, customer-specific testing and equity-related charges (benefits), including the effect of bonuses awarded in shares of common stock, can cause expenses to fluctuate from quarter-to-quarter.

     We expect research and development expenses in the quarter ending June 30, 2004 to be essentially consistent with the levels in the quarter ended March 31, 2004.

Sales and Marketing Expenses

     Sales and marketing expenses were $3.4 million and $3.3 million for the three months ended March 31, 2004 and 2003, respectively. Payroll-related expense increased $0.3 million primarily due to commission expense on $2.3 million higher sales in the first quarter of 2004 compared to the first quarter of 2003. Non-cash charges related to equity issuances increased $0.2 million due primarily to credits for the reversal of amortization of deferred compensation expense in excess of vesting for employees who terminated during the first quarter of 2003. Absorption to cost of goods sold of spending to support maintenance contracts and warranty declined $0.1 million. Such support costs are initially charged to Sales and Marketing expense and subsequently reclassified to either cost of sales or the provision for warranty claims based on associated activity such as product return levels and technical support case data. Due primarily to a smaller customer installed base, activity associated with maintenance and warranty was less than the prior year. Offsetting those increases in expense, facilities rent expense decreased by $0.2 million due to reductions in square footage and re-negotiation of rents at certain offices and the elimination of others. Travel expense declined $0.1 million due to continued cost saving measures. Depreciation expense declined $0.1 million due primarily to some assets becoming fully depreciated.

     We expect sales and marketing expenses in the quarter ending June 30, 2004 to be essentially consistent with the levels in the quarter ended March 31, 2004.

General and Administrative Expenses

     General and administrative expenses were $1.7 million for both the three months ended March 31, 2004 and 2003, respectively. Outside legal and accounting expense increased $0.3 million due to tax and structural changes related to international subsidiaries and audit-related matters. Other outside services increased $0.1 million primarily as a result of fees paid to an outside firm to assist us in finding partnership opportunities. Offsetting those increases, stock-based compensation expense declined $0.2 million primarily due to an expense credit for re-priced options as our stock price declined $.80 from December 31, 2003 to March 31, 2004. Payroll-related expense declined $0.1 million primarily due to reduced headcount and related benefits. Director and officer insurance expense declined $0.1 million as we were able to obtain better rates than in the prior year.

     General and administrative expenses in the second half of 2004 may significantly increase due to cost related to the implementation of Section 404 of the Sarbanes-Oxley Act of 2002, which requires management to report on, and our auditors to attest to, our internal controls.

Restructuring and Impairment

March 2003 and May 2002 Restructuring

     In March 2003, our senior management communicated reductions in our workforce related to the closure of a sales office in the Asia/Pacific Rim region. The employees were notified in March 2003 that their job functions would be

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eliminated and that termination benefits would be paid to them. As a result of the workforce reduction, five employees were designated for termination.

     In May 2002, our senior management approved a restructuring program to reduce our worldwide workforce, close certain sales offices, exit certain facilities and dispose of or abandon certain property and equipment. Employees were notified in May 2002 that certain job functions would be eliminated and that particular termination benefits would be paid to affected employees. As a result of the workforce reduction, 146 employees were designated for termination in the restructuring program. Most of the terminations took place in the second quarter of 2002, with the remainder taking place in the third quarter of 2002. The employees in the workforce reduction were from all functional groups and were located in offices in the United States, Europe and Asia. We also wrote down certain property and equipment to its expected realizable value as the assets have been either sold, disposed of or otherwise abandoned. The final $153,000 related to the restructuring program was paid in the three months ended March 31, 2004.

     Activity related to the March 2003 and May 2002 restructurings for the three months ended March 31, 2004 was as follows (in thousands):

     CoSine expects to pay the remaining $48,000 related to the workforce reduction in 2004.

Interest and Other Income

     For the three months ended March 31, 2004 and 2003, interest and other income was $0.1 million and $0.4 million, respectively. This reflects decreased interest income due to lower levels of cash and short-term investments and lower interest rates on invested amounts.

Interest Expense

     For the three months ended March 31, 2004 and 2003, interest expense was $2,000 and $128,000, respectively. The reduction reflects a decline in our debt.

Income Tax Provision

     For the three months ended March 31, 2004 and 2003, the provisions for income taxes were $43,000 and $42,000, respectively, and were comprised entirely of foreign corporate income taxes, which are a function of our operation of subsidiaries in various countries.

