UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

Commission File Number 000-30715

CoSine Communications, Inc.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number including area code:

(408) 236-7518

Securities Registered Pursuant to Section 12(b) of the Act:

None

Securities Registered Pursuant to Section 12(g) of the Act:

Common Stock, $.0001 Par Value

(Title of each class)

     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 þ          No o

      Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.     o

      Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).     Yes o          No þ

      The aggregate market value of the Common Stock held by non-affiliates of the Registrant (based on the closing price for the Common Stock on the Nasdaq National Market on March 15, 2005) was approximately $12,291,000. Shares of stock held by officers, directors and 5 percent or more stockholders have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

      As of March 19, 2005, there were 10,159,790 shares of the Registrant’s Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Not applicable

COSINE COMMUNICATIONS, INC.

FORM 10-K

Year Ended December 31, 2004

TABLE OF CONTENTS

SAFE HARBOR STATEMENT UNDER

PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

      This annual report on Form 10-K 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, the continued downturn in the telecommunications industry and slow development of the market for network-based IP services, failure to achieve revenue growth and profitability, 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 31 to 35 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 file in fiscal year 2005.

PART I

OVERVIEW

      CoSine Communications, Inc. (CoSine) was incorporated in California on April 14, 1997 and in August 2000 was reincorporated in the State of Delaware.

      Prior to and during the period ended September 30, 2004, we developed, marketed and sold a communications platform referred to as our IP Service Delivery Platform. Our product was designed to enable network service providers to rapidly deliver a portfolio of communication services to business and consumer customers. We marketed our IP Service Delivery Platform through our direct sales force and through resellers to network service providers in Asia, Europe and North America. We provided, and after a proposed merger with Tut Systems, Inc., Tut Systems, Inc. will continue to provide, customer service and support for our products through our support partner until December 31, 2005.

      Even during this period, the market for our IP Service Delivery Platform was still in the early stages of development, and the volume and timing of orders were difficult to predict. A customer’s decision to purchase our platform typically involved 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 affected repeat business, caused our revenue and operating results to vary significantly and unexpectedly from quarter to quarter and constrained our ability to secure new customers. We have not generated sufficient revenue to fund our operations and have been unable to increase our revenue in order to reduce our cash consumption and remain a viable and competitive supplier.

      On July 29, 2004, we announced that we were exploring various strategic alternatives and that we had hired an investment bank as our financial advisor, which had been first retained in May 2003.

      On September 8, 2004, we announced, in connection with our ongoing evaluation of strategic alternatives, that we had initiated actions to lay-off most of our employees, retaining a limited team of employees to provide customer support and handle matters related to the ongoing exploration of strategic alternatives. Subsequent to September 8, 2004, we have taken a number of actions to reduce our operating expenses and conserve our cash. We have notified our existing customers that the CoSine products have been formally discontinued and offered existing customers the opportunity to place “lifetime buy” orders to support their platform transition plans. We wrote our inventory down to estimated net realizable value at September 30, 2004 and December 31, 2004. We have terminated contract manufacturing arrangements, contractor and consulting arrangements and various facility leases.

      On October 28, 2004, we announced that we signed an agreement for early termination of our lease for our headquarters facility in Redwood City, California. Pursuant to the agreement, the lease was terminated on December 31, 2004.

      During the quarter ended December 31, 2004, we continued the actions initiated and announced in September 2004. Such actions included the termination of substantially all remaining employees, negotiation of transition support plans for our customers, termination of a facility lease in Japan, and termination of supplier, contractor and consulting agreements, as well as the initiation of liquidation procedures for certain of our foreign operations. We also completed the sale, scrap or write-off of our remaining inventory, property and equipment.

      As a result of these activities, as of December 31, 2004, our business consisted primarily of a customer support capability provided by a third party through December 31, 2005.

      Throughout the quarter ended December 31, 2004, we also continued to explore strategic alternatives, including a sale of the company, a sale or licensing of products, intellectual property, or individual assets or a winding-up and liquidation of the business. On January 7, 2005, we announced an agreement to be acquired by Tut Systems, Inc. in a stock-for-stock transaction valued at approximately $24.1 million. The merger is subject to shareholder approval and normal closing conditions. Should such transaction not be completed, we

will continue to support our existing customers through December 2005 through our transition support programs. We will also continue to explore strategic alternatives, which could include a liquidation of the Company and return of capital to shareholders.

INDUSTRY BACKGROUND

      Data networks, including the Internet, have rapidly evolved to become critical for the communications needs of many businesses and consumers. Despite the downturn within the telecommunications industry and the overall decrease in capital spending, service providers who offer high-speed connectivity services to businesses and consumers are continuing to invest in high-capacity networks using the latest broadband access, switching and routing products from both traditional and emerging communications equipment vendors.

      The delivery of high-speed connectivity is an intensely competitive industry. This competition has made it difficult for service providers to differentiate their service offerings on price alone.

      As businesses have become more dependent on the Internet and other data networks, they are increasingly seeking other communications services in addition to high-speed connectivity. To enable these services, a secure and reliable networking environment is required. The Internet, however, suffers from an inherent lack of security and dependability, which businesses have struggled to overcome by using technologies installed on customer premises equipment, or CPE. These technologies include firewalls, Denial of Service (DoS) mitigation, Public Key Infrastructure (PKI), VPNs with IPSec encryption (which is the masking of data for security purposes, or Multi-Protocol Label Switching (MPLS)). Businesses use additional CPE as more services are needed. This equipment can be costly to install and maintain, requiring large numbers of expensive networking personnel to manage. We believe that most businesses are having difficulty implementing these technologies and that many businesses are increasingly seeking to outsource IP services.

      Network service providers have begun to provide solutions to address this demand and achieve three important business objectives:

THE PROBLEMS OF A CPE-BASED APPROACH

      Although network service providers have started to offer additional services through the CPE-based approach, that approach is subject to a number of limitations.

      Each customer site requires multiple pieces of on-site equipment provided by numerous vendors. This equipment enables various functions, including routing, firewall protection and the mitigation of DoS attacks. We believe that the CPE-based model creates the following challenges that constrain the delivery of services for both network service providers and their customers:

      High Cost to Install and Manage. Installing and managing equipment located at dispersed customer sites can result in high costs for both service providers and their customers. Each new customer site or service requires new CPE, or the modification of existing CPE, as well as on-site service calls. This approach is costly and time consuming and often leads to delays in establishing service. Both service providers and their subscribers can incur significant maintenance and monitoring expenses for the CPE and for expensive personnel needed to manage these complex networks.

      Difficult to Expand. We believe that the CPE-based service delivery model is difficult to expand because on-site installation is required for each new site or service. Implementation challenges increase significantly as new services and devices are added, since each new network site must be connected to all existing network sites.

      Limited Network Services. In a CPE-based model, a subscriber’s data is typically encrypted before entering the service provider’s network. This encryption limits the service provider to simple data transmission because additional services must be implemented before encryption.

      Difficult to Integrate. CPE-based services often involve the integration of hardware and software from a variety of vendors. We believe that integrating and ensuring compatibility among a variety of hardware and software is a significant challenge.

      Inconsistent Quality of Service. Service providers may have difficulty offering consistent quality of service across all of these disparate network devices and implementing and supporting agreed levels of service.

THE NEED FOR A NEW NETWORK-BASED SERVICE DELIVERY MODEL

      We believe that the problems with CPE-based service delivery models have created a significant need for service providers to offer network-based services that operate on equipment located within the service providers’ networks. Delivering services in this manner requires the creation of a new and more intelligent network, through which services can be delivered quickly and cost-effectively. It also must serve thousands of customer sites from within a service provider’s network, without the need for equipment to be installed or managed on customers’ premises.

Limitations of Existing Network-Based Approaches

      Existing network-based approaches to providing IP services satisfy some needs, but are subject to certain limitations.

      Relocation of Customer Premises Equipment. While reducing the installation and management costs resulting from broad geographic dispersion of CPE, relocating this equipment to the service providers’ facilities does not fully address the remaining problems of CPE-based approaches. For example, this approach introduces costs associated with the need for large numbers of devices to be located in the already constrained space of the service providers’ facilities.

      Carrier Switches and Routers. Switches and routers used by service providers are specifically designed to forward packets of data through networks. We believe that this equipment lacks the flexibility and general-purpose computing capacity necessary to directly support a wide range of services because the equipment cannot be adapted to provide other services beyond a private IP WAN service based upon MPLS VPNs.

      Large General-Purpose Computers. Large general-purpose computers, commonly used in computer data centers, do not have routing capabilities or network access interfaces and are not designed specifically for data forwarding. We believe that these computers do not have the network management and operational systems required to meet stringent service provider requirements.

THE COSINE COMMUNICATIONS SOLUTION

      We believe our IP Service Delivery Platform provided a solution that was designed to allow service providers to build intelligent data networks and deliver a variety of applications to their end-users. Intelligent data networks are those designed to deliver applications from within a network without the need for specialized CPE. Our IP Service Delivery Platform, which was designed to deliver applications to thousands of subscribers simultaneously, consisted of hardware elements: a chassis, including our IPSX 9500 and IPSX 3500 Service Processing Switches, and sub-systems known as our IPSGs; and software components consisting of our InVision and InGage software.

STRATEGY

      Our objective was to become the leading supplier of carrier network equipment designed to deliver profitable applications and services seamlessly from within a service provider’s network. However, we were unable to generate sufficient revenue to fund our operations or to increase our revenue in order to reduce our cash consumption and remain a viable and competitive supplier. As a result, after extensive exploration of strategic alternatives, including a sale of the Company, a sale or licensing of products, intellectual property, or individual assets or a winding-up and liquidation of the business, we announced on January 7, 2005 an agreement to be acquired by Tut Systems, Inc. in a stock-for-stock transaction valued at approximately $24.1 million. This transaction is subject to shareholder approval and normal closing conditions. Should such transaction not be completed, we will continue to support our existing customers through December 2005 through our transition support programs. We will also continue to explore strategic alternatives, which could include a liquidation of the Company and return of capital to shareholders.

PRODUCTS AND TECHNOLOGY

      Prior to our announcement on September 8, 2004, our objective was to become the leading supplier of carrier network equipment designed to deliver profitable applications and services seamlessly from within a service provider’s network. Our IP Service Delivery Platform provided a solution that was designed to allow service providers to build intelligent data networks and deliver a variety of applications to their end-users. Intelligent data networks are those designed to deliver applications from within a network without the need for specialized CPE. Our IP Service Delivery Platform, which was designed to deliver applications to thousands of subscribers simultaneously, consisted of hardware elements: a chassis, including our IPSX 9500 and IPSX 3500 Service Processing Switches, and sub-systems known as our IPSGs; and software components consisting of our InVision and InGage software.

CUSTOMERS

      During the year ended December 31, 2004, we recognized revenue from 32 customers, of which Sprint, Infranet and NEC Corporation accounted for 24%, 15% and 14% of our revenue, respectively. Geographically, our revenue was distributed as follows: North America 35%, Asia/ Pacific 34% and Europe 31% (See Note 1 of the Notes to the Consolidated Financial Statements). A small number of customers account for a substantial portion of our revenues, and the loss of any one customer could have had a material impact on our results of operations. Currently, our business consists primarily of a customer service capability operated under contract by a third party.

SALES AND MARKETING

      With our announcement on September 8, 2004 that we were laying off all employees, we have ceased all sales and marketing activities, other than to offer existing customers transition support services through December 2005. At December 31, 2004, we have no employees in sales and marketing. Prior to September 8, 2004, we devoted a significant portion of our sales and marketing resources to customer evaluations and trials. The extensive capabilities of our IP Service Delivery Platform, the complexity of the networks in which it is installed and the stability and performance requirements of our customers frequently result in extended test and trial periods. Because of the complex nature of the testing process for our products and the equipment required, we often assist prospective customers with test and trial initiatives in order to facilitate their purchase decisions for our products. These evaluations and trials generally last between three and 12 months, depending

on the size and complexity of the customer’s planned deployment of the CoSine platform. Trials and evaluations consisted of, but were not limited to, the following:

      Evaluations and trials generally lasted longer for larger carriers who had more extensive networks, due to the rigorous testing they typically performed and the complexity of integrating any new technology into a large network. In general, field evaluations also lasted significantly longer than laboratory visits and involved greater support from our sales and services personnel.

Direct Sales

      Our direct sales organization was divided into three regions — North America, Asia Pacific and Europe — and concentrates on network service providers offering IP-based services. Account managers focused on selling to large individual customers and to select high-end resellers that specialize in offering solutions to the carrier market. Account managers worked with our customer services organization and our systems engineering group to provide customers with network design and build-out proposals. As part of our direct sales model, we used our field sales, engineering and executive personnel to establish multiple contacts within a potential customer’s business organization. With our announcement on September 8, 2004 that we were laying off all employees, we have ceased all direct sales activities.

CUSTOMER SERVICE AND SUPPORT

      With our announcement on September 8, 2004 that we were laying off all employees, we have ceased marketing our customer service and support to new customers. In connection with our decision to discontinue our products, we offered our existing customers transition support services through December 2005. These services are performed by a third party contractor. Prior to September 8, 2004, customer service and support played a key role in ensuring our customers’ success in using the IP Service Delivery Platform. The goal of our service organization was to assist service providers to generate sustainable new revenue in a short period of time. We sought to achieve this goal by providing a comprehensive set of service offerings starting with network architecture, design and installation, through product support. Our support offerings included hardware and software warranty services, access to our technical assistance center, on-site network engineers and technical information and assistance.

      At December 31, 2004, we have no employees in customer service and support. Our service and support operations are conducted by a third party contractor.

RESEARCH AND DEVELOPMENT

      With our announcement on September 8, 2004 that we were laying off all employees, we have ceased all research and development activities, other than to offer our existing customers transition support services, as provided by a third party contractor. At December 31, 2004, we have no employees in research and development.

      Our research and development expenses, including non-cash charges related to equity issuances, totaled $15.1 million, $21.8 million and $32.4 million for the years ended December 31, 2004, 2003 and 2002, respectively.

MANUFACTURING

      With our announcement on September 8, 2004 that we were laying off all employees and discontinuing our products, we took steps to cease all manufacturing activities. These steps included offering our existing customers a “last time buy”, terminating all contract manufacture and supply agreements, offering our remaining inventory for sale, scrapping unsold inventory and terminating our operations employees and contractors. These efforts were completed by December 31, 2004.

      Prior to September 8, 2004, we outsourced the manufacture of our IPSG, interface modules and chassis to two contract manufacturers. Our primary contract manufacturer — Solectron Corporation — procured raw materials, assembled our printed circuit boards, and built and tested the IPSGs and interface configurations used in our products. Raw materials consisted of electronic components from various manufacturers. Prior to our making new products generally available to customers, we occasionally purchased electronic components directly from manufacturers and then transferred the components to Solectron for assembly and test into finished products. Sonic Manufacturing Corporation procured raw materials and assembled and tested all chassis used in our products. The IPSGs, interface modules and chassis assemblies were delivered to our Redwood City, California facility, where we performed system build, system test, packing and shipment. Our contract manufacturers produced our products within 30 miles of our Redwood City facility. All contract manufacturing was done pursuant to a rolling 4-quarter forecast submitted by us.

      At December 31, 2004, we had no employees in our manufacturing operations group.

BACKLOG

      With our announcement on September 8, 2004 that we were laying off all employees, we have ceased all sales and marketing activities, other than to offer existing customers a “last time buy” on our products and offer transition support services through December 2005.

      Our backlog includes purchase orders from customers with approved credit status, representing products and services we plan to deliver within 12 months, plus our current balance of deferred revenue. At December 31, 2004 we had no backlog. At December 31, 2003 and 2002, our backlog totaled $3.5 million and $1.4 million, respectively.

COMPETITION

      The networking equipment business is extremely competitive, with numerous vendors offering products that enhance the functionality of a service provider’s network. Because our IP Service Delivery Platform enables a broad suite of services, our capabilities placed us in direct competition with a variety of networking equipment vendors who could offer specific products each addressing some of a service provider’s needs.

      In specific service areas, our competitors include Alcatel, Cisco, Lucent, Nortel, Siemens, Redback and Juniper. Our competitors market and sell products that offer VPN and firewall capabilities. These competitors and other new entrants are developing new infrastructure solutions for use within a service provider’s network. In general, we saw increased competition from suppliers of conventional routers who were attempting to offer value-added services at the network edge.

      We also compete with companies that provide traditional enterprise products, because our IP Service Delivery Platform may reduce the need for these products. These companies included SonicWall and NetScreen for firewalls, Avaya and Cisco for IPSec VPN encryption and Arbor Networks for DoS mitigation. Many of our competitors, particularly those that are large public companies, have substantially greater financial, marketing and development resources. Many of them have existing relationships with network service providers, which will make it more difficult for us to sell our products to those service providers.

      We believe that the principal areas of competition in these markets are product performance, reliability, expandability and cost-effectiveness. We believe that to be competitive in these markets, we had to deliver products that:

      We believe that positive factors pertaining to our competitive position included our technology, the expertise of our research and development personnel, our service and support organization and our intellectual property rights. We believe that negative factors pertaining to our competitive position include long-standing relationships of our competitors with key target customers and the fact that some of our competitors had substantial financial resources available to promote sales of their products and to develop products more directly competitive with ours.

INTELLECTUAL PROPERTY

      Our IPNOS, InVision and InGage software were developed internally and are protected by United States and foreign copyright laws. Our IP Service Delivery Platform system architecture and hardware were developed internally, and we own rights to the core interfaces and protocols between subsystems, which are the subject of pending United States patent applications. As of February 22, 2005, we have a total of 24 patent applications pending in the United States relating to the design of our products, two PCT patent applications pending and a patent application pending in each of Japan and the European Union.

      We have relied on copyright, patent, trade secret and trademark law to protect our intellectual property. As our business now consists primarily of a customer service capability operated under contract by a third party, we are now unable to make new product developments and frequent product enhancements that are essential to maintain the value, if any, of our intellectual property.

      We continue to license software from network software application companies for integration into our IP Service Delivery Platform necessary to offer our existing customers transition support services through December 2005. These licenses are terminable after a specified period or upon the occurrence of specified events. If one or more of these licenses are terminated, we may need to locate and incorporate alternative software providing comparable services.