LIQUIDITY AND CAPITAL RESOURCES

     Currently, we are not generating sufficient revenue to fund our operations. We expect our operating losses and net operating cash outflows to continue unless we are able to significantly increase our revenue. In 2001 and 2002 and, to a lesser extent, in March and May 2003, we announced that we had adopted business plans to reduce our operating expenses to reflect the then current and expected business conditions. As of the filing date of this report, we believe that we cannot make further significant reductions in our operating expenses and still remain a viable and competitive supplier.

     Based on our rate of quarterly cash consumption in the last four quarters of approximately $8.5 million, we believe that we possess sufficient liquidity and capital resources to fund our operations and working capital requirements for at least the next 12 months. However, because of our history of losses and use of cash in operations, certain of our existing

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and prospective customers may have concerns regarding our long-term financial viability and our ability to support their businesses, and as a result may choose to purchase equipment from other larger and more established suppliers. See “Risk Factors” on pages 19 - 24.

     We may seek to raise additional funds through debt or equity financing, or from other sources. There can be no assurances that additional funding will be available at all, or that if available, such financing will be obtainable on terms favorable to us.

Cash, Cash Equivalents and Short-Term Investments

     At March 31, 2004, cash, cash equivalents and short-term investments were $50.2 million. This compares with $57.8 million at December 31, 2003.

Operating Activities

     We used $7.0 million and $15.6 million of cash in operations for the three months ended March 31, 2004 and 2003, respectively. The decrease in net cash used in operating activities was primarily the result of the payment of $8.4 million of restructuring expenses in the first quarter of 2003.

Investing Activities

     For the three months ended March 31, 2004, investing activities used $0.6 million in cash while for the three months ended March 31, 2003, investing activities provided $20.1 million in cash. The change reflects a decrease of $20.5 million for net proceeds from the sale of short-term investments and an increase in capital expenditures of $0.2 million.

Financing Activities

     For the three months ended March 31, 2004 and 2003, $9,000 and $1.4 million, respectively, were used in financing activities. The decrease primarily reflects lower principal payments on working capital loans and capital leases, all of which have expired as of March 31, 2004.

OUTLOOK

     Although capital spending in the telecommunications industry has begun to recover, the market for network-based IP services continues to develop slowly. While we believe that this market represents a significant opportunity, we recognize that we must significantly reduce our cash consumption in the near term by significantly increasing revenues or we will not be able to survive. At March 31, 2004, we had $50.2 million in cash and short-term investments. Cash consumption during the quarter ending March 31, 2004 was $7.6 million. As of the filing of this report, we believe that we cannot make further significant reductions in our operating expenses, and at the same time continue with the research and development and marketing and sales activity necessary to compete effectively in our market. Therefore, we must achieve revenue growth in the near term by winning repeat business as our customers expand their network-based IP service offerings and by winning new customers as they seek to enter this market. There can be no assurance, however, that we will succeed in meeting these objectives.

     Our ability to pursue new customers is constrained by the relatively small size of our sales and support forces and the long sales cycle involved in the purchase of our products. Accordingly, the establishment of strategic reseller relationships is an important part of our strategy for 2004. By establishing those relationships, we can leverage the sales and support capabilities of these partners and thereby expand our potential market.

     Finally, we have evaluated a variety of different business scenarios and possible means to enhance CoSine’s chances of success. We have explored, and will continue to explore, OEM relationships, strategic partner relationships, mergers and acquisitions, and other corporate transactions and strategies as possible ways to maximize shareholder value, and we use industry and financial experts to assist us in seeking and evaluating such opportunities.

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RISK FACTORS

     The following discussion describes certain risk factors related to our business as well as to our industry in general.

We have a history of losses that we expect will continue, and if we do not achieve profitability we may cease operations.

     At March 31, 2004, we had an accumulated deficit of $485.8 million. We have incurred net losses since our incorporation. We cannot be certain that our revenue will grow or that we will generate sufficient revenue to become profitable. At March 31, 2004, we had $50.2 million in cash and short-term investments. Cash consumption during the quarter ending March 31, 2004 was $7.6 million. If we do not achieve profitability and are unable to obtain additional financing, we may run out of cash and cease operations.