EMPLOYEES

      On September 8, 2004, we announced, in connection with our ongoing evaluation of strategic alternatives, that we had initiated actions to lay-off most of our employees, retaining a limited team of employees to provide customer support and handle matters related to the ongoing exploration of strategic alternatives. Since September 8, 2004, we have taken a number of actions to reduce our operating expenses and conserve our cash and have laid-off substantially all of our employees.

      As a result of these activities, as of December 31, 2004, CoSine had 8 employees, all of whom were terminated in January 2005. Cosine’s two executive officers became independent contractors effective January 1, 2005. Stephen Goggiano served as our Chief Executive Officer until his death on January 14, 2005.

Terry Gibson served and continues to serve as our Chief Financial Officer and Secretary. On January 16, 2005, Mr. Gibson was also appointed as our Chief Executive Officer.

EXECUTIVE OFFICER OF THE REGISTRANT

      The name of our executive officer and his age, title and biography as of March 18, 2005 appears below.

      Terry Gibson has served as our Chief Executive Officer since January 16, 2005 and as our Executive Vice President and Chief Financial Officer since joining CoSine in January 2002. Prior to joining us, Mr. Gibson served as Chief Financial Officer of Calient Networks, Inc. from May 2000 through December 2001. He served as Chief Financial Officer of Ramp Networks, Inc. from March 1999 to May 2000 and as Chief Financial Officer of GaSonics, International from June 1996 through March 1999. He also served as Vice President and Corporate Controller of Lam Research Corporation from February 1991 through June 1996. Mr. Gibson holds a B.S. in Accounting from the University of Santa Clara.

AVAILABLE INFORMATION

      We file annual reports, quarterly reports, proxy statements and other documents with the Securities and Exchange Commission (SEC) under the Securities Exchange Act of 1934 (Exchange Act). The public may read and copy any materials that we file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street N.W., Washington, D.C. 20549. The public may obtain information on the operation of the public Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers, including CoSine, that file electronically with the SEC. The public can obtain any documents that we file with the SEC at http://www.sec.gov.

      We lease approximately 300 square feet of office space in San Jose, California under a month-to-month operating lease. We have terminated, or are in the process of terminating, all our sales office leases.

      On November 15, 2001, we, along with certain of our officers and directors, were named as defendants in a class action shareholder complaint filed in the United States District Court for the Southern District of New York, now captioned In re CoSine Communications, Inc. Initial Public Offering Securities Litigation, Case No. 01 CV 10105. The complaint generally alleges that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares in our initial public offering. The complaint brings claims for the violation of several provisions of the federal securities laws against those underwriters, and also against us and each of the directors and officers who signed the registration statement relating to the initial public offering. The plaintiffs seek unspecified monetary damages and other relief. Similar lawsuits concerning more than 300 other companies’ initial public offerings were filed during 2001, and this lawsuit is being coordinated with those actions in the Southern District of New York before Judge Shira A. Scheindlin.

      On or about July 1, 2002 an omnibus motion to dismiss was filed in the coordinated litigation on behalf of the issuer defendants, of which we and our named officer and directors are a part, on common pleading issues. In October 2002, pursuant to stipulation by the parties, the Court entered an order dismissing our named officers and directors from the action without prejudice. On February 19, 2003, the Court dismissed the Section 10(b) and Rule 10b-5 claims against us but did not dismiss the Section 11 claims against us.

      In June 2004, a stipulation of settlement and release of claims against the issuer defendants, including us, was submitted to the court for approval. The terms of the settlement, if approved, would dismiss and release all claims against the participating defendants (including us). In exchange for this dismissal, D&O insurance carriers would agree to guarantee a recovery by the plaintiffs from the underwriter defendants of at least $1 billion, and the issuer defendants would agree to an assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. The settlement is subject to a number of conditions, including court approval, which cannot be assured. If the settlement is not consummated, we intend 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.

      On January 18, 2005, we, along with our officers and directors, were named as defendants in a securities class action lawsuit filed in San Mateo County Superior Court. The suit requests that the acquisition of CoSine by Tut Systems, Inc be enjoined due to alleged self-dealing and breach of fiduciary duties by our officers and directors. We do not believe that the allegations contained in the complaint have merit and we intend to vigorously defend against such claims. An unfavorable resolution of this litigation could have a material adverse effect on the proposed merger with Tut Systems, Inc.

      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.

      On December 16, 2004, we held our Annual Meeting of Stockholders at which we recommended the election of Stephen Goggiano and R. David Spreng as Class I directors for a term expiring in 2007 and the ratification of Burr, Pilger & Mayer LLP as our independent registered public accounting firm for the 2004 fiscal year. The results of each matter voted upon are as follows:

PART II

      Our common stock has been traded on the Nasdaq National Market under the symbol COSN since our initial public offering in September 2000. Prior to that time there was no public market for our common stock. According to the records of our transfer agent, at March 15, 2005 we had approximately 237 shareholders of record. At that date there were approximately 5,937 beneficial owners of our common stock.

      The following table sets forth the high and low sales price of our common stock in the years ended December 31, 2004 and 2003.

Dividend Policy

      To date we have not declared or paid any cash dividends on our common stock. Our current policy is to retain future earnings, if any, for use in the operations, and we do not anticipate paying any cash dividends in the foreseeable future.

Use Of Proceeds of Registered Securities

      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 in underwriting discounts and approximately $3.5 million in 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 $218 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, including funding our operations, our working capital needs and capital expenditures. Pending further use of the net proceeds, we have invested them in short-term, interest-bearing, investment-grade securities.

      The selected consolidated financial data below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes. The selected consolidated statements of operations data for the years ended December 31, 2004, 2003 and 2002 and the selected consolidated balance sheet data as of December 31, 2004 and 2003, are derived from, and are qualified by reference to, the audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K. The selected consolidated statements of operations data for the fiscal years ended prior to December 31, 2002, and the selected consolidated balance sheet data prior to December 31, 2003, are derived from our audited consolidated financial statements that are not

included in this Annual Report on Form 10-K. The historical results presented below are not necessarily indicative of future results.

Quarterly financial information (unaudited):

OVERVIEW

      Prior to and during the period ended September 30, 2004, CoSine developed, marketed and sold a communications platform referred to as its IP Service Delivery Platform. CoSine’s product was designed to enable network service providers to rapidly deliver a portfolio of communication services to business and consumer customers. CoSine marketed its IP Service Delivery Platform through our direct sales force and through resellers to network service providers in Asia, Europe and North America. CoSine provided, and after the merger will continue to provide, customer service and support for its products through its support partner.

      Even during this period, the market for CoSine’s IP Service Delivery Platform was still in the early stages of development, and the volume and timing of orders were difficult to predict. A customer’s decision to purchase CoSine’s platform typically involved a significant commitment of its resources and a lengthy evaluation, testing and product qualification process. The long sales cycle and the timing of CoSine’s customers’ rollout of services made possible by CoSine’s platform, which affected repeat business, caused CoSine’s revenue and operating results to vary significantly and unexpectedly from quarter to quarter and constrained CoSine’s ability to secure new customers. CoSine has not generated sufficient revenue to fund its operations and has been unable to increase its revenue in the near term in order to reduce its cash consumption and remain a viable and competitive supplier.

      On July 29, 2004, CoSine announced that it was exploring various strategic alternatives and that CoSine had hired an investment bank as its financial advisor, which had been first retained in May 2003.

      On September 8, 2004, CoSine announced, in connection with its ongoing evaluation of strategic alternatives, that it had initiated actions to lay-off most of its employees, retaining a limited team of employees to provide customer support and handle matters related to the ongoing exploration of strategic alternatives. Since September 8, 2004, the Company has taken a number of actions to reduce its operating expenses and conserve its cash. CoSine has notified its existing customers that the CoSine products have been formally discontinued and offered existing customers the option to place “lifetime buy” orders to support their platform transition plans. The company has written its inventory down to estimated net realizable value at September 30, 2004. CoSine has terminated contract manufacturing arrangements, contractor and consulting arrangements and facility leases.

      On October 28, 2004, CoSine announced that it signed an agreement for early termination of its lease for its headquarters facility in Redwood City, California. Pursuant to the agreement, the lease was terminated on December 31, 2004.

      During the quarter ended December 31, 2004, we continued the actions initiated and announced in September 2004. Such actions included the termination of the remaining employees, negotiation of transition support plans for our customers, termination of a facility lease in Japan, and termination of supplier, contractor

and consulting agreements, as well as the initiation of liquidation procedures for certain of our foreign operations. We also completed the sale, scrap or write-off of our remaining inventory, property and equipment.

      As a result of these activities, as of December 31, 2004, our business consisted of primarily a customer service capability operated by a third party.

      Management’s overview of the Company’s position is discussed in more detail in the “Outlook” section on pages 30 to 31 and the “Liquidity” section on page 28.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

General

      Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosures 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 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.

      On July 29, 2004, CoSine announced that it was exploring various strategic alternatives and that CoSine had hired an investment bank as its financial advisor, which had been first retained in May 2003.

      On September 8, 2004, CoSine announced, in connection with its ongoing evaluation of strategic alternatives, that it had initiated actions to lay-off most of its employees, retaining a limited team of employees to provide customer support and handle matters related to the ongoing exploration of strategic alternatives. Since September 8, 2004, the Company has taken a number of actions to reduce its operating expenses and conserve its cash. CoSine has notified its existing customers that the CoSine products have been formally discontinued and offered existing customers the option to place “lifetime buy” orders to support their platform transition plans. The company has written its inventory down to estimated net realizable value at September 30, and December 31, 2004. CoSine has terminated contract manufacturing arrangements, contractor and consulting arrangements and facility leases.

      On October 28, 2004, CoSine announced that it signed an agreement for early termination of its lease for its headquarters facility in Redwood City, California. Pursuant to the agreement, the lease was terminated on December 31, 2004.

      As a result of these activities, as of December 31, 2004, CoSine’s business consisted of primarily a customer service capability operated by a third party.

      During the quarter ended December 31, 2004, we continued the actions initiated and announced in September 2004. Such actions included the termination of the remaining employees, negotiation of transition support plans for our customers, termination of a facility lease in Japan, and termination of supplier, contractor and consulting agreements, as well as the initiation of liquidation procedures for certain of our foreign operations. We also completed the sale, scrap or write-off of our remaining inventory, property and equipment.

      On January 7, 2005, we entered into an Agreement and Plan of Merger with Tut Systems, Inc., or Tut. The proposed merger will be a stock-for-stock transaction. Upon closing, CoSine’s shareholders will receive approximately 6.0 million shares of Tut common stock in exchange for all the outstanding shares of CoSine. The merger is subject to shareholder approval and is expected to close in April 2005.

      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 user of our product is normally a large network service provider, 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

      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 may be required.

Inventory Valuation

      In assessing the value of our inventory, we are required to make judgments about 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 used a 12-month forecast to assess future demand. Inventory write-downs are charged to cost of revenue. At September 30, 2004, in connection with our decision to discontinue our products, we recorded a charge of $3.5 million to write our inventory down to its estimated net realizable value. Our inventory was either sold, scrapped or fully written-off at December 31, 2004. During 2004 we sold $0.7 million of previously written-off inventory. During 2003, we charged $0.2 million of inventory write-downs and $0.1 million of excess purchase commitments to cost of revenue primarily as the result of reduced forecasted demand for certain of our components and we sold $0.9 million of previously written-down inventory.

Long-lived assets

      We evaluate the carrying value of long-lived assets, consisting primarily of property 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 on 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 such that we may be required to record further asset write-downs in the future. We had no impairment charges in 2003 or 2001. During 2004 and 2002, we charged $2.3 million and $18.8 million, respectively, to operating expenses as a result of impairments. During 2004, we had a gain of $0.9 million with the sale of

previously written-down long-lived assets. At December 31, 2004, all of our long-lived assets had been either sold, scrapped or fully written-off.

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 revenue may result.

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, stock issued in lieu of cash compensation to suppliers and re-priced stock options.

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

      The deferred compensation and amortization associated with shares and options relating to the following transactions is required to be re-measured at the end of each accounting period, based on the current stock price. 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:

      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 estimated fair value. Deferred compensation is presented as a reduction to stockholders’ equity on the consolidated 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.

      In the first quarter of 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 issued is calculated the following quarter based on the fixed value of the common stock issued, as determined at quarter-end, divided by CoSine’s stock price on the issuance date. Compensation expense is accrued in full in the quarter in which it is earned. No employee bonuses were earned in the second, third or fourth quarters of 2004 as the quarterly objectives were not met.

      In the second quarter of 2004, we issued to a reseller a warrant to acquire 254,489 shares of CoSine stock at an exercise price of $4.65 per share. The warrant has a two-year term beginning May 28, 2004 and vests ratably over the term. If during the two-year term (1) any person or entity acquires a greater than 50% interest in CoSine or the ownership or control of more than 50% of the voting stock of CoSine or (2) CoSine sells substantially all of its intellectual property assets, the warrant becomes exercisable. Even if the reseller does not immediately exercise the warrant upon the occurrence of such an event that makes the warrant exercisable (a “trigger event”), the reseller shall be entitled to securities, cash and property to which it would have been entitled to upon the consummation of the trigger event, less the aggregate price applicable to the warrant. We calculated the fair value of the warrant to be approximately $487,000 using the Black-Scholes option pricing model, using a volatility factor of ..97, a risk-free interest rate of 2.5%, and an expected life of two years. The fair value of the warrant was being amortized over the two-year expected life of the warrant. During the year ended December 31, 2004, we amortized $6,000 to cost of revenue and $42,000 to general and administrative expenses.

RESULTS OF OPERATIONS

      On July 29, 2004, we announced that we were exploring various strategic alternatives and that we had hired an investment bank as our financial advisor.

      On September 8, 2004, CoSine announced that after an extensive evaluation of strategic alternatives, the Company initiated actions to lay-off most of its employees, laying off 100 employees in September 2004 while retaining a limited team of employees to provide customer support and handle matters related to the ongoing exploration of strategic alternatives. Since September 8, 2004, the Company has taken a number of actions to reduce its operating expenses and conserve its cash. CoSine has notified its existing customers that the CoSine products are now formally discontinued and that existing customers the option to place “lifetime buy” orders to support their transition plans. The Company has written its inventory down to estimated net realizable value at September 30 and December 31, 2004.

      During the quarter ended December 31, 2004, we continued the actions initiated and announced in September 2004. Such actions included the termination of the remaining employees, negotiation of transition support plans for our customers, termination of a facility lease in Japan, and termination of supplier, contractor and consulting agreements, as well as the initiation of liquidation procedures for certain of our foreign operations. We also completed the sale, scrap or write-off of our remaining inventory, property and equipment. These activities will continue in 2005.

      CoSine’s business currently consists of a customer support capability supported by a third party contractor. We do not intend to offer this support capability after December 31, 2005.

      Our announcement that we have discontinued our product and that we began our cost-cutting initiatives, including the lay-off of substantially all of our employees, has adversely impacted demand for our products.

Revenue

      The majority of our revenue is recognized from the sale of our IP Service Delivery Platform and subsequent service support arrangements. We recognize product revenue at the time of shipment, assuming that persuasive evidence of an arrangement exists, the sales price is fixed or determinable and collection is probable, unless we have future obligations for installation or require customer acceptance, in which case revenue is deferred until these obligations are met. Our product incorporates software that is not incidental to the related hardware and, accordingly, we recognize revenue in accordance with the American Institute of Certified Public Accountants issued Statement of Position 97-2 “Software Revenue Recognition.” For

arrangements that include the delivery of multiple elements, the revenue is allocated to the various products based on “vendor-specific objective evidence of fair value” (VSOE). We establish VSOE based on either the price charged for the product when the same product is sold separately or for products not yet sold separately, based on the list prices of such products individually established by management with the relevant authority to do so.

      Revenue from perpetual software licenses is recognized upon shipment or acceptance, if required. Revenue from one-year term licenses is recognized on a straight-line basis over the one-year license term. Post-delivery technical support, such as on-site service, phone support, parts and access to software upgrades, when and if available, is provided under separate support services agreements. In cases where the support services are sold as part of an arrangement including multiple elements, we allocate revenue to the support service based on the VSOE of the service and recognize it on a straight-line basis over the service period. Revenue from consulting and training services is recognized as the services are provided.

      Amounts billed in excess of revenue recognized are included as deferred revenue in the accompanying consolidated balance sheets.

      Revenue from customers by geographic region for the years ended December 31, 2004, 2003 and 2002 was as follows, in thousands:

      Hardware, software and service revenue for the years ended December 31, 2004, 2003 and 2002 was as follows, in thousands:

      In 2004, unit shipments again declined. The decline was noted in all regions and was due to completion of expansion projects for certain customers in Japan and North America and no significant new customer wins or expansions by existing customers, partially offset by over $700,000 in “last time buy” sales in connection with our announced plans to discontinue our products. Service revenue remained relatively constant as existing customers continued to purchase service and support for their installed units. Software revenue increased over 2003 due to certain customers purchasing new software licenses for their existing installed base.

      In 2003, unit shipments declined. The decline reflects the fact that we made sales to fewer customers, as we have focused our sales efforts on certain large service providers. The decline also reflects lower sales to existing customers, due in part to the timing of their expansion plans. Partially offsetting this decline, our average selling price improved in 2003 as compared to 2002 due to a favorable product and regional mix. Software revenue declined $1.4 million due to fewer new customers. We generally sell our primary software product, InVision, in our initial sale to new customers.

      At December 31, 2004, our business consists of a customer support operation, provided by a third party contractor. These services are only being offered to our existing customers through December 31, 2005. As such, we expect our revenues to decline significantly during 2005 as our customers make other arrangements to service and support their equipment or decide to remove or replace their CoSine equipment. See “Outlook” section on page 30 to 31 and “Risk Factors” section on pages 31 to 35.

      As of December 31, 2004, 2003 and 2002, we deferred $0.5 million, $3.5 million and $1.4 million, respectively, of revenue from contracts that we immediately invoiced but which provide for subsequent customer acceptance, consulting services and post-contract support services.