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

     Many large telecommunications service providers purchase capital equipment from vendors with a history of successful operations including positive cash flow. Our history of losses and use of cash in operations may cause certain service providers to decide not to purchase equipment from us because of concerns regarding our long-term financial viability and our ability to support their businesses. Unless we can generate positive cash flows by increasing revenues, concerns regarding our long-term financial viability may cause some potential customers to purchase product from other larger, more established suppliers including Cisco Systems, Lucent Technologies, Nortel Networks, Alcatel, Ericsson, Siemens, and Juniper Networks.

The market for managed network-based IP services is still in the early stages of growth. As a result, demand may fluctuate.

     The market for managed network-based IP services is still in the early stages of growth. We believe that the market for these services will grow, but the timing of this growth is linked to the development of this market by service providers and the growth of enterprise demand. Until the market develops further, demand may not increase significantly and may continue to fluctuate. If our quarterly or annual operating results do not meet the expectations of securities analysts or investors, the trading price of our common stock could decline.

Our ability to sustain or grow our business may be harmed if we are unable to develop and maintain certain strategic relationships with third parties to market and sell our products.

     Because we are a relatively small company with correspondingly small sales and support groups, our success will depend in part upon our ability to form and maintain distribution partnerships, including agreements under which we sell our products to certain service provider customers through distribution partners. We may not be able to establish sufficient reseller relationships to enable us to expand our potential market and achieve revenue growth. The amount and timing of resources that our distribution partners devote to our business, if any, is not within our control. Our distribution partners may not perform their obligations as expected. In some cases, agreements with our distribution partners may be relatively new, and we cannot be certain that we will be able to achieve expected revenues from such partners or sustain the level of revenue generated thus far under similar arrangements. If any of our distribution partners chooses not to renew, breaches or terminates its agreement or fails to perform its obligations under its agreement, we may not be able to sustain or grow our business. In the event that such relationships are terminated, we may not be able to continue to maintain or develop similar relationships or to replace distribution partners. In addition, any such agreements we enter into in the future may not be successful.

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

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

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

If we fail to retain key personnel, our operations could suffer and our stock price could be negatively impacted.

     Maintaining key personnel may be difficult for a number of reasons, including but not limited to market demand, stock price, growth opportunities, management philosophy, company performance and competitive activity. If we lose key personnel we may find it difficult and costly to recruit new management and other personnel and this may have a negative affect on our performance and in turn on our stock price.

The long sales cycle for our platform may cause our revenue and operating results to vary significantly from quarter to quarter, and the price of our stock to decline.

     A customer’s decision to purchase our IP Service Delivery Platform involves a significant commitment of its resources and a lengthy evaluation, testing and product qualification process that may run from three to twelve months. Network service providers and other customers with complex networks usually expand their networks in increments on a periodic basis. We may receive purchase orders for significant dollar amounts on an irregular and unpredictable basis. These events may cause our revenue and operating results to vary significantly and unexpectedly from quarter to quarter, which could cause our stock price to decline.

We participate in a competitive marketplace, and our failure to compete successfully would limit our ability to increase our market share and harm our business.

     Competition in the network infrastructure market is intense, and we expect that competition in the market for IP networking services will also be intense. If we are unable to compete effectively, our revenue and market share will be negatively affected.

     We face competition from companies in the network infrastructure market, including Cisco Systems, Lucent Technologies, Nortel Networks, Alcatel, Ericsson, Siemens, and Juniper Networks. Many of our competitors are larger companies with significantly greater resources than we have, and we expect to face increased competition from larger companies in the future. Some of these larger competitors have pre-existing relationships involving a range of product lines with the network service providers who are the principal potential customers for our IP Service Delivery Platform. These competitors may offer vendor financing, which we generally do not offer, undercut our prices or use their pre-existing relationships with our customers to induce them not to use our IP Service Delivery Platform.

Future consolidation in the telecommunications equipment industry may increase competition that could harm our business.

     The markets in which we compete are characterized by increasing consolidation both within the data communications sector and by companies combining or acquiring data communications assets and assets for delivering voice-related services. We cannot predict with certainty how industry consolidation will affect our competitors. We may not be able to compete successfully in an increasingly consolidated industry. Increased competition and consolidation in our industry could require that we reduce the prices of our products and result in our loss of market share, which would materially adversely affect our business, financial condition and results of operations. Because we may be dependent on certain strategic relationships with third parties in our industry, any additional consolidation involving these parties could reduce the demand for our products and otherwise harm our business prospects.