Non-Cash Charges and Credits Related to Equity Issuances

      We amortized (benefited from) ($0.8) million, $1.3 million and ($0.3) million of non-cash charges (credits) related to equity issuances to cost of revenue, operating expenses and interest expense, for the years ended December 31, 2004, 2003 and 2002, respectively.

      Below is a reconciliation of non-cash charges related to equity issuances for the years ended December 31, 2004, 2003 and 2002, affecting our cost of revenue, operating expenses and interest expense, in thousands:

      Equity-related charges, which are largely dependent on our quarterly stock price, may cause our expenses to materially fluctuate from quarter-to-quarter and year-to-year.

Cost of Revenue

      Cost of revenue includes all costs of producing our sold products, including the costs of outsourced manufacturing, software royalties, shipping, warranties, related manufacturing overhead costs and the costs of providing our service offerings, including personnel engaged in providing maintenance and consulting services to our customers. To the extent that the value of inventory is written down, this will be reflected in cost of revenue. We have also incurred non-cash charges and credits related to equity issuances. We have outsourced the majority of our manufacturing and repair operations. A significant portion of our cost of revenue consists of payments to our contract manufacturers. We conducted manufacturing engineering, final assembly, configuration testing and documentation control at our facilities in Redwood City, California.

      For the year ended December 31, 2004, cost of revenue was $7.1 million, of which $4.1 million or 58% represented the write-down of inventory, $(0.7) million or 10% represented sales of previously written-down inventory, $0.4 million or 6% represented costs to terminate contract manufacturing agreements, $2.8 million or 39% represented the material, labor and overhead, warranty and the cost of providing services and $0.5 million, or 7% represented software royalties. For the year ended December 31, 2003, cost of revenue was $6.8 million, of which $6.1 million or 90% represented materials, labor, production overhead and warranties, $0.7 million or 10% represented software royalties, $0.5 million or 7% represented reductions in overhead absorption rate for raw materials and semi-finished goods, $0.2 million or 3% represented inventory write-downs, $0.1 million or 2% represented non-cash charges related to equity issuances and ($0.9) million or

(13%) represented the sale of previously written down inventory. For the year ended December 31, 2002, cost of revenue was $13.8 million, of which $12.6 million or 92% represented materials, labor, production overhead and warranties, $1.5 million or 11% represented inventory write-downs, $1.0 million or 7% represented software royalties, ($0.1) million or (1%) represented non-cash credits related to equity issuances in manufacturing operations and ($1.2) million or (9%) represented the sale of previously written down inventory.

Gross Profit

      For the years ended December 31, 2004, 2003 and 2002, gross profit was $2.6 million or 27% of revenue, $7.9 million, or 54% of revenue, and $9.8 million, or 42% of revenue, respectively.

      The 27 percentage point decrease in gross margin for the year ended December 31, 2004 compared to the year ended December 31, 2003 was primarily the result of the net $2.8 million inventory write-down and the $0.4 million in costs to terminate contract manufacturing agreements, partially offset by lower warranty and manufacturing overhead costs.

      The twelve percentage point improvement in gross margin for the year ended December 31, 2003, compared to the year ended December 31, 2002 was primarily the result of a ten percentage point reduction in materials, labor and product overhead costs as a percentage of sales. A lower provision for inventory write-downs additionally improved gross margin by five percentage points. The improvements were partially offset by a reduction in the inventory overhead rate on raw materials and semi-finished goods, which accounted for a three percentage point reduction 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 and reductions in maintenance contract support costs due to headcount and overhead reductions.

Research and Development Expenses

      Research and development expenses consist primarily of salaries and related personnel costs, fees paid to contractors and outside service providers, and the costs of laboratory equipment and prototypes related to the design, development and testing of our products. We have also incurred non-cash charges and credits related to equity issuances. We expense our research and development costs as they are incurred. Several components of our research and development effort require significant expenditures, the timing of which can cause significant quarterly variability in our expenses. The number of prototypes required to build and test a complex product such as the IP Service Delivery Platform is large, and this building and testing process occurs over a short period of time.

      Research and development expenses were $15.1 million, $21.8 and $32.4 million for the years ended December 31, 2004, 2003, and 2002, respectively.

      Research and development expense decreased $6.7 million or 31% in the year ended December 31, 2004 due primarily to our decision in September 2004 to discontinue our products and lay-off all of our employees to conserve cash. The majority of our research and development employees were laid-off in September 2004 while a small team of engineers were retained to support customer transition activities, documentation of our intellectual property, due diligence and technical support for our ongoing review of strategic alternatives and the training of a subcontractor for ongoing customer support programs. Research and development expense decreased $10.6 million or 33% in the year ended December 31, 2003 as compared to the year ended December 31, 2002. This resulted partly from a $4.8 million reduction in salary and employee-related expenses reflecting a full year of lower headcount in 2003 following our May and October 2002 restructurings. Depreciation expense was $3.7 million lower due to the reduced carrying value of assets resulting from impairment charges recorded in the second and third quarters of 2002 (See Note 9 of the Notes to the Consolidated Financial Statements for further details). Facilities and information technology infrastructure costs were $2.6 million lower as a result of reductions in personnel and square footage occupied. Non-cash charges related to equity issuances were $1.0 million higher due to credits taken in 2002 for the reversal of amortization of deferred compensation in excess of vesting for employees who were terminated that year.

      Non-cash credits related to equity issuances were $0.2 million for the year ended December 31, 2004. Non-cash charges related to equity issuances were $0.6 million for the year ended December 31, 2003. Non-cash credits related to equity issuances were $0.4 million for the year ended December 31, 2002.

Sales and Marketing Expenses

      Sales and marketing expenses consist primarily of salaries and related expenses for personnel engaged in sales, marketing and customer evaluations, as well as the costs associated with customer evaluations and trials and other promotional and marketing expenses. We devote substantial sales and marketing resources to customer evaluations and trials. The complexity of our IP Service Delivery Platform and the networks in which it is installed and integrated may often require extensive evaluation periods and trials. These trials are conducted by our customers at customer-designated locations or within our sales laboratories and require support from our highly trained systems engineers and service and support personnel. These evaluations and trials generally take approximately three to 12 months.

      Sales and marketing expenses were $10.1 million, $13.8 million, and $28.3 million for the years ended December 31, 2004, 2003, and 2002, respectively.

      Sales and marketing expense decreased by $3.8 million or 27% in the year ended December 31, 2004. The decrease is due primarily to our decision in September 2004 to discontinue our products and lay-off all of our employees to conserve cash. The majority of our sales and marketing employees were laid-off in September 2004 while a select team of employees were retained to support customer transition activities, including negotiating transition support plans, last time buys and related matters. Sales and marketing expense decreased $14.5 million or 51% in the year ended December 31, 2003, compared to the year ended December 31, 2002. This resulted partly from an $8.7 million reduction in salary and employee-related expenses reflecting a full year of lower headcount in the 2003 following our May and October 2002 restructurings and lower commission expense. Depreciation expense and expense related to CoSine product used in labs declined $2.8 million due primarily to the reduced carrying value of assets resulting from impairment charges recorded in the second and third quarters of 2002 and some assets becoming fully depreciated. Facilities and information technology infrastructure expense declined by $2.7 million as a result of reductions in personnel, square footage occupied and sales office rents. Travel expense declined $1.6 million due to cost saving measures and associated reductions in headcount. Marketing spending on events and market development declined $1.4 million due to attending fewer tradeshows and cost saving measures. Partially offsetting those savings, non-cash charges related to equity issuances increased $1.0 million due to credits for the reversal of amortization of deferred compensation expense in excess of vesting in 2002 for employees who were terminated during that year. Absorption to cost of revenue of spending to support maintenance contracts and warranty declined $1.8 million. Such support costs are initially charged to Sales and Marketing expense and subsequently reclassified to either cost of revenue 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 in the prior year.

      Non-cash credits related to equity issuances were $0.2 million in the year ended December 31, 2004. Non-cash charges related to equity issuances were $0.1 million for the year ended December 31, 2003. Non-cash credits related to equity issuances were $0.9 million for the year ended December 31, 2002.

General and Administrative Expenses

      General and administrative expenses consist primarily of salaries and related expenses for executive, finance, legal, accounting and human resources personnel as well as other corporate expenses, including non-cash charges related to equity issuances.

      General and administrative expenses were $6.1 million, $7.2 million, and $11.0 million for the years ended December 31, 2004, 2003 and 2002, respectively.

      General and administrative expense decreased $1.2 million or 15% for the year ended December 31, 2004. The decrease is due primarily to our decision in September 2004 to discontinue our products and lay-off all of our employees to conserve cash. The majority of our general and administrative employees were laid off in October and November of 2004, and substantially all employees were laid-off by December 31, 2004. Our administrative functions are now performed by consultants, including some former employees. General and administrative expense decreased $3.8 million or 35% in the year ended December 31, 2003, compared to the year ended December 31, 2002. This resulted partly from payroll-related expense, which declined $1.8 million, reflecting a full year of lower headcount in the 2003 following our May and October 2002 restructurings. Depreciation expense declined $0.5 million due to the reduced carrying value of the underlying fixed assets resulting from impairment charges recorded in the second and third quarters of 2002. Legal, accounting and audit services declined $0.5 million as a result of cost-saving measures. Non-cash charges related to equity issuances declined $0.5 million due to lower headcount and our use of an accelerated amortization method, which results in lower charges in each subsequent period. Bad debt expense declined $0.4 million as a result of lower revenue and lower actual bad debt experience.

      General and administrative non-cash credits related to equity issuances were $0.3 million for the year ended December 31, 2004. General and administrative non-cash charges related to equity issuances were $0.5 million and $0.9 million for the years ended December 31, 2003 and 2002, respectively.

Restructuring and Impairment Charges

      In the quarter ended December 31, 2004, CoSine continue its previously announced restructuring activities. Such activities included the termination of the remaining workforce, with a charge of $619,000, termination of a facility lease in Redwood City for a net charge of $2,522,000 and the termination of an office in Japan for a net charge of $396,000. The Redwood City lease termination included a cash payment of $3,763,000, forfeiture of a $420,000 lease deposit, the write-off of $388,000 unamortized value of warrants issued in connection with the original execution of the lease, net of accrued rent of $2,049,000. In addition, CoSine accrued $1,037,000 for the termination of non-cancelable software license agreements, as the licenses were not expected to be used in the ongoing operations.

      Activity related to the December 2004 restructuring is as follows, (in thousands):

      In September 2004, CoSine announced actions to terminate most of its workforce, retaining a limited team of employees to provide customer support and handle matters related to the ongoing exploration of strategic alternatives. The specific actions include workforce reductions, with a charge of $2,872,000, announced discontinuance of the CoSine products, with a related charge to cost of sales of $3,466,000 to write inventory down to net realizable value and a $75,000 charge for unrecoverable royalties, and termination of third party manufacturing agreements, with a charge of $375,000.

      Effective September 23, 2004, CoSine approved severance agreements to Stephen Goggiano, its president and chief executive officer, and Terry Gibson, its chief financial officer, covering the period of August 1, 2004 through the earlier of (i) December 31, 2004 or (ii) the termination of their respective employments due to the elimination of their respective jobs if caused by a merger, sale, acquisition, liquidation, dissolution,

consolidation or similar corporate transaction, in exchange for their continued service to CoSine as it explores strategic alternatives, including a sale of the Company, a sale or licensing of products, intellectual property, or individual assets or a winding-up and liquidation of the business. In exchange for their continued service during this time period, Mr. Goggiano and Mr. Gibson will each receive a retention bonus equal to 100% of their base 2004 annual salary payable on or before December 31, 2004. In addition, upon completion of these services, CoSine shall pay for the cost of Mr. Goggiano’s and Mr. Gibson’s family health care coverage for a period of up to 12 months after termination of their respective employment. These amounts were accrued in the December 31, 2004 restructuring and the termination payments were paid in January 2005.

      Activity related to the September 2004 restructuring is as follows (in thousands):

      In May and March 2003, our senior management communicated additional reductions in our workforce related to employees in our European region and the closure of a sales office in the Asia/ Pacific Rim region. The employees were notified in May and 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. The restructuring programs were an extension of the October 2002 restructuring, which was implemented to reduce operating expenses and conserve cash.

      Activity related to the May and March 2003 restructuring for the years ended December 31, 2004 and 2003 was as follows, (in thousands):

      In October 2002, our senior management approved a restructuring program to reduce our 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 were paid out through September of 2003. In addition, during the first quarter of 2003, we settled obligations associated with a leased facility in Redwood City, California that we exited during 2002 and made a payment of $8,104,000. The restructuring program was implemented to reduce operating expenses and conserve cash.

      Activity related to the October 2002 restructuring for the years ended December 31, 2003 and 2002 was as follows, (in thousands):

      In May 2002, our senior management approved a restructuring plan to reduce our worldwide workforce, close certain sales offices, exit certain facilities and dispose of or abandon certain property and equipment. Employees were notified in May 2002 that certain job functions would be eliminated and that particular termination benefits would be paid to affected employees. As a result of the workforce reduction, 146 employees were designated for termination in the restructuring 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. 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 March 2004. We also wrote down certain property and equipment to its expected realizable value as the assets have been either sold, disposed of or otherwise abandoned. The restructuring program was implemented to reduce operating expenses and conserve cash.

      Activity related to the May 2002 restructuring for the years ended December 31, 2003 and 2002 was as follows, (in thousands):

Impairment of Long-lived Assets

      As a result of our assessment of our business, we concluded that indicators of impairment of our long-lived assets were present at September 30, 2004 and at June 30, 2004. Such indicators included ongoing operating losses, inability to achieve sustainable revenue growth, including our failure to attract new customers, and our decision to evaluate strategic alternatives. Accordingly, we performed an impairment test of the carrying value of our long-lived assets, consisting primarily of property and equipment in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Based on an undiscounted cash flow analysis, the cash flows expected to be generated by our long-lived assets during their estimated remaining useful lives were not sufficient to recover the net book value of the assets. Consequently, we obtained a valuation report outlining the estimated fair value of the assets, based on quoted market prices, from an independent appraiser and recorded an impairment charge of $2.3 million to write down the carrying value of our long-lived assets held for use to their fair values in the second quarter of 2004. At September 30, 2004, the Company obtained competitive bids from qualified prospective purchasers to determine the fair values of long-lived assets. The fair values, as indicated by competitive bids, exceeded the net book value of the long-lived assets at September 30, 2004, accordingly no adjustment was made in the third quarter of 2004. During 2004, we had a gain of $0.9 million with the sales of previously written-down long-lived assets. At December 31, 2004, we had sold, scrapped or written-off all of our long-lived assets.

      As a result of our assessment of market conditions and the related effect on its business plan, we concluded that indicators of impairment of its long-lived assets were present during the second and third quarters of 2002. Accordingly, we performed an impairment test of the carrying value of our long-lived assets, consisting primarily of property and equipment, in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Based on an undiscounted cash flow analysis, the cash flows expected to be generated by our long-lived assets during their estimated remaining useful lives were not sufficient to recover the net book value of the assets. Consequently, we obtained a valuation report outlining the estimated fair value of the assets, based on quoted market prices, from an independent appraiser and recorded an impairment charge of $15,512,000 to write down the carrying value of our long-lived assets held for use to their fair values in the second and third quarters of 2002. In addition, property and equipment that was idled or abandoned was written down by approximately $3,248,000 to its estimated net realizable value.

Interest Income and Other Income (Expense)

      For the year ended December 31, 2004, interest income and other income (expense) was $0.2 million, a decrease of $0.4 million when compared with the year ended December 31, 2003. For the year ended December 31, 2003, interest income and other income (expense) was $0.6 million, a decrease of $2.3 million when compared with the year ended December 31, 2002. For the year ended December 31, 2002, interest and other income (expense) was $3.8 million. The decrease from 2003 to 2004 is due to decreased interest income due to lower levels of cash and short-term investments and lower interest rates on invested amounts.

Interest Expense

      For the year ended December 31, 2004, interest expense was nil as compared to $0.2 million for the year ended December 31, 2003. For the year ended December 31, 2002, interest expense was $1.0 million. The year over year decreases reflect reduced equipment loans and capital leases.

Income Tax Provision

      Provisions for income taxes of $33,000, $0.3 million and $0.5 million for the years ended December 31, 2004, 2003 and 2002, respectively, were comprised entirely of foreign corporate income taxes, which are a function of our operations in subsidiaries in various countries. The provision for income taxes is based on

income taxes on minimum profits the foreign operations generated for services they provided to us. Our tax expense for fiscal 2005 will continue to depend on the amount and mix of income derived from sources subject to corporate income taxes of foreign taxing jurisdictions.

      We have not recognized any benefit from the future use of net operating loss carryforwards for these periods, or for any other periods, since our incorporation. We are not recognizing the potential tax benefits of our net operating loss carryforwards because we do not have sufficient evidence that we will generate adequate profits to use them.

      Use of the net operating loss and tax credit carryforwards may be subject to substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code of 1986, and similar state provisions. The annual limitation may result in the expiration of net operating loss and tax credit carryforwards before utilization.

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 and do not expect to sustain or significantly increase our revenue.

      On July 29, 2004, we announced that we were exploring various strategic alternatives and that we had hired an investment bank as our financial advisor. On September 8, 2004, we announced that we were laying-off substantially all of our employees and were discontinuing our products while continuing to evaluate strategic alternatives. Based on restructuring activities initiated in September 2004 and continued in the quarter ended December 31, 2004, on the costs to complete all such activities, on the significant reduction in cash usage once such activities are completed, and on the costs to extend customer support activities through December 2005, 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, our restructuring activities and our ongoing review of strategic alternatives, raise substantial doubt as to our ability to continue as a going concern. See “Financial Results and Liquidity” in Note 1 of the Notes to the Consolidated Financial Statements. See “Outlook” on pages 30 to 31 and “Risk Factors” on pages 31 to 35, which describes strategic alternatives we are currently exploring.