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

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     Our future success depends on network service providers, who are our customers, generating revenue from the sale of services delivered using our products. Sales of our products may decline or be delayed if our customers do not successfully introduce commercial services derived from our IP Service Delivery Platform or if our customers do not generate revenue from these services sufficient to realize an attractive return on their investment in our IP Service Delivery Platform. In addition, the long cycle for service providers to introduce new services made possible by our platform may cause our revenue and operating results to vary significantly from quarter to quarter.

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

If our IP Service Delivery Platform does not achieve market acceptance, we may be unable to achieve profitability.

     Our products offer a new approach for delivering services by network service providers, who may perceive our products as being more expensive than the other technologies and products they purchase. If network service providers do not accept our IP Service Delivery Platform as a method for delivering services to their customers, our ability to increase our revenue, achieve profitability and continue operations would be harmed.

Our IP Service Delivery Platform is our only product line, and our future revenue depends on its commercial success.

     Our IP Service Delivery Platform, which is comprised of hardware and software, is the only product line that we currently offer to our customers. Our future revenue depends on the commercial success of our IP Service Delivery Platform. If customers do not adopt, purchase and successfully implement our IP Service Delivery Platform in large numbers, our revenue will not grow.

If our products contain defects, we may be subject to significant liability claims from our customers, distribution partners and the end-users of our products and incur significant unexpected expenses and lost sales.

     Our products are technically complex and can be adequately tested only when put to full use in large and diverse networks with high amounts of traffic. They have in the past contained, and may in the future contain, undetected or unresolved errors or defects. Despite extensive testing, errors, defects or failures may be found in our current or future products or enhancements after commencement of commercial shipments. If this happens, we may experience delay in or loss of market acceptance and sales, product returns, diversion of development resources, injury to our reputation, inability to attract new customers, or increased service and warranty costs, any of which could have a material adverse effect on our business, financial condition and results of operations. Moreover, because our products are designed to provide critical communications services, we may receive significant liability claims. We attempt to include in our agreements with customers and distribution partners provisions intended to limit our exposure to liability claims. However, our customers and distribution partners may not be willing to agree to such provisions, and in any event such provisions may not be effective in any or all cases or under any or all scenarios, and they may not preclude all potential claims resulting from a defect in one of our products or from a defect related to the installation or operation of one of our products. Although we maintain product liability and errors and omissions insurance covering certain damages arising from implementation and use of our products, our insurance may not cover all claims sought against us. Liability claims could require us to spend significant time and money in litigation or to pay significant damages. As a result, any such claims, whether or not successful, could seriously damage our reputation and our business.

If we fail to develop and market new products or features, we will have difficulty attracting customers.

     Based on our prior experience, we expect that our customers will require product features that our current IP Service Delivery Platform does not have. Our products are technically complex, and the development of new products or features is an uncertain, time-consuming and labor-intensive process. We may experience design, manufacturing or marketing problems with our new products. If we fail to develop new or enhanced products that meet customer requirements, our ability to attract and retain customers will be hindered.

     If we fail to introduce new products in a timely manner we may experience erratic revenue growth, which could negatively affect profitability and in turn have a negative impact on our stock price. In addition, such a failure could result in additional costs such as excess inventory, customer conversion costs, higher than expected product costs and higher than expected operating expenses in research and development and in sales and marketing.

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If our products do not work the way our customers expect, orders for our products may be cancelled and the market perception of our products could be harmed.

     If our products do not work with our customers’ or their end-users’ networks, the market perception of our products could be harmed and orders for our products could be cancelled. In particular, if an actual or perceived breach of network security occurs in a customer’s or its end-user’s network that uses our products, we may be subject to lawsuits for losses suffered by customers or their end-users.

     If we have to redesign or modify our products to make them compatible with a customer’s or end-user’s network, our sales cycle could be extended, our research and development costs may increase and profit margins on our products may decline.

Because the markets in which we compete are prone to rapid technological change and the adoption of standards different from those that we use, our products could become obsolete, and we could be required to incur substantial costs to modify our products to remain competitive.

     The market for our IP Service Delivery Platform is prone to rapid technological change, the adoption of new standards, frequent new product introductions and changes in customer and end-user requirements. We may be unable to respond quickly or effectively to these developments. We may experience difficulties that could prevent our development of new products and features. The introduction of new products or technologies by competitors, or the emergence of new industry standards, could render our products obsolete or could require us to incur costs to redesign our products.

We rely upon a limited number of customers, and any decrease in revenue from these customers or failure to increase our customer base could harm our operating results.

     The loss of one or more of our customers, a reduction in purchases of our products by certain of our customers or the decline of a key customer’s business may limit our revenue growth and harm our operating results. Our customers may reduce or discontinue purchases of our products at any time. In the first quarter of 2004, we generated 77 percent of our revenue from four customers.

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

A failure of our contract manufacturers or our sole source and limited source suppliers to meet our needs would seriously harm our ability to timely fill customer orders.

     If any of our manufacturers terminates its relationship with us or is unable to produce sufficient quantities of our products in a timely manner and at satisfactory quality levels, our ability to fill customer orders on time, our reputation and our operating results will suffer. Our contract manufacturers do not have a long-term obligation to supply products to us. Qualifying new contract manufacturers and starting volume production is expensive and time consuming and would disrupt our business.

     We purchase several key components, including field programmable gate arrays, some integrated circuits and memory devices, and power supplies from a single source or a limited number of sources. We do not have long-term supply contracts for these components. If our supply of these components is interrupted, we may be unable to locate an alternate source in a timely manner or at favorable prices. Interruption or delay in the supply of these components could cause us to lose sales to existing and potential customers.

If any of our significant suppliers were to terminate their relationships with us or compete against us, our revenue and market share would likely be reduced.

     Many of our suppliers also have significant development and marketing relationships with our competitors and have significantly greater financial and marketing resources than we do. If they develop and market products in the future in competition with us, or form or strengthen arrangements with our competitors, our revenue and market share will likely be reduced.

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If we fail to predict our manufacturing requirements accurately, we could incur additional costs or manufacturing delays.

     We provide forecasts of our demand to our contract manufacturers up to twelve months before scheduled delivery of products to our customers. If we overestimate our manufacturing requirements, we may have excess or obsolete inventory, which could harm our operating results. If we underestimate our requirements, our contract manufacturers may have an insufficient inventory, which could interrupt manufacturing of our products and result in delays in shipments and revenue. If we do not accurately anticipate lead times for components, we may experience component shortages.

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

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

We rely on our intellectual property rights to be competitive, and if we are unable to protect these rights, we may never become profitable.

     We rely on a combination of copyright, trademark, patent and trade secret laws and restrictions on disclosure to protect our intellectual property rights. Monitoring unauthorized use of our products is difficult, and we cannot be certain that the steps we have taken will prevent unauthorized use of our technology. If we are unable to protect our intellectual property rights, our ability to supply our products as they have been designed could suffer, and our ability to become profitable could be harmed.

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

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

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

If we become subject to unfair hiring claims, we could be prevented from hiring needed personnel, or from pursuing or implementing our research, and could incur substantial liabilities or costs.

     Companies in our industry whose employees accept positions with competitors frequently claim that these competitors have engaged in unfair hiring practices or that the employment of these persons would involve the disclosure or use of trade secrets or information subject to an obligation of confidentiality. We have been threatened with claims like these in the past and may receive claims of this kind in the future. These claims could prevent us from hiring personnel or from using the knowledge and experience brought to us by the personnel whom we hire. We could also incur substantial costs and damages in defending against these claims, regardless of their merits. Defending ourselves against such claims could divert the attention of our management away from our operations.

Insiders continue to have substantial control over us and they could delay or prevent a change in our corporate control even if our other stockholders wanted it to occur.

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     Our executive officers, directors and principal stockholders who hold 5% or more of the outstanding common stock and their affiliates beneficially own a significant portion of our outstanding common stock. These stockholders will be able to exercise significant control over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This could delay or prevent an outside party from acquiring or merging with us even if our other stockholders wanted it to occur.

If we cannot obtain director and officer liability insurance in acceptable amounts for acceptable rates, we may have difficulty recruiting and retaining qualified directors and officers.

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

Fluctuations in demand can lead to impairment of the value of our long-lived assets.

     Fluctuations in demand can also lead to the consideration of asset impairment charges. The carrying value of property, plant and equipment is reviewed if the facts and circumstances suggest that property, plant and equipment may be impaired. An impairment review requires management to make certain estimates and judgments regarding future cash flows that management expects to be generated by groups of assets.

     We evaluate the carrying value of our long-lived assets, consisting primarily of property, plant and equipment, whenever certain events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. In assessing the recoverability of long-lived assets, we compare the carrying value to the undiscounted future cash flows the assets are expected to generate. If the total of the undiscounted future cash flows is less than the carrying amount of the assets, the assets will be written down to their estimated fair value. Significant judgments and assumptions are required in the forecast of future operating results used in the preparation of the estimated future cash flows, including long-term forecasts of overall market conditions and our participation in the market. For example, we recorded a write-down of $15.5 million in fiscal year 2002. Changes in these estimates could have a material adverse effect on the assessment of the long-lived assets, thereby requiring us to record further asset write-downs in the future.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Sensitivity

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

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

     A sensitivity analysis was performed on our investment portfolio as of March 31, 2004 based on a modeling technique that measures hypothetical fair market value changes that would result from a parallel shift in the yield curve of plus or minus 100 basis points. Based on this analysis, a hypothetical 100 basis point increase or decrease in interest rates would result in a $106,000 decrease or increase, respectively, in the fair value of our investments in debt securities as of March 31, 2004.

Exchange Rate Sensitivity

     Currently, all of our revenue and most of our expenses are denominated in U.S. dollars. However, since a portion of our operations sales and service activities are outside of the U.S., we have entered into transactions in other currencies. We are primarily exposed to changes in exchange rates for the Euro, Japanese Yen, and British Pound. Because we transact expenses only in foreign currency, we are adversely affected by a weaker U.S. dollar relative to major currencies worldwide. Additionally, because some of our obligations are denominated in foreign currencies, a weaker U.S. dollar creates foreign exchange losses. We have not engaged in any foreign exchange hedging activities to date.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures. The Securities and Exchange Commission defines the term “disclosure controls and procedures” to mean a company’s controls and other procedures that are designed to ensure that information required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms. While our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives, the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions regardless of how remote. Our president and chief executive officer and our executive vice president and chief financial officer have concluded, based on the evaluation of the effectiveness of the disclosure controls and procedures by our management, as of the end of the period covered by this report, that our disclosure controls and procedures were generally effective for this purpose.

Changes in Internal Controls. There were no changes in our internal control over financial reporting during the fiscal quarter ending March 31, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

     In connection with the audit of our financial statements for the fiscal year ended December 31, 2003, our management and our independent auditors reported to our Audit Committee two matters involving internal controls that our independent auditors considered to be reportable conditions, but that were not material weaknesses, under standards established by the American Institute of Certified Public Accountants.

•		The first matter related to revenue recognition control processes. The annual audit process identified instances of a lack of timely communication between the sales and finance departments for certain contractual terms and an instance of incorrect interpretation of the accounting literature for a certain type of transaction.
•		The second matter related to the financial close process. Certain adjustments were identified in the annual audit process, related to stock-based compensation amortization, a balance sheet adjustment for a specific fixed asset

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capitalization, foreign income tax accruals and inventory reserves. In addition, there were instances where accounting analyses did not include evidence of a timely review of the accounting entries by our finance department.

     In response to these observations, we instituted additional processes and procedures in the first quarter of 2004 to improve internal control over revenue recognition and the financial close processes. With respect to the revenue recognition process, we have reviewed our key procedures and have realigned those procedures to improve communications between the sales, finance and legal departments, updated documentation requirements, and ensured that key sales and finance staff members have completed updated formal revenue recognition-related training. With respect to the financial close process, we have also reviewed key procedures and have realigned those procedures to improve the accuracy of the process as well as provide enhanced evidence of timely review.

     While our president and chief executive officer and our executive vice president and chief financial officer believe that we have taken the necessary steps to resolve the reportable conditions discussed above, we intend to continue to refine our internal control processes on an ongoing basis.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

     On November 15, 2001, CoSine and certain of its officers and directors were named as defendants in a securities class action lawsuit filed in the United States District Court, Southern District of New York. The complaint generally alleges that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares in CoSine’s initial public offering. The complaint brings claims for the violation of several provisions of the federal securities laws against those underwriters, and also against the Company and each of the directors and officers who signed the registration statement relating to the initial public offering. Various plaintiffs have filed similar actions asserting virtually identical allegations against more than 250 other companies. The lawsuit and all other “IPO allocation” securities class actions currently pending in the Southern District of New York have been assigned to Judge Shira A. Scheindlin for coordinated pretrial proceedings. In October 2002, the individual defendants were dismissed without prejudice pursuant to a stipulation. The issuer defendants filed a coordinated motion to dismiss on common pleading issues, which the Court granted in part and denied in part in an order dated February 19, 2003. The Court’s order dismissed the Section 10(b) and Rule 10b-5 claims against the Company but did not dismiss the Section 11 claims against the Company.

     In June 2003, the plaintiffs in all of the cases presented a settlement proposal to all of the issuer defendants. Under the proposed settlement, the plaintiffs will dismiss and release all claims against participating issuer defendants in exchange for a contingent payment guaranty by the insurance companies collectively responsible for insuring the issuer defendants in all of the related cases, and the assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. Under the guaranty, the insurers will be required to pay the amount, if any, by which $1 billion exceeds the aggregate amount ultimately collected by the plaintiffs from the underwriter defendants in all the cases, up to the limits of the applicable insurance policies. The Company will not be required to make any cash payments under the settlement, unless the Company’s insurer is required to pay on the Company’s behalf an amount that exceeds the Company’s insurance coverage. The Company does not believe that this circumstance will occur. In July 2003, a special committee of the Company’s Board of Directors approved the proposed settlement. The settlement is subject to acceptance by a substantial majority of the issuer defendants, and execution of a definitive settlement agreement. The settlement is also subject to approval of the court, which cannot be assured. If the settlement is not consummated, the Company intends to defend the lawsuit vigorously. However, we cannot predict its outcome with certainty. If we are not successful in our defense of this lawsuit, we could be forced to make significant payments to the plaintiffs and their lawyers, and such payments could have a material adverse effect on our business, financial condition and results of operations if not covered by our insurance carrier. Even if these claims are not successful, the litigation could result in substantial costs and divert management’s attention and resources, which could adversely affect our business, results of operations and financial position.

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

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ITEM 2. CHANGES IN SECURITIES; USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

(a)		On September 25, 2000, in connection with our initial public offering, a Registration Statement on Form S-1 (File No. 333-35938) was declared effective by the Securities and Exchange Commission, pursuant to which 1,150,000 shares of our common stock were offered and sold for our account at a price of $230 per share, generating gross offering proceeds of $264.5 million. The managing underwriters were Goldman, Sachs & Co., Chase Securities Inc., Robertson Stephens, Inc. and JP Morgan Securities Inc. Our initial public offering closed on September 29, 2000. The net proceeds of the initial public offering were approximately $242.5 million after deducting approximately $18.5 million of underwriting discounts and approximately $3.5 million of other offering expenses.
		We did not pay directly or indirectly any of the underwriting discounts or other related expenses of the initial public offering to any of our directors or officers, any person owning 10% or more of any class of our equity securities, or any of our affiliates.
		We have used approximately $192 million of the funds from the initial public offering to fund our operations. We expect to use the remaining net proceeds for general corporate purposes, to fund our operations, working capital and capital expenditures. Pending further use of the net proceeds, we have invested them in short-term, interest-bearing, investment-grade securities.
(e)		The following table provides information about purchases by the Company during the quarter ended March 31, 2004 of equity securities that are registered by the Company pursuant to Section 12 of the Exchange Act:

ISSUER PURCHASES OF EQUITY SECURITIES

     Under our 1997 Plan, we are authorized to repurchase shares of our common stock that were previously issued pursuant to the exercise of stock options granted under the 1997 Plan. Such common stock is reacquired by us privately pursuant to repurchase rights contained in restricted stock purchase agreements or pursuant to optionee defaults on promissory notes issued in connection with the exercise of such options. All shares repurchased in the first quarter of 2004 were reacquired pursuant to optionee defaults on promissory notes and were therefore non-cash. As of the date of this report, 160,850 outstanding shares remain subject to the foregoing repurchase right

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

	(a)		Exhibit Index on page 32.
	(b)		Reports on Form 8-K.
			On February 17, 2004, the Company issued a press release in which it reported earnings for the quarter and year ended December 31, 2003. A copy of such press release was furnished by the Company with a Form 8-K on February 17, 2004 as Exhibit 99.1.

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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 13, 2004

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EXHIBIT INDEX

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