      On September 8, 2004, CoSine announced that after an extensive evaluation of strategic alternatives, the Company initiated actions to lay-off most of its employees, retaining a limited team of employees to provide customer support and handle matters related to the ongoing exploration of strategic alternatives. Since September 8, 2004, the Company has taken a number of actions to reduce its operating expenses and conserve its cash. CoSine has notified its existing customers that the CoSine products are now formally discontinued and that existing customers may place “lifetime buy” orders to support their transition plans. The Company has written its inventory down to estimated net realizable value at September 30, 2004 and December 31, 2004. The Company has taken steps to terminate contract manufacturing arrangements, contractor and consulting arrangements and facility leases. These activities continued during the quarter ended December 31, 2004, at which time CoSine’s business consisted primarily of a customer support capability supported by a third party contractor.

      On January 7, 2005, the Company signed a definitive agreement to merge with Tut Systems, Inc. in a stock-for-stock transaction whereby CoSine will be acquired by and merged into Tut Systems, Inc in exchange for approximately 6 million shares of Tut Systems, Inc common stock. The agreement is subject to shareholder approval and normal closing conditions.

      Should the merger with Tut Systems, Inc not be completed, the Company would continue to explore strategic alternatives, including a sale of the Company, a sale or licensing of products, intellectual property, or individual assets or a winding-up and liquidation of the business and a return of capital. Pending the completion of the proposed merger or, should the merger not be completed, the outcome of the Company’s review of strategic alternatives, and pending any definitive decisions to close or liquidate the business, the Company will continue to prepare its financial statements on the assumption that it will continue as a going concern, which contemplates the realization of assets and liquidation of liabilities in the normal course of

business. As such, the financial statements do not include any adjustments to reflect possible future effects of the recoverability and classification of assets or the amounts and classification of liabilities that may result from any decisions made with respect to the Company’s assessment of its strategic alternatives. If at some point the Company were to decide to pursue alternative plans, the Company may be required to present the financial statements on a different basis. As an example, if the Company were to decide to pursue a liquidation and return of capital, it would be appropriate to prepare and present financial statements on the liquidation basis of accounting, whereby assets are valued at their estimated net realizable values and liabilities are stated at their estimated settlement amounts.

      There can be no assurance that any transaction or other corporate action will result from our exploration of strategic alternatives. Further there can be no assurance concerning the type, form, structure, nature, results, timing or terms and conditions of any such potential action, even if such an action does result from this exploration.

Cash, Cash Equivalents and Short-Term Investments

      At December 31, 2004, cash, cash equivalents and short-term investments were $24.9 million. This compares with $57.8 million at December 31, 2003.

Operating Activities

      We used $33.0 million in cash for operations for the year ended December 31, 2004, a decrease of $5.4 million from the amount used in 2003. The net loss in the year ended December 31, 2004 included significant non-cash charges, such as a $2.7 million inventory write-down, a $1.4 million property and equipment net impairment charge, and $2.0 million of other non-cash restructuring charges. Working capital changes also contributed to the reduced cash usage, specifically, reductions in accounts receivable, partially offset by reductions in accounts payable and accrued liabilities.

      We used $38.4 million in cash for operations for the year ended December 31, 2003, a decrease of $16.3 million from the amount used in 2002. Our $59.0 million decrease in net loss was partially offset by an increase in accrued expenses, a less favorable decrease in accounts receivable and lower non-cash expenses in 2003 compared to 2002. Items primarily contributing to the increase in accrued expense and lower non-cash charges included the following:

      We used $54.7 million in cash for operations for the year ended December 31, 2002. The decrease in use of cash in 2002 was primarily the result of an improvement in working capital and a lower net loss. The working capital improvement was primarily due to reductions in accounts receivable, inventory and deferred revenue.

Investing Activities

      For the year ended December 31, 2004, investing activities provided $22.4 million in cash, a decrease of $28.9 million from the prior year. The decrease in cash provided was due to reduced balances in our short-term investment portfolio in 2004 as compared to 2003, combined with a $1.9 million reduction in capital expenditures from 2003 to 2004, partially offset by proceeds from sales of fixed assets.

      For the year ended December 31, 2003, investing activities provided $51.2 million in cash. The increase in cash provided in 2003 was the result of an increase in proceeds from the sales and maturities of short-term investments compared over investment purchases.

      For the year ended December 31, 2002, we used $4.7 million in cash for investing activities, a decrease of $57.2 million over 2001. The decrease in cash provided in 2002 represents a reduction in proceeds from the sales and maturities of short-term investments partially offset by a reduction in capital expenditures.

Financing Activities

      For the year ended December 31, 2004, we generated $97,000 from financing activities as compared to a usage of $2.4 million in 2003. The improvement is due to the $3.6 million reduction in equipment and working capital loan and lease payments in 2004 as compared to 2003, partially offset by a $1.2 million reduction in proceeds from sales of common stock.

      For the year ended December 31, 2003, we used $2.4 million in cash from financing activities, or $2.9 million less than 2002. The reduction in cash used was primarily the result of lower principal payments on working capital loans and leases and higher proceeds from stock option exercises.

      For the year ended December 31, 2002, we used $5.2 million in cash from financing activities. The increase in cash used resulted from reduced proceeds from issuances of common stock.

Contractual Obligations

      Our contractual obligations as of December 31, 2004 are as follows (in thousands):

OUTLOOK

      Although capital spending in the telecommunications industry has begun to recover, the market for network-based IP services continues to develop slowly. We do not believe we can achieve the sustainable revenue growth necessary to survive as a stand-alone entity. On July 29, 2004, we announced that we were exploring various strategic alternatives and that we had hired an investment bank as our financial advisor. On September 8, 2004, CoSine announced that after an extensive evaluation of strategic alternatives, the Company initiated actions to lay-off most of its employees, retaining a limited team of employees to provide customer support and handle matters related to the ongoing exploration of strategic alternatives. Since September 8, 2004, the Company has taken a number of actions to reduce its operating expenses and conserve its cash. CoSine has notified its existing customers that the CoSine products are now formally discontinued and that existing customers may place “lifetime buy” orders to support their transition plans. Based on our current forecasts for future product demand, the Company has written its inventory down to estimated net realizable value at September 30, 2004 and December 31, 2004. The Company has taken steps to terminate contract manufacturing arrangements, contractor and consulting arrangements and facility leases. These activities continued into the quarter ended December 31, 2004, at which time CoSine’s business consisted primarily of a customer support capability supported by a third party contractor through December 31, 2005.

      At December 31, 2004, we had $24.9 million in cash and short-term investments. Cash consumption by operations during the year ended December 31, 2004 was $33.0 million. Based on restructuring activities

initiated in September 2004 through December 31, 2004, on the costs to complete all such activities, on the significant reduction in cash usage once such activities are completed, and on the expected net costs to extend customer support activities through December 2005, 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.

      On January 7, 2005, we signed an agreement to merge with Tut Systems, Inc. (Tut) in a stock-for-stock transaction. Refer to our filing on Form S-4, dated February 15, 2005. This transaction is subject to shareholder approval and normal closing conditions. Prior to signing the merger agreement with Tut, we were actively evaluating a variety of alternatives, including possible merger and asset sales transactions, licensing arrangements, and dissolution of the Company and distribution of assets to stockholders. There can be no assurance that the Tut merger will be completed, or that any transaction or other corporate action will result from our exploration of strategic alternatives. Further, there can be no assurance concerning the type, form, structure, nature, result, timing or terms and conditions of any such potential action, even if such an action does result from this exploration.

Recent Accounting Pronouncements

      In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”) which requires the measurement of all share-based payments to employees, including grants of employee stock options, using a fair-value-based method and the recording of such expense in the consolidated statements of operations. SFAS 123R requires companies to assess the most appropriate model to calculate the value of the options. There are a number of requirements under the new standard that would result in differing accounting treatment than currently required. These differences include, but are not limited to, accounting for the tax benefit on employee stock options and for stock issued under our employee stock purchase plan. SFAS 123R must be adopted no later than July 1, 2005 and the Company will begin to apply it in the quarter beginning on that date. The adoption of SFAS 123R is expected to result in an increase in expense during the second half of 2005 based on unvested options outstanding as of December 31, 2004 and current compensation plans. While the effect of adoption depends on the level of share-based payments granted in the future and unvested grants on the date the Company adopts SFAS 123R, the effect of this accounting standard on its prior operating results would approximate the effect of SFAS 123 as described in the disclosure of pro forma net loss and net loss per share in Note 1 of the Notes to Consolidated Financial Statements.

      In March 2004, the FASB issued Emerging Issues Task Force No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-1”), which provided new guidance for assessing impairment losses on investments. Additionally, EITF 03-1 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-1; however, the disclosure requirements remain effective for annual periods ending after June 15, 2004. The Company will evaluate the impact of EITF 03-1 once final guidance is issued.

RISK FACTORS

      This report (including the “Outlook” section above) 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, the continued downturn in the telecommunications industry and slow development of the market for network-based IP services, failure to achieve revenue growth and profitability, 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 below in this section, as well as the other risk factors discussed below. 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 file in fiscal year 2005.

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

      CoSine has incurred losses since inception and expects that its net losses and negative cash flow will continue for the foreseeable future as CoSine seeks to consummate the merger with Tut or another strategic alternative, if any. In September 2004, we announced the termination of most of our employees to facilitate the strategic alternatives then in consideration. In addition, as we seek to consummate the merger with Tut or another strategic alternative, we continue to expend our remaining cash resources. Further, we may incur significant expenses in connection with the merger with Tut or other possible strategic alternatives, to the extent we are able to do so pursuant to the terms of the merger agreement with Tut. If CoSine fails to merge with Tut, consummate another strategic alternative or raise additional capital, the resulting reduction of its available cash resources could result in CoSine ceasing operations and liquidating. In the case of a liquidation or bankruptcy, CoSine would need to hold back or distribute assets to cover liabilities before paying stockholders and, therefore, stockholders may not receive any proceeds for their ownership in CoSine. However, we believe we have adequate cash resources to continue to realize our assets and discharge our liabilities as a company through 2005.

      If the merger with Tut is not consummated, CoSine’s stock price may decline due to any or all of the following potential consequences:

      If the merger with Tut is consummated, the holders of CoSine common stock will become holders of Tut common stock. In addition, prior to the completion of the merger and unless the merger agreement with Tut is terminated, CoSine believes that the price of its common stock will be determined in part by the expectation that the merger will be completed and that its stockholders will become stockholders of Tut and that the price of CoSine common stock will be affected by the price of Tut common stock.

      Tut’s current operations differ substantially from CoSine’s operations, and Tut’s results of operations and the price of Tut common stock may be affected by factors different from those that affect CoSine’s results of operations and the price of its common stock before the merger. Such factors include Tut’s actual results of operations and investor expectations in regard to those results of operations.

      If the merger with Tut is not consummated, CoSine may be unable to satisfy the requirements for continued listing of its common stock on the Nasdaq National Market. The rules of the Nasdaq National Market require that companies listed on the Nasdaq National Market continue to have an operating business. If the merger with Tut is not consummated, CoSine may be forced to cease its business operations. If Nasdaq delists CoSine’s common stock from the Nasdaq National Market, the ability of CoSine stockholders to buy and sell shares will be materially impaired, and the trading price of CoSine’s common stock may be materially impaired.

      CoSine’s directors and officers have various interests in the merger besides being its stockholders. These interests include the agreement by Tut to continue to indemnify and insure CoSine’s directors and officers for various claims.

      CoSine has incurred recurring operating losses, and operations have not generated positive cash flows. CoSine has determined that the merger with Tut is the best means available to leverage its remaining cash resources and to maximize stockholder value. In the event CoSine is unable to effect the merger with Tut or effect another strategic alternative, CoSine will be required to find another buyer or distribute its assets. In the case of a distribution, CoSine would need to hold back assets to cover liabilities, and stockholders would be expected to receive much less than they would in the merger, if any.

      As a result of CoSine’s exploration of strategic alternatives, its board of directors may deem it advisable to dissolve the company and distribute assets to stockholders. Liquidation and dissolution may not create value to CoSine’s stockholders or result in any remaining capital for distribution to their stockholders. The precise nature, amount and timing of any distribution to CoSine’s stockholders would depend on and could be delayed by, among other things, sales of their non-cash assets and claim settlements with creditors.

      Certain of CoSine’s customer contracts contain provisions relating to the availability of products, spare parts and services for periods up to ten years. CoSine is in discussions with its customers and CoSine and its customers are jointly developing alternative plans, but CoSine’s customers may choose to sue CoSine for breach of contract.

      Capital expenditures within the telecommunications industry have 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.

      While the industry in general appears to be recovering, the market for network-based IP services continues to develop slowly. Until the market develops further, demand for network-based IP services may not increase significantly, limiting the strategic alternatives available to CoSine and thereby causing its stock price to decline.

      CoSine’s IP Service Delivery Platform, which is comprised of hardware and software, was the only product line that CoSine offered to our customers and has been discontinued. CoSine has no plans to offer any other product line. If the telecommunications industry does not value CoSine’s intellectual property, its strategic alternatives will be adversely impacted.

      CoSine’s 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 CoSine’s current products or enhancements after commencement of commercial shipments. If this happens, CoSine may experience product returns, injury to its reputation, increased service and warranty costs, any of which could have a material adverse effect on its business, financial condition and results of operations. Moreover, because CoSine’s products are designed to provide critical communications services, CoSine may receive significant liability claims. CoSine attempted to include in its agreements with customers and distribution partners provisions intended to limit CoSine’s exposure to liability claims. However, its 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 CoSine’s products or from a defect related to the installation or operation of one of its products. Although CoSine maintains product liability and errors and omissions insurance covering certain damages arising from implementation and use of their products, CoSine’s insurance may not cover all claims sought against it. Liability claims could require it 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 CoSine’s reputation and its business.

      The market for managed network-based IP services is prone to rapid technological change, the adoption of new standards, frequent new product introductions and changes in customer and end-user requirements. The introduction of new products or technologies by competitors, or the emergence of new industry standards, could render CoSine’s intellectual property obsolete adversely impacting strategic alternatives available to them.

      CoSine licenses from third-party suppliers certain software applications incorporated in their IP Service Delivery Platform. Their inability to renew or obtain any third party license that CoSine needs could require it to obtain substitute technology at a lower quality and higher cost. These outcomes could seriously impair CoSine’s ability to consummate an acceptable strategic alternative.

      CoSine relies on a combination of copyright, trademark, patent and trade secret laws and restrictions on disclosure to protect their intellectual property rights. Monitoring unauthorized use of CoSine’s products is difficult, and CoSine cannot be certain that the steps it has taken will prevent unauthorized use of CoSine’s technology. If CoSine is unable to protect its intellectual property rights, the value of their intellectual property may be impaired, adversely impacting their ability to consummate acceptable strategic alternatives.

      CoSine may become a party to litigation in the future to protect its intellectual property or because others may allege infringement of their intellectual property. These claims and any resulting lawsuits could subject it to significant liability for damages or invalidate CoSine’s 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 CoSine’s infringement of a third-party’s intellectual property also could force it to:

      At December 31, 2004, CoSine had an accumulated deficit of $516 million. CoSine has incurred net losses since its incorporation. If it does not achieve profitability and is unable to obtain additional financing, CoSine will run out of cash and cease operations.

      Like most other public companies, CoSine carries insurance protecting its 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. Cosine pays significant premiums to acquire and maintain this insurance, which is provided by third-party insurers, and CoSine agrees 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 the company and certain of its 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 CoSine have a $500,000 retention. As a result, the costs CoSine incurs in defending this lawsuit will not be reimbursed until they exceed $500,000. The policies that would cover any future lawsuits may not provide any coverage to CoSine and may cover the directors and officers only in the event CoSine is unwilling or unable to cover their costs in defending against and resolving any future claims. As a result, CoSine’s costs in defending any future lawsuits could increase significantly. Particularly in the current economic environment, CoSine cannot assure you that in the future it 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 CoSine’s financial condition in the event that it is required to defend against and resolve any

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

Interest Rate Sensitivity

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

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

      A sensitivity analysis was performed on our December 31, 2004 investment portfolio 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 100 basis points. Based on this analysis, a hypothetical 100 basis point increase in interest rates would result in a $40,000 decrease in the fair value of our investments in debt securities as of December 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.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

CoSine Communications, Inc.

      We have audited the accompanying consolidated balance sheet of CoSine Communications, Inc. (the “Company”) as of December 31, 2004 and the related consolidated statements of operations, stockholders’ equity, and cash flows for the year then ended. Our audit also included the financial statement schedule listed in Item 15(a)(2). The consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audit.

      We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

      In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of CoSine Communications, Inc. as of December 31, 2004 and the results of their operations and their cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule when considered in relation to the consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

      As discussed in Note 1 to the consolidated financial statements, the Company’s actions in September 2004, in connection with its ongoing evaluation of strategic alternatives, to terminate most of its employees and discontinue production activities in an effort to conserve cash raise substantial doubt about its ability to continue as a going concern. Management’s plans as to these matters are also described in Note 1. The financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amount and classification of liabilities that may result from the outcome of this uncertainty.

Palo Alto, California

March 21, 2005

REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED

PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders of

CoSine Communications, Inc.

      We have audited the accompanying consolidated balance sheet of CoSine Communications, Inc. as of December 31, 2003, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the two years in the period ended December 31, 2003. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2) for each of the two years in the period ended December 31, 2003. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

      We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

      In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of CoSine Communications, Inc. at December 31, 2003, and the consolidated results of its operations and its cash flows for each of the two years in the period ended December 31, 2003, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. The financial statement schedule does not include any adjustments to reflect the possible future effects on the recoverability and classification of assets that may result from the outcome of the uncertainty regarding the Company’s ability to continue as a going concern.

      As discussed in Note 1 to the consolidated financial statements, the Company’s actions in September 2004, in connection with its ongoing evaluation of strategic alternatives, to terminate most of its employees and discontinue production activities in an effort to conserve cash raise substantial doubt about its ability to continue as a going concern. Management’s plans as to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty.

San Jose, California

February 6, 2004, except for the third, fourth

and fifth paragraphs of Note 1, as to which the date is

February 14, 2005

COSINE COMMUNICATIONS, INC.

CONSOLIDATED BALANCE SHEETS

See accompanying notes.

COSINE COMMUNICATIONS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

See accompanying notes.

COSINE COMMUNICATIONS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY