Item 1.
Business
OVERVIEW
CoSine Communications, Inc. (CoSine) was incorporated in California on April 14, 1997 and in August 2000 was reincorporated in the State of Delaware. We develop, market and sell a communications platform designed to enable network service providers to rapidly deliver a portfolio of profitable communication services to business and consumer customers. Examples include:
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virtual private networks, or VPNs, which are secure private networks that run on the Internet and other communications networks;
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firewalls, which are security programs designed to prevent unwanted network traffic; and
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secure broadband access, which is secure high-speed access to the Internet and other communications networks.
Our Internet Protocol (IP) Service Delivery Platform consists of hardware elements: a chassis, including our IPSX 9500™ and IPSX 3500™ Service Processing Switches (IPSXs), and sub-systems known as our IP Service Generators (IPSGs) that support various IP services; and software elements consisting of our InVision™ Service Management software for network management and InGage™ Customer Network Management software.
Our network-based platform is designed to:
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allow delivery of applications and services to tens of thousands of subscriber networks simultaneously;
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help address the cost, management complexity and scalability issues of service delivery; and
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reduce the need for equipment on a customer’s premises to provide these applications and services.
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:
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attracting subscribers through differentiated services that can be layered on top of basic high-speed connectivity services;
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increasing revenue from business subscribers who are demanding additional services; and
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reducing subscriber turnover, because customers must consider the total cost of replacing multiple services and evaluate the risk of moving critical business services to a new service provider.
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
Our IP Service Delivery Platform provides a solution that is 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 is designed to deliver applications to thousands of subscribers simultaneously, consists 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.
We believe our products offer the following benefits for service providers and their customers:
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the ability of service providers to increase revenue by delivering a variety of services to their customers;
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faster availability of new services for delivery by service providers;
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reduced operating expenses for service providers through automated delivery and customer activation, centralized billing and fewer on-site service calls;
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the ability of service providers to attract new customers and reduce customer turnover;
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the ability of subscribers to monitor and control their outsourced services;
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reliability and scalability;
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software-based network management capabilities for service providers and their customers; and
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the ability to support and operate with existing network standards and applications.
STRATEGY
Our objective is to become the leading supplier of carrier network equipment designed to deliver profitable applications and services seamlessly from within a service provider’s network. The key elements of our strategy are:
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Work Closely with Customers to Facilitate New Services. We work closely with our customers to develop features to meet their complex and distinct needs. We believe that our customers’ input and cooperation are essential to the design of new features for our platform and its use in their networks.
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Expand Sales, Distribution, Support and Service Capabilities. We have built a team of support and service professionals to assist our customers with the design, implementation and efficient operation of our platform within their networks. We intend to expand this capability by seeking additional reseller partners.
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Develop New Technologies and Products. We have developed a fully distributed and virtualized hardware and software architecture that we believe will allow us to rapidly develop future products and enhancements. We intend to continue our significant investment in research and development to create new technologies and products.
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Pursue Strategic Partners. We intend to expand our existing marketing, sales service and support capabilities through strategic relationships, mergers or acquisitions. We believe that working with companies that provide complementary products or services for intelligent data networks will assist us in bringing greater value to our customers.
PRODUCTS AND TECHNOLOGY
IP Service Delivery Platform
Our products are offered in various configurations and combinations depending on the size of the service provider and the specific service offerings. The IPSX 9500 and IPSX 3500 come with the operating system software already loaded. A network service provider may buy the hardware with no additional software applications. However, the hardware will often be ordered with our InVision Service Management software. Our InGage Customer Network Management software is a packaged tool kit that allows a service provider to develop customer network management capabilities to give their end-users visibility and control into their managed services.
As our product is fully functional at the time of shipment, no significant installation services are necessary once the product has been received at the customer’s site.
IPSX Service Processing Switch Family
Our IPSX family of service processing switches combines the functionality of high-performance networking hardware, distributed computing hardware and operating system software. It is designed to be installed in a service provider’s facility and is the platform from which services are delivered.
Our switch family is based on a computing architecture that allows distributed computing to occur simultaneously within a multi-processor system. This approach combines the computing power of multiple processing engines to deliver more performance than a single-processor architecture. This approach, which is designed to be scalable, allows additional processing resources (and thus subscriber service capacity) to be added to the platform as they are needed. This is in sharp contrast to edge routers with their centralized architecture which has a fixed ceiling of subscriber capacity and service processing performance power.
IPSX Hardware Architecture. The IPSX hardware architecture involves two key design elements, our chassis design and our service generator design, that create a modular and flexible platform. We have two chassis designs: 1) the IPSX 9500, which provides a total of 26 slots, 13 in the front and 13 in the rear, and 2) the IPSX 3500, which provides eight slots.
The IPSG is a self-contained subsystem that delivers computationally intense IP services such as VPNs and managed firewalls. It operates within CoSine’s IPSXs deployed at the edge of a carrier’s network. Each
IPSG is assembled with a combination of various processing engines and interface modules to provide specific functionality. The performance of our IPSGs is enhanced by CoSine-originated integrated circuits, our processing architecture and our IP Network Operating System (IPNOS™).
IPNOS Software. Our operating system software, or IPNOS, is designed to provide:
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real-time processing, which allows the IPSX to perform its functions without significant delay;
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an object-oriented environment, which provides a simple framework for multiple instances of the same application to operate securely and independently;
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fault-tolerance, with the goal that if any component fails, a backup will immediately take its place with no loss of service; and
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distributed computing, which spreads applications and data over multiple processors at the same time.
InVision Service Management Software
InVision is a scalable network management software product designed to allow service providers to manage our IP Service Delivery Platform and the services being offered to their customers. It is designed to be installed in the service provider’s network operations center and provides a broad range of management services for each application. It also enables service providers to develop templates and tools to facilitate the process of delivering new services.
InVision is designed for scalability to meet the needs of the largest service provider networks and conforms to the telecommunication industry network management standards. The InVision system runs on the Sun Solaris server and Microsoft Windows NT operating systems.
InGage Customer Network Management Software
InGage is a network management software product that allows subscribers to manage their services through an interface that can be securely accessed through the Internet. InGage enables a subscriber to remotely manage services without affecting the services of any other subscriber and monitor the usage of various services.
SERVICE OFFERING EXAMPLES
Our IP Service Delivery Platform can support the following network applications:
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enterprise VPN service;
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wholesale VPN service;
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secure broadband service; and
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combined traditional and IP networking service.
Enterprise Virtual Private Network Service
Our platform is designed to enable service providers with IP backbone networks to offer their enterprise subscribers VPN services without the need for costly customer premises equipment. Using traditional connections, enterprise subscribers can access our IP Service Delivery Platform located at their service provider’s closest facility. Each IPSX acts as a private aggregation point for these connections and can provide secure routing services between all of a customer’s sites within a virtual network. Once the traffic reaches the IPSX, our IP Service Delivery Platform can provide encryption and authentication services. The traffic can then be securely transmitted less expensively over public IP networks or the Internet. In addition to encrypted VPN services, we also offer MPLS-based VPNs per the IETF standard RFC 2547.
Wholesale VPN Service
A wholesale ISP that provides wholesale VPN and other services to regional ISPs can use our IP Service Delivery Platform to offer these regional ISPs services for resale to their subscribers. ISPs using CPE-based
encryption cannot easily offer network-based services because traffic is encrypted on the customer’s premises before being sent to the network. Once encrypted by the customer, the service provider cannot interpret the contents of the packet and, as a result, cannot layer on any services.
When CPE-based encrypted traffic from a customer site is directed by the regional ISP to our IPSX within the wholesale ISP’s network, the wholesale ISP can decrypt the traffic and offer services on behalf of regional ISPs. The wholesale ISP can then re-encrypt the traffic and forward it to its next destination. This allows the regional ISP to offer a wide range of services to its customers from the wholesale ISP’s network in a cost-effective, scalable manner.
Secure Broadband Service
Broadband local access carriers installing digital subscriber line, or DSL, cable modem or broadband wireless data services control consumer and business access to the Internet and other data networks. These carriers are very often positioned to provide wholesale broadband access to their service provider customers. We believe that wholesale broadband connectivity is becoming a commodity, and these data carriers are seeking ways to lower costs of providing this connectivity and to increase revenues through services. Our platform is designed to enable broadband data carriers to provide traffic aggregation and service switching. Additionally, our platform potentially lowers the cost of operation for carriers by allowing them to transport the aggregated traffic over IP networks instead of using traditional connections to reach their wholesale customers.
Our platform also gives data carriers and their service provider customers several new revenue-generating opportunities with the utilization of a network-based firewall to secure any kind of broadband access connection.
Combined Traditional and IP Networking Service
Many traditional domestic and international carriers have invested in frame relay and asynchronous transfer mode, or ATM, network equipment. Frame relay is a data communications service that puts data into variable-sized units for transmission, while ATM is a communications switching technology that organizes data into standard-sized units for transmission. We believe that these networks and the enterprises using them will continue to grow. Large enterprise customers using these networks generally cannot afford to quickly transition their entire organization to a new IP-based network. Our platform is designed to enable traditional service providers to use their frame relay or ATM networks to obtain the benefit of IP services. We believe that this will enable service providers to pursue revenue opportunities from new services using their significant investments in equipment.
CUSTOMERS
During the year ended December 31, 2003, we recognized revenue from 38 customers, of which Sprint and Nissho Corporation accounted for 41% and 12% of our revenue, respectively. Geographically, our revenue was distributed as follows: Asia/ Pacific 35%; United States 47%; and Europe 18% (See Note 1 of the Notes to the Consolidated Financial Statements). Japan and Korea accounted for 20% and 12% of our revenue, respectively.
Currently a small number of customers account for a substantial portion of our revenues, and the loss of any one customer can have a material impact on our results of operations.
SALES AND MARKETING
We sell our products through our direct sales organization and resellers targeting specific countries. At December 31, 2003, we had 30 people in our sales and marketing organization.
We continue to devote 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 may consist of, but are not limited to, the following:
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Customer visits to our sales laboratory in Redwood City, California;
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Laboratory visits and trials with CoSine systems that are shipped to customers’ laboratory sites and/or customer network points of presence for field testing; and
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Field trials with multiple CoSine systems for large carriers to validate CoSine’s platform in the prospective customer’s global network.
Evaluations and trials generally last longer for larger carriers who have more extensive networks, due to the rigorous testing they typically perform and the complexity of integrating any new technology into a large network. In general, field evaluations also last significantly longer than laboratory visits and involve greater support from CoSine sales and services personnel.
Direct Sales
Our direct sales organization is divided into three regions - North America, Asia Pacific and Europe - and concentrates on network service providers offering IP-based services. Account managers focus on selling to large individual customers and to select high-end resellers that specialize in offering solutions to the carrier market. Account managers work with our customer services organization and our systems engineering group to provide customers with network design and build-out proposals. Account managers are directed by regional Vice Presidents, or General Managers, who report directly to the Senior Vice President of Worldwide Sales.
As part of our direct sales model, we use our field sales, engineering and executive personnel to establish multiple contacts within a potential customer’s business organization. We believe that developing and maintaining ongoing relationships with key individuals in our customers’ engineering, operations, marketing and executive departments is important to our success.
International Sales and Resellers
We have sales offices in a total of five countries in Europe, Asia and North America. For customers in countries in which we have local offices, most of our sales transactions are conducted directly with the customer. However, if the customer prefers to make a purchase through a reseller with which the customer has an established relationship, we may conduct business through the reseller. In countries in which we do not have a local sales office, our sales transactions are typically conducted through resellers.
CUSTOMER SERVICE AND SUPPORT
Customer service and support play a key role in ensuring our customers’ success in using the IP Service Delivery Platform. The goal of our service organization is to assist service providers to generate sustainable new revenue in a short period of time. We seek 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 include hardware and software warranty services, access to our technical assistance center, on-site network engineers and technical information and assistance.
Our professional services include consulting offerings designed to support service providers from initial planning through implementation and ongoing operation. Our network engineers and consultants are skilled in network design and architecture, VPN technologies, IP security, IP routing protocols and network performance and availability.
At December 31, 2003, we had 11 employees in our customer service and support organization.
RESEARCH AND DEVELOPMENT
We have a team of skilled engineers with extensive experience in designing:
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scalable Internet software;
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high performance computing platforms;
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application specific integrated circuits with advanced packaging technologies;
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network communications protocols;
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Internet security protocols;
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Internet firewalls;
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managed network services;
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operating system design; and
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network management software.
Our engineers have come from data networking, computer systems, computer security and telecommunications companies. Our research and development group is organized into teams that work on multiple generations of products. We seek to offer our customers new products as they are needed, as well as enhancements to existing products.
We plan to enhance our core technology and develop additional applications for our IP Service Delivery Platform. We are dedicating substantial resources to the development of new features for the IPSX 9500 and 3500. The design phase of these features is expected to have a minimum nine to 12 month development cycle.
Our research and development efforts are driven by market demand, the availability of new technology and customer feedback. We have invested significant time and resources to create a structured process for undertaking all product development projects. Following an assessment of market demand, our research and development team develops a set of functional product specifications based on input from our product management, sales and service organizations. This process is designed to provide a framework for defining and addressing the steps, tasks and activities required to bring product concepts and development projects to market.
We work closely with our customers to determine the features and functionality they want from our products. We use their feedback to define and prioritize our product development efforts. To continue developing additional applications for our IP Service Delivery Platform, we plan to continue to work with current and potential customers to develop products that address the needs of the market.
At December 31, 2003, we had 78 employees in our research and development group. Since April of 2001, we have had several restructurings in order to reduce our operating expenses. These restructurings involved significant reductions in our workforce, including our research and development group. These reductions have required us to prioritize our research and development objectives and to focus on enhancement of the performance of our platform and the development of features that are most important to our core customer base.
Our research and development expenses, including non-cash charges related to equity issuances, totaled $21.8 million, $32.4 million and $66.1 million for the years ended December 31, 2003, 2002 and 2001, respectively.
MANUFACTURING
We outsource the manufacture of our IPSG, interface modules and chassis to two contract manufacturers. Our primary contract manufacturer - Solectron Corporation - procures raw materials, assembles our printed circuit boards, and builds and test the IPSGs and interface configurations used in our products. Raw materials consist of electronic components from various manufacturers. Prior to our making new products generally available to customers, we occasionally purchase electronic components directly from manufacturers and then transfer the components to Solectron for assembly and test into finished products. Sonic
Manufacturing Corporation procures raw materials and assembles and tests all chassis used in our products. The IPSGs, interface modules and chassis assemblies are delivered to our Redwood City, California facility, where we perform system build, system test, packing and shipment. Our contract manufacturers produce our products within 30 miles of our Redwood City facility. All contract manufacturing is done pursuant to a rolling 4-quarter forecast submitted by CoSine.
We believe that our use of outsourced manufacturing minimizes the space and inventory investment needed for manufacturing operations and enables us to:
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adjust manufacturing volumes quickly to meet changes in customer demand;
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focus on production planning and key commodity management; and
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take advantage of the purchasing power of our contract manufacturers.
The use of third-party contract manufacturers could result in interruptions in our manufacturing operations if our relationships with these parties are terminated or our manufacturing subcontractors are unable or unwilling to produce sufficient quantities of products in a timely manner and at satisfactory quality levels. Also, we rely on single or limited sources for various key components, and the loss or delay of these sources could also interrupt our manufacturing operations. We have not experienced any interruptions in producing our products due to a shortage of these key components.
At December 31, 2003, we had 10 employees in our manufacturing operations group.
BACKLOG
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, 2003, 2002 and 2001, our backlog totaled $3.5 million, $1.4 million and $4.4 million, respectively. We expect most of the orders in our backlog as of December 31, 2003 to be filled in 2004.
After the successful completion of a customer evaluation and trial, there is generally a short time between order and shipment. In addition, customers occasionally change delivery schedules or cancel orders. We do not believe that backlog as of a particular date is necessarily indicative of future revenues for any particular period. However, we expect that most of our future sales will come from repeat business from existing customers as well as the successful completion of customer evaluations and trials.
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 place us in direct competition with a variety of networking equipment vendors who can 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 are seeing increasing competition from suppliers of conventional routers who are 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 include SonicWall and NetScreen for firewalls, Avaya and Cisco for IPSec VPN encryption and Arbor Networks for DoS mitigation. In addition, as we continue to add functionality through the addition of third-party applications to the IPSX platform, we will compete with leading vendors in each new segment we enter.
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. Some competitors may seek to use intellectual property rights to limit our ability to compete.
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 must deliver products that:
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provide extremely high network reliability;
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provide high performance;
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scale easily and efficiently through service virtualization and unparalleled service processing capability;
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operate with existing network designs and equipment vendors;
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reduce the complexity of the network by decreasing the need for multiple layers of equipment;
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provide a cost-effective solution for service providers; and
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are supported by responsive customer service and support.
We believe that positive factors pertaining to our competitive position include 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 have 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 March 14, 2004, we have a total of 21 patent applications pending in the United States relating to the design of our products, four PCT patent applications pending and a patent application pending in each of Japan and the European Union.
Although we rely on copyright, patent, trade secret and trademark law to protect our intellectual property, we believe that the technological and creative skills of our personnel, new product developments and frequent product enhancements are essential to maintain our technology leadership.
We license software from network software application companies for integration into our IP Service Delivery Platform. 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.
Our success will depend upon our ability to obtain necessary intellectual property rights and protect our intellectual property rights. We cannot be certain that we will be able to obtain necessary intellectual property rights or that other parties will not contest our intellectual property rights.
EMPLOYEES
As of December 31, 2003, we had 148 full-time employees, 78 of whom were engaged in research and development, 30 in sales and marketing, 19 in general corporate, finance and administration, 11 in customer support and 10 in manufacturing. None of our employees is represented by a labor union. None of our officers or key employees is bound by an employment agreement for any specific term. We have not experienced any work stoppages, and we consider our relations with our employees to be good.
In addition we utilize contractors based in India for certain software development and maintenance functions.
EXECUTIVE OFFICERS
The names of our executive officers and their ages, titles and biographies as of March 25, 2004 appear below.
Stephen Goggiano became Chief Executive Officer on March 3, 2002. Previously, he had served as Chief Operating Officer since joining CoSine in December 1999 and assumed the position of President in April 2001. Prior to joining CoSine, Mr. Goggiano held various positions at SGI, formerly known as Silicon Graphics, Inc., a provider of computing systems and software, from 1989 to 1999. These positions included Senior Vice President and General Manager of SGI’s Server and Supercomputer division, and Senior Vice President of worldwide manufacturing and customer service. Mr. Goggiano holds a B.S. in Business from San Jose State University.
Terry Gibson has served as Executive Vice President and Chief Financial Officer since joining CoSine in January 2002. Prior to joining CoSine, 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.
Jerry Jalaba has served as Senior Vice President of Sales since joining CoSine in August 2003. Prior to joining CoSine, Mr. Jalaba served as Vice President, Worldwide Sales and Support of Filanet/ Uroam from September 2001 to June 2003. From November 2000 to July 2001, he served as Vice President, Enterprise Solutions Group of Palm. From January 2000 to October 2000, he served as Senior Vice President, Worldwide Sales, Service and Marketing of Ramp Networks. From June 1998 to November 1999, he served as Vice President, Sales and Service of Vertical Networks. From April 1993 to June 1998 he worked at 3Com Corporation, where he served in various senior sales positions, including Vice President of Worldwide Sales Operations and Vice President of Enterprise Sales, North America. Prior to 3Com Corporation, he spent 13 years at IBM where he held several sales, marketing and network consulting roles. Mr. Jalaba holds a B.S. from the Massachusetts Institute of Technology and an MBA from the University of Southern California.
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 also make available free of charge through our Internet site (http://www.cosinecom.com) our most recent annual reports, quarterly reports, proxy statements and certain other documents filed with the SEC. These documents are available as soon as reasonably practicable after we file them with the SEC.
Item 2.
Item 2.
Properties
CoSine leases approximately 48,000 square feet of office and manufacturing space in Redwood City, California under an operating lease that expires in December 2011. Additionally, CoSine maintains sales offices in France, the United Kingdom, Japan, Korea and other regions of the United States. We believe the space will be sufficient for our current and anticipated needs through at least December 2004.
Item 3.
Item 3.
Legal Proceedings
On November 15, 2001, CoSine and certain of its officers and directors were named as defendants in a securities class action lawsuit filed in the United States District Court, Southern District of New York. The complaint generally alleges that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares in CoSine’s initial public offering. The complaint brings claims for the violation of several provisions of the federal securities laws against those underwriters, and also against the Company and each of the directors and officers who signed the registration statement relating to the initial public offering. Various plaintiffs have filed similar actions asserting virtually identical allegations against more than 250 other companies. The lawsuit and all other “IPO allocation” securities class actions currently pending in the Southern District of New York have been assigned to Judge Shira A. Scheindlin for coordinated pretrial proceedings. In October 2002, the individual defendants were dismissed without prejudice pursuant to a stipulation. The issuer defendants filed a coordinated motion to dismiss on common pleading issues, which the Court granted in part and denied in part in an order dated February 19, 2003. The Court’s order dismissed the Section 10(b) and Rule 10b-5 claims against the Company but did not dismiss the Section 11 claims against the Company.
In June 2003, the plaintiffs in all of the cases presented a settlement proposal to all of the issuer defendants. Under the proposed settlement, the plaintiffs will dismiss and release all claims against participating issuer defendants in exchange for a contingent payment guaranty by the insurance companies collectively responsible for insuring the issuer defendants in all of the related cases, and the assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. Under the guaranty, the insurers will be required to pay the amount, if any, by which $1 billion exceeds the aggregate amount ultimately collected by the plaintiffs from the underwriter defendants in all the cases, up to the limits of the applicable insurance policies. The Company will not be required to make any cash payments under the settlement, unless the Company’s insurer is required to pay on the Company’s behalf an amount that exceeds the Company’s insurance coverage. The Company does not believe that this circumstance will occur. In July 2003, a special committee of the Company’s Board of Directors approved the proposed settlement. The settlement is subject to acceptance by a substantial majority of the issuer defendants, and execution of a definitive settlement agreement. The settlement is also subject to approval of the court, which cannot be assured. If the settlement is not consummated, the Company intends to defend the lawsuit vigorously. However, we cannot predict its outcome with certainty. If we are not successful in our defense of this lawsuit, we could be forced to make significant payments to the plaintiffs and their lawyers, and such payments could have a material adverse effect on our business, financial condition and results of operations if not covered by our insurance carrier. Even if these claims are not successful, the litigation could result in substantial costs and divert management’s attention and resources, which could adversely affect our business, results of operations and financial position.
In the ordinary course of business, CoSine is involved in legal proceedings involving contractual obligations, employment relationships and other matters. Except as described above, CoSine does not believe there are any pending or threatened legal proceedings that will have a material impact on its financial position or results of operations.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of security holders during the quarter ended December 31, 2003.
PART II
Item 5.
Item 5.
Market for Registrant’s Common Stock and Related Stockholder Matters
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 18, 2004 we had approximately 302 shareholders of record. At that date there were approximately 7,707 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, 2003 and 2002, retroactively adjusted for the September 17, 2002 1-for-10 reverse stock split. All share and per share information in this Form 10-K have been restated to reflect this reverse stock split.
Equity Compensation Plan Information
The information required under Section 201(d) of Regulation S-K is set forth in Item 12 of this report.
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 expansion of the business, 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 $185 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.
Item 6.
Item 6.
Selected Financial Data
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, 2003, 2002 and 2001 and the selected consolidated balance sheet data as of December 31, 2003 and 2002, are derived from, and are qualified by reference to, the audited consolidated financial statements included elsewhere in this Form 10-K. The selected consolidated statement of operations data for the fiscal years ending prior to December 31, 2001, and the selected consolidated balance sheet data prior to December 31, 2002, 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):
(1)
Includes restructuring and impairment charges of $24.0 million in the second quarter of 2002, restructuring charges of $0.7 million in the third quarter of 2002 and restructuring charges of $9.8 million in the fourth quarter of 2002.
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
OVERVIEW
We develop, market and sell a communications platform that we refer to as our IP Service Delivery Platform. Our product is designed to enable network service providers to rapidly deliver a portfolio of communication services to business and consumer customers. We market our IP Service Delivery Platform through our direct sales force and through resellers to network service providers in Asia, Europe and North America. We provide customer service and support for our products directly and through support partners.
The market for our IP Service Delivery Platform is still in the early stages of development, and the volume and timing of orders are difficult to predict. A customer’s decision to purchase our platform typically involves a significant commitment of its resources and a lengthy evaluation, testing and product qualification process. The long sales cycles and the timing of our customers’ rollout of services made possible by our platform, which affects repeat business, may cause our revenue and operating results to vary significantly and unexpectedly from quarter to quarter. While we believe that the market for network-based IP services will continue to grow and represents a significant opportunity, we have not generated sufficient revenue to fund our operations. We believe that we have a technically strong product that can deliver IP services at a lower cost than competing products. However, we must increase our revenue in the short term in order to reduce our cash consumption and remain a viable and competitive supplier.
Management’s overview of the Company’s position is discussed in more detail in the “Outlook” section on page 28 and the “Liquidity” section on page 26.
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 disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, allowance for doubtful accounts, inventory valuation, long-lived assets, warranties and equity issuances. Additionally, the audit committee of our board of directors reviews these critical accounting estimates at least annually. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. These estimates form the basis for certain judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.
The following accounting policies are significantly affected by the judgments and estimates we use in the preparation of our consolidated financial statements.
Revenue Recognition
Most of our sales are generated from complex arrangements. Recognizing revenue in these arrangements requires our making significant judgments, particularly in the areas of customer acceptance and collectibility.
Certain of our sales arrangements require formal acceptance by our customers. In such cases, we do not recognize revenue until we have received formal notification of acceptance. Although we work closely with our customers to help them achieve satisfaction with our products prior to and after acceptance, the timing of customer acceptance can greatly affect the timing of our revenue.
While the end 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 use a 12-month forecast to assess future demand. Inventory write-downs are charged to cost of sales. During 2003, we charged $0.2 million of inventory write-downs and $0.1 million of excess purchase commitments to cost of sales primarily as the result of reduced forecasted demand for certain of our components and we sold $0.9 million of previously written-down inventory. If actual demand for our products is less than our forecasts, additional inventory write-downs may be required.
Long-lived assets
We evaluate the carrying value of long-lived assets, consisting primarily of property, plant and equipment, whenever certain events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. In assessing the recoverability of long-lived assets, we compare the carrying value to the undiscounted future cash flows the assets are expected to generate. If the total of the undiscounted future cash flows is less than the carrying amount of the assets, the assets will be written down to their estimated fair value. Fair value is generally determined by calculating the discounted future cash flows using a discount rate based 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 2002, we charged $18.8 million to operating expenses as a result of impairments.
Warranties
We provide a basic limited warranty, including repair or replacement of parts, and technical support. The specific terms and conditions of those warranties vary depending on the customer or region in which we do business. We estimate the costs that may be incurred under our basic limited warranty and record a liability in the amount of such costs at the time product revenue is recognized. Our warranty obligation is affected by the number of installed units, product failure rates, materials usage and service delivery costs incurred in correcting product failures. Each quarter, we assess the adequacy of our recorded warranty liabilities and adjust the amounts as necessary. In future periods, if actual product failure rates, materials usage or service delivery costs differ from our estimates, adjustments to cost of sales may result.
Impact of Equity Issuances on Operating Results
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 revenue in 2001 was affected significantly by warrants issued to our first three customers, Qwest Communications International, Inc., AduroNet Limited and Broadband Office, Inc. These warrants were issued upon receipt of substantial purchase orders in 2000 which were preceded by a period of cooperation with us in the marketing, development and refinement of our products. Our revenue from these customers consisted of receipts from sales, including equity issued in connection with sales, less receipts for equity issued in connection with sales. As of December 31, 2001, the value of the warrants granted to these customers was fully amortized and as a result, our revenue in 2003 and 2002 was not affected by the value of warrants granted to customers.
Our cost of goods sold, operating expenses and interest expense were also affected significantly in 2001 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:
•
Non-recourse promissory notes receivable: During the fourth quarter of 2000, we converted full-recourse promissory notes received from employees upon the early exercise of unvested employee stock options to non-recourse obligations. Accordingly, we are required to re-measure the compensation associated with these shares until the earlier of repayment of the note or default. Deferred compensa-
tion expense, which is recorded at each re-measurement, is amortized over the remaining vesting period of the underlying options.
•
Re-priced stock options: In November 2002, we re-priced 1,091,453 outstanding employee stock options to purchase shares of our common stock with original exercise prices ranging from $5.45 per share to $159.38 per share. These options were re-priced to $5.00 per share, which was higher than the fair market value of the underlying shares on the re-pricing date. In July 2001, we re-priced 722,071 unexercised employee stock options to $15.50 per share, the fair market value of the underlying shares on the re-pricing date. These options had previously been granted at prices ranging from $40.00 to $400.00 per share. Compensation will be re-measured for these options until they are exercised, canceled, or expire. At December 31, 2003, 603,411 stock options re-priced in November 2002 were still outstanding.
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 balance sheet and is then amortized using an accelerated method over the vesting period of the applicable options. When an employee terminates, an expense credit is recorded for any amortization that has been previously recorded as an expense in excess of vesting.
RESULTS OF OPERATIONS
For the years ended December 31, 2003, 2002 and 2001, we reported basic and diluted net losses per share of $3.57, $9.72 and $15.09, respectively. Charges related to equity issuances to customers, suppliers, employees and consultants increased net loss per share by $0.13 for the year ended December 31, 2003, decreased net loss per share by $0.03 for the year ended December 31, 2002 and increased net loss per share by $3.62 for the year ended December 31, 2001. All per share amounts have been restated to reflect our 1-for-10 reverse stock split, effected in September 2002.
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, 2003, 2002 and 2001 was as follows, in thousands:
Hardware, software and service revenue for the years ended December 31, 2003, 2002 and 2001 was as follows, in thousands:
In 2003, unit shipments declined. The decline reflects 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.
Because the market for network-based IP services is in the early stages of development, service provider demand for our products may fluctuate until service providers are able to further develop enterprise demand for such services and accelerate revenue growth from the sale of such services. See “Outlook” section on page 28 and “Risk Factors” section on pages 29 to 35.
We issued no warrants to customers during the years ended December 31, 2003, 2002 and 2001. At December 31, 2003, 2002 and 2001, there were no unamortized non-cash charges related to warrants issued to customers.
As of December 31, 2003, 2002 and 2001, we deferred $3.5 million, $1.4 million and $2.7 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) $1.3 million, ($0.3) million and $32.1 million of non-cash charges related to equity issuances to cost of goods sold, operating expenses and interest expense, for the years ended December 31, 2003, 2002 and 2001, respectively.
Below is a reconciliation of non-cash charges related to equity issuances for the years ended December 31, 2003, 2002 and 2001, affecting our cost of goods sold, 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 Goods Sold
Cost of goods sold 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 goods sold. 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 goods sold consists of payments to our contract manufacturers. We conduct manufacturing engineering, final assembly, configuration testing and documentation control at our facilities in Redwood City, California.
For the year ended December 31, 2003, cost of goods sold 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 goods sold 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. For the year ended December 31, 2001, cost of goods sold was $30.2 million, of which $12.7 million or 41% represented materials, labor, production overhead and warranties, $12.3 million or 42% represented inventory write-downs, $2.3 million or 8% represented non-cash charges related to equity issuances in manufacturing operations and $2.9 million or 9% represented software royalties.
Gross Profit
For the years ended December 31, 2003, 2002 and 2001, gross profit was $7.9 million, or 54% of revenue, $9.8 million, or 42% of revenue and $4.1 million, or 12% of revenue, respectively.
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.
We expect our gross margin to be primarily affected by regional product mix and configurations, the volume of product sold and pricing pressures, the amount of excess inventory reserve charges and the amount of written-down inventory sold. The mix of products that our customers purchase is unpredictable and, because of lead times required to buy certain components and the timing of our customers’ orders, we purchase inventory based on forecasted demand. The amount of excess inventory purchase commitments and excess inventory charges related to on-hand inventory is dependent on us purchasing the correct mix of inventory. In addition, if our unit sales volumes are significantly lower than forecasted demand, excess inventory charges will result.
Research and Development Expenses
Research and development expenses 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 $21.8 million, $32.4 million and $66.1 million for the years ended December 31, 2003, 2002 and 2001, respectively.
Research and development expense decreased $10.6 million or 33% in the year ended December 31, 2003, 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.
Research and development expense decreased $33.7 million or 51% in the year ended December 31, 2002, compared to the year ended December 31, 2001. This resulted partly from a $14.9 million reduction in salary and employee-related expenses reflecting lower headcount in the current period. Non-cash charges related to equity issuances were lower by $11.2 million due to the reversal of amortization of deferred compensation in excess of vesting for employees who were terminated and our use of an accelerated amortization method for employee stock compensation, which results in lower charges in each subsequent period. Facilities and information technology infrastructure costs were $3.6 million lower as a result of reductions in personnel and square footage occupied. Depreciation expense was $2.9 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).
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. Non-cash charges related to equity issuances were $10.8 million for the year ended December 31, 2001.
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. We anticipate that customer evaluations and trials will continue to require a substantial amount of our sales and marketing resources. We have also incurred non-cash charges related to equity issuances. Since April of 2001, we have had several restructurings in order to reduce our operating expenses. These restructurings involved significant reductions in our workforce, including our sales and marketing group. We will attempt to partially offset the effect of these reductions by establishing relationships with resellers in selected markets.
Sales and marketing expenses were $13.8 million, $28.3 million and $60.0 million for the years ended December 31, 2003, 2002 and 2001, respectively.
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 goods sold 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 sales or the provision for warranty claims based on associated activity such as product return levels and technical support case data. Due primarily to a smaller customer installed base, activity associated with maintenance and warranty was less than in the prior year.
Sales and marketing expense decreased $31.7 million or 53% in the year ended December 31, 2002, compared to the year ended December 31, 2001. This resulted partly from a $13.6 million decrease in non-cash charges related to equity issuances due to the reversal of amortization of deferred compensation in excess of vesting for employees who were terminated and our use of an accelerated amortization method for employee stock compensation, which results in lower charges in each subsequent period. Salary and employee-related expenses were reduced by $9.2 million reflecting lower headcount in the current period and lower commission expense. Marketing program expense declined by $3.5 million due to cost saving measures. Travel expense declined by $2.2 million due to lower headcount and the implementation of cost saving measures. Evaluation unit and lab amortization expense declined by $1.8 million due to reduced trials and 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). Finally, facilities and information technology infrastructure expense declined by $1.7 million.
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. Non-cash charges related to equity issuances were $12.7 million for the year ended December 31, 2001.
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 $7.2 million, $11.0 million and $23.5 million for the years ended December 31, 2003, 2002 and 2001, respectively.
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 expense decreased $12.5 million or 53% in the year ended December 31, 2002, compared to the year ended December 31, 2001. This resulted partly from a $5.3 million decrease in non-cash charges related to equity issuances due to the reversal of amortization of deferred compensation in excess of vesting for employees who were terminated and our use of an accelerated amortization method for employee stock compensation, which results in lower charges in each subsequent period. Salary and employee-related expenses declined by $3.4 million reflecting lower headcount in the current period. Depreciation expense was lower by $1.8 million 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). Reduced use of outside professional services resulted in a decrease of $0.8 million.
General and administrative non-cash charges related to equity issuances were $0.5 million, $0.9 million and $6.2 million for the years ended December 31, 2003, 2002 and 2001, respectively.
General and administrative expenses in 2004 may significantly increase due to costs related to the implementation of Section 404 of the Sarbanes-Oxley Act of 2002, which requires management to report on, and our auditors to attest to, our internal controls.
Restructuring and Impairment Charges
May and March 2003 Restructuring
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. Amounts related to the workforce reduction and the other items are expected to be paid through June of 2004. 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 year ended December 31, 2003 was as follows, (in thousands):
October 2002 Restructuring
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 as 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):
May 2002 Restructuring
In May 2002, our senior management approved a restructuring plan to reduce our worldwide workforce, close certain sales offices, exit certain facilities and dispose of or abandon certain property and equipment. Employees were notified in May 2002 that certain job functions would be eliminated and that particular termination benefits would be paid to affected employees. As a result of the workforce reduction, 146 employees were designated for termination in the restructuring 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 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.
April and September 2001 Restructuring
In April and September of 2001, our senior management approved restructuring programs to reduce our worldwide workforce, close certain sales offices, exit certain facilities and idle certain property and equipment. Employees affected by the April 2001 program were notified and terminated in April 2001. With respect to the September 2001 program, notification was given to employees in September 2001 that certain job functions would be eliminated and that particular termination benefits would be paid to affected employees. The restructuring programs were implemented to reduce operating expenses and conserve cash.
Activity related to the April and September 2001 restructuring for the year ended December 31, 2002 and 2001 was as follows (in thousands):
As a result of the workforce reductions, approximately 55 employees were terminated in the second quarter of 2001, and approximately 50 employees were designated for termination in the third quarter of 2001 restructuring program and were then terminated in the fourth quarter of 2001. The employees in both
workforce reductions were from all functional groups and were primarily located in the Redwood City, California offices. Certain property and equipment has been written down to its expected realizable value.
Amounts related to the worldwide workforce reduction were paid out through mid-2002, and lease commitments were paid out over the respective lease terms through mid-2002.
Interest Income and Other Income (Expense)
For the year ended December 31, 2003, interest income and other income (expense) was $0.8 million, a decrease of $3.0 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, a decrease of $7.0 million when compared with 2001. The year over year decreases reflect 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, 2003, interest expense was $0.2 million, a decrease of $0.8 million when compared with the year ended December 31, 2002. For the year ended December 31, 2002, interest expense was $1.0 million, a decrease of $0.7 million when compared with the year ended December 31, 2001. The year over year decreases reflect reduced equipment loans and capital leases.
Income Tax Provision
Provisions for income taxes of $0.3 million, $0.5 million and $0.8 million for the years ended December 31, 2003, 2002 and 2001, 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 2004 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 unless we are able to significantly increase our revenues, reduce our operating expenses or both. In April and September 2001, May and October 2002 and, to a lesser extent, in March and May 2003, we announced that we had adopted business plans to reduce our operating expenses to reflect current and expected business conditions. We cannot assure you that we will be able to decrease our operating expenses significantly below current levels and still remain a viable and competitive supplier.
Based on our rate of quarterly cash consumption in 2003 of approximately $9 million (which excludes $8.1 million paid to settle a lease obligation related to facilities we exited in Redwood City, California), we believe that we possess sufficient liquidity and capital resources to fund our operations and working capital requirements for at least the next 12 months. However, because of our history of losses and use of cash in operations, certain of our existing and prospective customers may have concerns regarding our long-term financial viability and our ability to support their businesses, and as a result may choose to purchase equipment from other larger and more established suppliers. See “Risk Factors” on pages 29 - 35.
Prior to our initial public offering in September 2000, we financed our operations primarily through sales of convertible preferred stock for net proceeds of $166.6 million, plus equipment and working capital loans and
capital leases. Upon the closing of our initial public offering on September 29, 2000, we received cash proceeds, net of underwriters’ discount and offering expenses, totaling $242.5 million, and all of our convertible preferred stock was converted into 7.0 million shares of common stock.
We may seek to raise additional funds through debt or equity financing or from other sources. There can be no assurances that additional funding will be available at all, or that if available, such financing will be obtainable on terms favorable to us.
Cash, Cash Equivalents and Short-Term Investments
At December 31, 2003, cash, cash equivalents and short-term investments were $57.8 million. This compares with $101.5 million at December 31, 2002.
Operating Activities
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 include the following:
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Accrued other liabilities declined $10.8 million, primarily as a result of paying down $9.4 million of restructuring expenses accrued in the 2002.
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The net loss for the year ended December 31, 2002 included a non-cash write-down of $18.8 million for the impairment of fixed assets.
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Depreciation expense declined $7.7 million due to the reduced carrying value of property and equipment resulting from impairment charges recorded in the second and third quarters of 2002 and some property and equipment becoming fully depreciated.
We used $54.7 million in cash for operations for the year ended December 31, 2002, a decrease of $45.4 million from the amount used in 2001. 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, 2003, investing activities provided $51.2 million in cash, an increase of $56.0 million over 2002. 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, 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, an increase of $0.6 million from 2001. The increase in cash used resulted from reduced proceeds from issuances of common stock.
Contractual Obligations
Our contractual obligations as of December 31, 2003 are as follows (in thousands):
OUTLOOK
Fourth Quarter 2003 revenue of $2.4 million marked a disappointing end to a challenging year. While our cost management and cash flow improvement actions yielded improvements from 2002 to 2003, we must drive significant, near-term revenue growth. Although capital spending in the telecommunications industry has begun to recover, the market for network-based IP services has continued to develop slowly. We see evidence that a number of major carriers will move to a network-based approach to IP services delivery. This trend is reflected in the expansion plans of our existing customers, as well as those of prospective customers. Our research and interaction with our carrier customers indicates that enterprise customers large and small are increasingly demanding low cost, secure, communications capabilities, along with value-added IP services such as IP Sec and MPLS VPN, Firewall and Dos Shield. Carriers, at the same time, are looking for ways to provide and scale such capabilities to serve hundreds or thousands of geographically dispersed users in a profitable manner. We believe that we have a strong, differentiated product that can deliver network-based IP services at a lower cost than the competitive alternatives.
While we believe that the market for network-based IP services represents a significant opportunity, we recognize the need to increase revenues and decrease cash consumption in the short term. As of the filing date of this report, we believe that we cannot make further significant reductions in our operating expenses, and at the same time continue to win new business, support our existing customers and continue with the research and development necessary to compete effectively in our market. Therefore, we must achieve revenue growth in the near term by winning repeat business as our customers seek to expand their network-based IP service offerings and capturing new customers as they begin to enter this market. However, there can be no assurance that we will succeed in meeting these objectives. Our ability to achieve such revenue growth will depend, in part, on the rate of growth in enterprise adoption of the network-based IP services delivery model.
Our ability to pursue new customers is constrained by the relatively small size of our sales force and the long sales cycle involved in the purchase of our products. Accordingly, the establishment of strategic reseller relationships is an important part of our strategy for 2004. By establishing these relationships, we can leverage the sales and support capabilities of these partners and thereby expand our potential market. In addition, we have evaluated a variety of different business scenarios and possible means for facilitating CoSine’s long-term success. We have explored, and will continue to explore, OEM relationships, strategic partner relationships, mergers and acquisitions as possible ways to facilitate CoSine’s long-term success and build shareholder value, and we use industry and financial experts to assist us in seeking and evaluating such opportunities.
Recent Accounting Pronouncements
In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities.” FIN 46 addresses consolidation by business enterprises of variable interest entities. Under that interpretation, certain entities known as Variable Interest Entities (“VIEs”) must be consolidated by the primary beneficiary of the entity. The primary beneficiary is generally defined as having the majority of the risks and rewards arising from the VIE. For VIEs in which a significant (but not majority) variable interest is held, certain disclosures are required. We have not entered
into any arrangements or made any investments which qualify as a VIE in the period after January 31, 2003 and therefore the initial implementation of FIN 46 had no impact on our financial statements. For VIEs acquired before February 1, 2003, we are required to apply the accounting and disclosure rules set forth in FIN 46 in the first quarter of 2004. We have determined that the adoption of FIN 46 will not have any impact on our financial statements.
In December 2003, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 104 (“SAB 104”), “Revenue Recognition.” SAB 104 revises or rescinds portions of the interpretive guidance included in Topic 13 of the codification of staff accounting bulletins in order to make this interpretive guidance consistent with current authoritative accounting and auditing guidance and SEC rules and regulations. The adoption of SAB 104 did not have a material effect on our financial statements for the period ending December 31, 2003.
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 2004.
The following discussion describes certain risk factors related to our business as well as to our industry in general.
We have a history of losses that we expect will continue, and if we do not achieve profitability we may cease operations.
At December 31, 2003, we had an accumulated deficit of $478.4 million. We have incurred net losses since our incorporation. We cannot be certain that our revenue will grow or that we will generate sufficient revenue to become profitable. If we do not achieve profitability and are unable to obtain additional financing, we may run out of cash and cease operations.
Due to our losses, we could lose major opportunities with large service providers who are concerned with our long-term financial viability.
Many large telecommunications service providers purchase capital equipment from vendors with a history of successful operations including positive cash flow. Our history of losses and use of cash in operations may cause certain service providers to decide not to purchase equipment from us because of concerns regarding our long-term financial viability and our ability to support their businesses. Unless we can generate positive cash flows by either increasing revenues or decreasing costs, concerns regarding our long-term financial viability may cause some potential customers to purchase product from other larger, more established suppliers including Cisco Systems, Lucent Technologies, Nortel Networks, Alcatel, Ericsson, Siemens, and Juniper Networks.
The market for managed network-based IP services is still in the early stages of growth. As a result, demand may fluctuate.
The market for managed network-based IP services is still in the early stages of growth. We believe that the market for these services will grow, but the timing of this growth is linked to the development of this market by service providers and the growth of enterprise demand. Until the market develops further, demand may not increase significantly and may continue to fluctuate. If our quarterly or annual operating results do not meet the expectations of securities analysts or investors, the trading price of our common stock could decline.
The outlook for capital spending in the telecommunications industry directly impacts our business.
Our business depends on capital expenditures within the telecommunications industry, which has experienced a significant downturn since 2001. Capital spending in the industry as a whole has slowed as a result of a lack of available capital for many emerging service providers and a generally cautious approach to capital spending within the industry.
While the industry in general appears to be recovering, the ultimate duration of this downturn is unknown. Due to reductions in capital spending plans by our customers and uncertainty within the telecommunications industry, we anticipate that this trend will continue to have a substantial, adverse effect on our revenue growth for at least the remainder of the current fiscal year. No assurance can be given that the Company’s net revenue and operating results will not be further adversely affected by the current downturn or any future downturns.
The long sales cycle for our platform may cause our revenue and operating results to vary significantly from quarter to quarter, and the price of our stock to decline.
A customer’s decision to purchase our IP Service Delivery Platform involves a significant commitment of its resources and a lengthy evaluation, testing and product qualification process that may run from three to twelve months. Network service providers and other customers with complex networks usually expand their networks in increments on a periodic basis. We may receive purchase orders for significant dollar amounts on an irregular and unpredictable basis. These events may cause our revenue and operating results to vary significantly and unexpectedly from quarter to quarter, which could cause our stock price to decline.
We participate in a competitive marketplace, and our failure to compete successfully would limit our ability to increase our market share and harm our business.
Competition in the network infrastructure market is intense, and we expect that competition in the market for IP networking services will also be intense. If we are unable to compete effectively, our revenue and market share will be negatively affected.
We face competition from companies in the network infrastructure market, including Cisco Systems, Lucent Technologies, Nortel Networks, Alcatel, Ericsson, Siemens, and Juniper Networks. Many of our competitors are larger companies with significantly greater resources than we have, and we expect to face increased competition from larger companies in the future. Some of these larger competitors have pre-existing relationships involving a range of product lines with the network service providers who are the principal potential customers for our IP Service Delivery Platform. These competitors may offer vendor financing, which we generally do not offer, undercut our prices or use their pre-existing relationships with our customers to induce them not to use our IP Service Delivery Platform.
Future consolidation in the telecommunications equipment industry may increase competition that could harm our business
The markets in which we compete are characterized by increasing consolidation both within the data communications sector and by companies combining or acquiring data communications assets and assets for delivering voice-related services. We cannot predict with certainty how industry consolidation will affect our competitors. We may not be able to compete successfully in an increasingly consolidated industry. Increased competition and consolidation in our industry could require that we reduce the prices of our products and result in our loss of market share, which would materially adversely affect our business, financial condition and
results of operations. Because we may be dependent on certain strategic relationships with third parties in our industry, any additional consolidation involving these parties could reduce the demand for our products and otherwise harm our business prospects.
Our ability to sustain or grow our business may be harmed if we are unable to develop and maintain certain strategic relationships with third parties to market and sell our products.
Because we are a relatively small company with correspondingly small sales and support groups, our success will depend in part upon our ability to form and maintain distribution partnerships, including agreements under which we agree to sell our products to certain service provider customers through distribution partners. We may not be able to establish sufficient reseller relationships to enable us to expand our potential market and achieve revenue growth. The amount and timing of resources that our distribution partners devote to our business, if any, is not within our control. Our distribution partners may not perform their obligations as expected. In some cases, agreements with our distribution partners may be relatively new, and we cannot be certain that we will be able to achieve expected revenues from such partners or sustain the level of revenue generated thus far under similar arrangements. If any of our distribution partners chooses not to renew, breaches or terminates its agreement or fails to perform its obligations under its agreement, we may not be able to sustain or grow our business. In the event that such relationships are terminated, we may not be able to continue to maintain or develop similar relationships or to replace distribution partners. In addition, any such agreements we enter into in the future may not be successful.
If our customers are unable to generate sales of services using our products and to manage delivery of these services to their customers, we may be unable to sell our products.
Our future success depends on network service providers, who are our customers, generating revenue from the sale of services delivered using our products. Sales of our products may decline or be delayed if our customers do not successfully introduce commercial services derived from our IP Service Delivery Platform or if our customers do not generate revenue from these services sufficient to realize an attractive return on their investment in our IP Service Delivery Platform. In addition, the long cycle for service providers to introduce new services made possible by our platform may cause our revenue and operating results to vary significantly from quarter to quarter.
Our ability to generate future revenue also depends on whether network service providers successfully forecast market trends and identify customer demand for the services and features that our products would enable network service providers to offer their customers.
If our IP Service Delivery Platform does not achieve market acceptance, we may be unable to achieve profitability.
Our products offer a new approach for delivering services by network service providers, who may perceive our products as being more expensive than the other technologies and products they purchase. If network service providers do not accept our IP Service Delivery Platform as a method for delivering services to their customers, our ability to increase our revenue, achieve profitability and continue operations would be harmed.
Our IP Service Delivery Platform is our only product line, and our future revenue depends on its commercial success.
Our IP Service Delivery Platform, which is comprised of hardware and software, is the only product line that we currently offer to our customers. Our future revenue depends on the commercial success of our IP Service Delivery Platform. If customers do not adopt, purchase and successfully implement our IP Service Delivery Platform in large numbers, our revenue will not grow.
If our products contain defects, we may be subject to significant liability claims from our customers, distribution partners and the end-users of our products and incur significant unexpected expenses and lost sales
Our products are technically complex and can be adequately tested only when put to full use in large and diverse networks with high amounts of traffic. They have in the past contained, and may in the future contain,
undetected or unresolved errors or defects. Despite extensive testing, errors, defects or failures may be found in our current or future products or enhancements after commencement of commercial shipments. If this happens, we may experience delay in or loss of market acceptance and sales, product returns, diversion of development resources, injury to our reputation, inability to attract new customers, or increased service and warranty costs, any of which could have a material adverse effect on our business, financial condition and results of operations. Moreover, because our products are designed to provide critical communications services, we may receive significant liability claims. We attempt to include in our agreements with customers and distribution partners provisions intended to limit our exposure to liability claims. However, our customers and distribution partners may not be willing to agree to such provisions, and in any event such provisions may not be effective in any or all cases or under any or all scenarios, and they may not preclude all potential claims resulting from a defect in one of our products or from a defect related to the installation or operation of one of our products. Although we maintain product liability and errors and omissions insurance covering certain damages arising from implementation and use of our products, our insurance may not cover all claims sought against us. Liability claims could require us to spend significant time and money in litigation or to pay significant damages. As a result, any such claims, whether or not successful, could seriously damage our reputation and our business.
If we fail to develop and market new products or features, we will have difficulty attracting customers.
Based on our prior experience, we expect that our customers will require product features that our current IP Service Delivery Platform does not have. Our products are technically complex, and the development of new products or features is an uncertain, time-consuming and labor-intensive process. We may experience design, manufacturing or marketing problems with our new products. If we fail to develop new or enhanced products that meet customer requirements, our ability to attract and retain customers will be hindered.
If we fail to introduce new products in a timely manner we may experience erratic revenue growth, which could negatively affect profitability and in turn have a negative impact on our stock price. In addition, such a failure could result in additional costs such as excess inventory, customer conversion costs, higher than expected product costs and higher than expected operating expenses in research and development and in sales and marketing.
If our products do not work the way our customers expect, orders for our products may be cancelled and the market perception of our products could be harmed.
If our products do not work with our customers’ or their end-users’ networks, the market perception of our products could be harmed and orders for our products could be cancelled. In particular, if an actual or perceived breach of network security occurs in a customer’s or its end-user’s network that uses our products, we may be subject to lawsuits for losses suffered by customers or their end-users.
If we have to redesign or modify our products to make them compatible with a customer’s or end-user’s network, our sales cycle could be extended, our research and development costs may increase and profit margins on our products may decline.
Because the markets in which we compete are prone to rapid technological change and the adoption of standards different from those that we use, our products could become obsolete, and we could be required to incur substantial costs to modify our products to remain competitive.
The market for our IP Service Delivery Platform is prone to rapid technological change, the adoption of new standards, frequent new product introductions and changes in customer and end-user requirements. We may be unable to respond quickly or effectively to these developments. We may experience difficulties that could prevent our development of new products and features. The introduction of new products or technologies by competitors, or the emergence of new industry standards, could render our products obsolete or could require us to incur costs to redesign our products.
We rely upon a limited number of customers, and any decrease in revenue from these customers or failure to increase our customer base could harm our operating results.
The loss of one or more of our customers, a reduction in purchases of our products by certain of our customers or the decline of a key customer’s business may limit our revenue growth and harm our operating results. Our customers may reduce or discontinue purchases of our products at any time. In 2003, we generated 53 percent of our revenue from two customers.
Our future success will depend on attracting additional customers. Failure to increase our customer base would hinder our growth and harm our operating results.
A failure of our contract manufacturers or our sole source and limited source suppliers to meet our needs would seriously harm our ability to timely fill customer orders.
If any of our manufacturers terminates its relationship with us or is unable to produce sufficient quantities of our products in a timely manner and at satisfactory quality levels, our ability to fill customer orders on time, our reputation and our operating results will suffer. Our contract manufacturers do not have a long-term obligation to supply products to us. Qualifying new contract manufacturers and starting volume production is expensive and time consuming and would disrupt our business.
We purchase several key components, including field programmable gate arrays, some integrated circuits and memory devices, and power supplies from a single source or a limited number of sources. We do not have long-term supply contracts for these components. If our supply of these components is interrupted, we may be unable to locate an alternate source in a timely manner or at favorable prices. Interruption or delay in the supply of these components could cause us to lose sales to existing and potential customers.
If any of our significant suppliers were to terminate their relationships with us or compete against us, our revenue and market share would likely be reduced.
Many of our suppliers also have significant development and marketing relationships with our competitors and have significantly greater financial and marketing resources than we do. If they develop and market products in the future in competition with us, or form or strengthen arrangements with our competitors, our revenue and market share will likely be reduced.
If we fail to predict our manufacturing requirements accurately, we could incur additional costs or manufacturing delays.
We provide forecasts of our demand to our contract manufacturers up to twelve months before scheduled delivery of products to our customers. If we overestimate our manufacturing requirements, we may have excess or obsolete inventory, which could harm our operating results. If we underestimate our requirements, our contract manufacturers may have an insufficient inventory, which could interrupt manufacturing of our products and result in delays in shipments and revenue. If we do not accurately anticipate lead times for components, we may experience component shortages.
If necessary licenses of third-party technology are terminated or become unavailable or too expensive, our competitive position and our product offering will suffer.
We license from third-party suppliers certain software applications incorporated in our IP Service Delivery Platform. Also, we may need to license technology from other third-party suppliers to enable us to develop new products or features. Our inability to renew or obtain any third-party license that we need could require us to obtain substitute technology of lower quality or at greater cost. These outcomes could seriously impair our ability to sell our products and could harm our operating results.
We rely on our intellectual property rights to be competitive, and if we are unable to protect these rights, we may never become profitable.
We rely on a combination of copyright, trademark, patent and trade secret laws and restrictions on disclosure to protect our intellectual property rights. Monitoring unauthorized use of our products is difficult, and we cannot be certain that the steps we have taken will prevent unauthorized use of our technology. If we
are unable to protect our intellectual property rights, our ability to supply our products as they have been designed could suffer, and our ability to become profitable could be harmed.
If we become involved in an intellectual property dispute, we could be subject to significant liability, the time and attention of our management could be diverted and we could be prevented from selling our products.
We may become a party to litigation in the future to protect our intellectual property or because others may allege infringement of their intellectual property. These claims and any resulting lawsuit could subject us to significant liability for damages or invalidate our proprietary rights. These lawsuits, regardless of their merits, likely would be time-consuming and expensive to resolve and would divert management time and attention. Any potential intellectual property litigation alleging our infringement of a third-party’s intellectual property also could force us to:
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stop selling products or services that use the challenged intellectual property;
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obtain from the owner of the infringed intellectual property right a license to sell the relevant technology, which license may not be available on reasonable terms, or at all; or
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redesign those products or services that use the infringed technology.
If we fail to retain key personnel, our operations could suffer and our stock price could be negatively impacted.
Maintaining key personnel may be difficult for a number of reasons, including but not limited to market demand, stock price, growth opportunities, management philosophy, company performance and competitive activity. If we lose key personnel we may find it difficult and costly to recruit new management and other personnel and this may have a negative affect on our performance and in turn on our stock price.
If we become subject to unfair hiring claims, we could be prevented from hiring needed personnel, or from pursuing or implementing our research, and could incur substantial liabilities or costs.
Companies in our industry whose employees accept positions with competitors frequently claim that these competitors have engaged in unfair hiring practices or that the employment of these persons would involve the disclosure or use of trade secrets or information subject to an obligation of confidentiality. We have been threatened with claims like these in the past and may receive claims of this kind in the future. These claims could prevent us from hiring personnel or from using the knowledge and experience brought to us by the personnel whom we hire. We could also incur substantial costs and damages in defending against these claims, regardless of their merits. Defending ourselves against such claims could divert the attention of our management away from our operations.
Insiders continue to have substantial control over us and they could delay or prevent a change in our corporate control even if our other stockholders wanted it to occur.
Our executive officers, directors and principal stockholders who hold 5% or more of the outstanding common stock and their affiliates beneficially own a significant portion of our outstanding common stock. These stockholders will be able to exercise significant control over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This could delay or prevent an outside party from acquiring or merging with us even if our other stockholders wanted it to occur.
If we cannot obtain director and officer liability insurance in acceptable amounts for acceptable rates, we may have difficulty recruiting and retaining qualified directors and officers.
Like most other public companies, we carry insurance protecting our officers and directors against claims relating to the conduct of our business. This insurance covers, among other things, the costs incurred by companies and their management to defend against and resolve claims relating to management conduct and results of operations, such as securities class action claims. These claims typically are expensive to defend against and resolve. We pay significant premiums to acquire and maintain this insurance, which is provided by third-party insurers, and we agree to underwrite a portion of such exposures under the terms of the insurance
coverage. One consequence of the current economic downturn and decline in stock prices has been a substantial increase in the number of securities class actions and similar claims brought against public corporations and their management, including our company and certain of our current and former officers and directors. Consequently, insurers providing director and officer liability insurance have in recent periods sharply increased the premiums they charge for this insurance, raised retentions (that is, the amount of liability that a company is required to pay to defend and resolve a claim before any applicable insurance is provided), and limited the amount of insurance they will provide. Moreover, insurers typically provide only one-year policies. The insurance policies that may cover the current securities lawsuit against us have a $250,000 retention. As a result, the costs we incur in defending this lawsuit will not be reimbursed until they exceed $250,000. The policies that would cover any future lawsuits may not provide any coverage to us and may cover the directors and officers only in the event we are unwilling or unable to cover their costs in defending against and resolving any future claims. As a result, our costs in defending any future lawsuits could increase significantly. Particularly in the current economic environment, we cannot assure you that in the future we will be able to obtain sufficient director and officer liability insurance coverage at acceptable rates and with acceptable deductibles and other limitations. Failure to obtain such insurance could materially harm our financial condition in the event that we are required to defend against and resolve any future or existing securities class actions or other claims made against us or our management arising from the conduct of our operations. Further, the inability to obtain such insurance in adequate amounts may impair our future ability to retain and recruit qualified officers and directors.
Fluctuations in demand can lead to impairment of the value of our long-lived assets
Fluctuations in demand can also lead to the consideration of asset impairment charges. The carrying value of property, plant and equipment is reviewed if the facts and circumstances suggest that property, plant and equipment may be impaired. An impairment review requires management to make certain estimates and judgments regarding future cash flows that management expects to be generated by groups of assets.
We evaluate the carrying value of our long-lived assets, consisting primarily of property, plant and equipment, whenever certain events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. In assessing the recoverability of long-lived assets, we compare the carrying value to the undiscounted future cash flows the assets are expected to generate. If the total of the undiscounted future cash flows is less than the carrying amount of the assets, the assets will be written down to their estimated fair value. Significant judgments and assumptions are required in the forecast of future operating results used in the preparation of the estimated future cash flows, including long-term forecasts of overall market conditions and our participation in the market. For example, we recorded a write-down of $15.5 million in fiscal year 2002. Changes in these estimates could have a material adverse effect on the assessment of the long-lived assets, thereby requiring us to record further asset write-downs in the future.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures about Market Risk
Interest Rate Sensitivity
We do not currently use derivative financial instruments for speculative trading or hedging purposes. In addition, we maintain our cash equivalents in government and agency securities, debt instruments of financial institutions and corporations and money market funds. Our exposure to market risks from changes in interest rates relates primarily to corporate debt securities. We place our investments with high credit quality issuers and, by policy, limit the amount of the credit exposure to any one issuer.
Our general policy is to limit the risk of principal loss and ensure the safety of invested funds by limiting market and credit risk. All highly-liquid investments with a maturity of less than three months at the date of purchase are considered to be cash equivalents, and all investments with maturities of three months or greater are classified as available-for-sale and considered to be short-term investments.
A sensitivity analysis was performed on our December 31, 2003 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 $123,000 decrease in the fair value of our investments in debt securities as of December 31, 2003.
Exchange Rate Sensitivity
Currently, all of our revenue and most of our expenses are denominated in U.S. dollars. However, since a portion of our operations sales and service activities are outside of the U.S., we have entered into transactions in other currencies. We are primarily exposed to changes in exchange rates for the Euro, Japanese yen, and British pound. Because we transact expenses only in foreign currency, we are adversely affected by a weaker U.S. dollar relative to major currencies worldwide. Additionally, because some of our obligations are denominated in foreign currencies, a weaker U.S. dollar creates foreign exchange losses. We have not engaged in any foreign exchange hedging activities to date.
Item 8.
Item 8.
Financial Statements and Supplementary Data
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Stockholders
CoSine Communications, Inc.
We have audited the accompanying consolidated balance sheets of CoSine Communications, Inc. as of December 31, 2003 and 2002, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the financial statement schedule listed at Item 15(a). These consolidated financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the 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 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of CoSine Communications, Inc. at December 31, 2003 and 2002, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States. 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 stated therein.
/s/ ERNST & YOUNG LLP
San Jose, California
February 6, 2004
COSINE COMMUNICATIONS, INC.
CONSOLIDATED BALANCE SHEETS
See accompanying notes.
COSINE COMMUNICATIONS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(1)
Cost of goods sold includes $130 of non-cash charges related to equity issuances in 2003, $101 of non-cash credits related to equity issuances in 2002 and $2,283 of non-cash charges related to equity issuances in 2001.
(2)
Research and development expenses include $568 of non-cash charges related to equity issuances in 2003, $385 of non-cash credits related to equity issuances in 2002 and $10,818 of non-cash charges related to equity issuances in 2001.
(3)
Sales and marketing expenses include $124 of non-cash charges related to equity issuances in 2003, $854 of non-cash credits related to equity issuances in 2002 and $12,685 of non-cash charges related to equity issuances in 2001.
(4)
General and administrative expenses include $459, $925 and $6,177 of non-cash charges related to equity issuances in 2003, 2002 and 2001, respectively.
(5)
Interest expense includes $30, $131 and $154 of non-cash charges related to equity issuances in 2003, 2002 and 2001, respectively.
(6)
Other includes foreign exchange losses of $432, $281 and $302 in 2003, 2002 and 2001, respectively.
See accompanying notes.
COSINE COMMUNICATIONS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(In thousands, except share data)
See accompanying notes.
COSINE COMMUNICATIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes.
COSINE COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Summary of Significant Accounting Policies
Description of Business
CoSine Communications, Inc. (“the Company” or “CoSine”) was incorporated in California on April 14, 1997 and in August 2000 was reincorporated in the State of Delaware. CoSine is engaged in the development and sale of network-based, high-performance Internet service delivery platforms for the global business Internet Protocol Service Provider market.
Basis of Presentation
The consolidated financial statements include all of the accounts of CoSine and its wholly owned subsidiaries. All significant inter-company balances and transactions have been eliminated.
In September 2002, CoSine completed a stockholder approved reverse stock split. The ratio of the reverse stock split was one-for-ten and reduced the number of shares of issued and outstanding common stock from approximately 100 million shares to approximately 10 million shares. All share and per share data has been restated to reflect this reverse stock split.
Use of Estimates
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and the accompanying notes. Actual results could differ from these estimates. Estimates are used in accounting for, but not limited to, revenue recognition, allowance for doubtful accounts, inventory valuations, long-lived asset valuations, accrued liabilities including warranties, and equity issuances. Estimates and assumptions are reviewed periodically and the effects of revisions are reflected in the consolidated financial statements in the period of determination.
Impairment of Long-Lived Assets
The Company evaluates the carrying value of long-lived assets, consisting primarily of property, plant and equipment, whenever certain events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. In assessing the recoverability of long-lived assets, the Company compares the carrying value to the undiscounted future cash flows the assets are expected to generate. If the total of the undiscounted future cash flows is less than the carrying amount of the assets, the assets will be written down to their estimated fair value. Fair value is generally determined by calculating the discounted future cash flows using a discount rate based upon the Company’s 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 the Company’s participation in the market. Changes in these estimates could have a material adverse effect on the assessment of the long-lived assets, thereby requiring the Company to record further asset write-downs in the future.
Significant Concentrations
Financial instruments that potentially subject CoSine to concentrations of credit risk primarily consist of cash equivalents and short-term investments. CoSine mitigates investment risk by investing only in government and high quality corporate securities and by limiting the amount of exposure to any one issuer. The Company is exposed to credit risks in the event of default by these institutions to the extent of the amount recorded on the balance sheet.
COSINE COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
CoSine relies on a few companies as the sole source of various materials in the production process. CoSine also utilizes third-party subcontractors to manufacture its product. If these suppliers were unable to satisfy the material and production requirements, CoSine may be unable to meet customer demand. Alternatively, if CoSine overestimates manufacturing requirements, CoSine or its contract manufacturers may have excess or obsolete inventory, which could result in CoSine recording charges in connection with those materials.
For the year ended December 31, 2003, CoSine recognized revenue from two customers who accounted for 41% and 12% of total revenue, respectively. At December 31, 2003, CoSine had two customers who accounted for 52% and 19%, respectively, of total accounts receivable. For the year ended December 31, 2002, CoSine recognized revenue from two customers who accounted for 22% and 15% of total revenue, respectively. At December 31, 2002, CoSine had two customers who accounted for 33% and 15%, respectively, of total accounts receivable. For the year ended December 31, 2001, CoSine recognized revenue from transactions with two customers which each accounted for 11% of total revenue. The Company generally does not require collateral and maintains adequate reserves for potential credit losses.
Guarantees
CoSine from time to time enters into certain types of contracts that require the Company to indemnify parties against certain third party claims that may arise. These contracts primarily relate to: (i) certain real estate leases under which the Company may be required to indemnify property owners for environmental liabilities and other claims arising from the Company’s use of the applicable premises, (ii) certain agreements with the Company’s officers, directors and employees, under which the Company may be required to indemnify such persons for liabilities arising out of their employment relationship, (iii) contracts under which the Company may be required to indemnify customers against loss or damage to property or persons as a result of willful or negligent conduct by CoSine employees or sub-contractors, (iv) contracts under which the Company may be required to indemnify customers against third party claims that a CoSine product infringes a patent, copyright or other intellectual property right and (v) procurement or license agreements under which the Company may be required to indemnify licensors or vendors for certain claims that may be brought against them arising from the Company’s acts or omissions with respect to the supplied products or technology.
Generally, a maximum obligation is not explicitly stated. Because the obligated amounts associated with this type of agreement are not explicitly stated, the overall maximum amount of the obligation cannot be reasonably estimated. Historically, CoSine has not been obligated to make payments for these obligations, and no liabilities have therefore been recorded for these obligations on its balance sheet as of December 31, 2003.
Cash, Cash Equivalents and Short-Term Investments
CoSine considers all highly liquid investments purchased with original maturities of three months or less from the date of purchase to be cash equivalents. Investments with maturities in excess of three months and less than one year are considered to be short-term investments. Management determines the appropriate classification of cash equivalents and investment securities at the time of purchase and reevaluates the determination as of each balance sheet date. Management has classified CoSine’s marketable securities as available-for-sale securities in the accompanying consolidated financial statements. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported in a separate component of stockholders’ equity. Realized gains and losses and declines in value judged to be other-than-temporary, if any, on available-for-sale securities are included in interest income. Interest on securities classified as available-for-sale is also included in interest income. The cost of securities sold is based on the specific identification method.
CoSine invests excess cash in U.S. government and agency securities, debt instruments of financial institutions and corporations, and money market funds with strong credit ratings. CoSine has established guidelines about the diversification of its investments and their maturities.
COSINE COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Short-term investments including cash equivalents and short-term investments, were as follows (in thousands):
As of December 31, 2003 and 2002, the fair value approximated the amortized cost of available-for-sale securities. All available-for-sale securities have contractual maturities of one year or less.
As of December 31, 2003 and 2002, $150,000 and $500,000, respectively, of restricted cash was included in long-term deposits. The amount represents a security deposit for corporate bank credit cards.
Allowance for Doubtful Accounts
CoSine maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to pay their invoices. In order to estimate the appropriate level of this allowance, the Company analyzes historical bad debts, customer concentrations, current customer credit-worthiness, current economic trends and changes in customer payment patterns.
Inventories
Net inventories stated at the lower of cost (first-in, first-out) or market, consisted of the following (in thousands):
Included in net semi-finished goods at December 31, 2003 and 2002 was $126,000 and $289,000, respectively, of goods used for customer evaluation purposes. Included in net finished goods inventory at December 31, 2003 was $160,000 of goods awaiting customer acceptance. There was no finished goods inventory awaiting customer acceptance at December 31, 2002.
In assessing the value of inventory, CoSine is required to make judgments as to future demand and then compare that demand with current inventory quantities and firm purchase commitments. If inventories and firm purchase commitments are in excess of forecasted demand, the value of inventory is written down. CoSine generally uses a 12-month forecast to assess future demand. Inventory write-downs are charged to cost of sales. During 2003, CoSine sold $891,000 of previously written-down inventory and $193,000 of inventory was written down. During 2002, CoSine sold $1,236,000 of previously written-down inventory and $646,000 of inventory was written down. In addition, charges of $113,000 and $819,000 were recorded in 2003 and 2002, respectively, in connection with excess purchase commitments at CoSine’s contract manufacturers.
COSINE COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
CoSine periodically reviews the rates used to determine overhead capitalization applied to inventory. As a result of restructuring activity and refinements in its business model, the Company adjusted the overhead absorption rate for raw materials and semi-finished goods downward during the year ended December 31, 2003. This change in estimate increased cost of goods sold by $527,000 for the year ended December 31, 2003.
Property and Equipment
Property and equipment at December 31, 2003 and 2002 are stated at cost, net of accumulated depreciation. Property and equipment are depreciated using the straight-line method over estimated useful lives of the assets (ranging from one to five years) or the related lease term, if shorter.
In 2002, an impairment charge of $15,512,000 was recorded against property and equipment. In addition, assets that were either sold, disposed of or otherwise abandoned were written down by $3,248,000 to their estimated net realizable value. In 2001, $4,593,000 of property and equipment was written down to its net realizable value as part of the restructuring program initiated in September 2001. (See Note 9)
Property and equipment at each year end consisted of the following (in thousands):
Warranties
CoSine provides a basic limited warranty, including repair or replacement of parts, and technical support. The specific terms and conditions of those warranties vary depending on the customer or region in which CoSine does business. CoSine estimates the costs that may be incurred under its basic limited warranty and records a liability in the amount of such costs at the time product revenue is recognized. CoSine’s warranty obligation is affected by the number of installed units, product failure rates, materials usage and service delivery costs incurred in correcting product failures. CoSine periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary.
Changes in CoSine’s warranty liability were as follows (in thousands):
COSINE COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Stock-Based Compensation
CoSine accounts for employee and director stock option grants using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (APB 25) and related interpretations as described in FASB Interpretation No. 44, “Accounting for Certain Transactions involving Stock Compensation,” (FIN 44). The fair value disclosures required by Statement of Financial Accounting Standards Board Statement No. 123, “Accounting for Stock-Based Compensation,” (SFAS 123) are included below and in Note 6. SFAS 123 requires the disclosure of pro forma information regarding net loss and net loss per share as if CoSine had accounted for its stock options under the fair value method.
In connection with CoSine’s initial public offering, the fair value of its common stock was reevaluated and deferred stock compensation for option grants to employees was recorded, representing the difference between the fair value of the common stock for financial reporting purposes and the exercise price of the underlying options. Cosine is also required to remeasure compensation associated with the unvested shares issued upon exercise of unvested employee stock options for full recourse promissory notes that were subsequently converted to non-recourse obligations. The amount of deferred stock-based compensation is amortized over the vesting period of the individual options, using the graded vesting method.
In November 2002, CoSine repriced 1,091,453 outstanding employee stock options to purchase shares of CoSine’s common stock with original exercise prices ranging from $5.45 per share to $159.38 per share. These options were repriced to $5.00 per share, which was above the fair market value of the underlying shares on the repricing date. CoSine recorded deferred stock compensation and compensation charges in connection with these repriced options, as the price of CoSine’s stock was higher than the repriced amount at December 31, 2002 and during certain quarters of 2003. In July 2001, CoSine repriced 722,071 unexercised employee stock options to $15.50 per share, the fair market value of the underlying shares on the repricing date. These options had previously been granted at prices ranging from $40.00 to $400.00 per share. During the years ended December 31, 2002 and 2001, CoSine did not record any deferred stock compensation in connection with these repriced options as the price of CoSine’s stock was not higher than the repriced amount at any quarter-end during those periods (See Note 6). Compensation associated with re-priced options will be remeasured until they are exercised, canceled or expire.
Stock options granted to non-employees are accounted for in accordance with SFAS 123 and the Emerging Issues Task Force Consensus No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling Goods or Services,” which requires the value of such options to be periodically remeasured as they vest over a performance period. The fair value of such options is determined using the Black-Scholes model.
Pro Forma Information
CoSine has elected to continue to follow APB 25 to account for employee stock options because the alternative fair value method of accounting prescribed by SFAS 123 requires the use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, no compensation expense is recognized when the exercise price of employee stock options equals the market price of the underlying stock on the date of grant.
COSINE COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table illustrates the effect on CoSine’s net loss and net loss per share if CoSine had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation (in thousands, except per share data):
The fair value of CoSine’s options was estimated at the grant date using the Black-Scholes option pricing model with the following weighted average assumptions:
The estimated weighted-average fair value of shares granted under the Purchase Plan in 2003 was $2.22, using a volatility of 0.47, risk-free interest rate of 1.3% and an expected life of one year. The estimated weighted-average fair value of shares granted under the Purchase Plan in 2002 was $1.60, using a volatility of 0.67, risk-free interest rate of 1% and an expected life of one year. The estimated weighted-average fair value of shares granted under the Purchase Plan in 2001 was $5.20, using a volatility of 1.15, risk-free interest rate of 2% and an expected life of six months.
Revenue Recognition
The majority of CoSine’s revenue is recognized from the sale of its IP Service Delivery Platforms and subsequent service support arrangements. CoSine recognizes 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 CoSine has future obligations for installation or requires customer acceptance, in which case revenue is deferred until these obligations are met. CoSine’s product incorporates software that is not incidental to the related hardware and, accordingly, CoSine recognizes 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). CoSine establishes VSOE based on either the price charged for the product when the same product is sold separately or for
COSINE COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
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 by CoSine under separate support services agreements. In cases where the support service is sold as part of an arrangement including multiple elements, CoSine allocates revenue to the support service based on the VSOE of the services and recognizes 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.
During 2000, CoSine issued warrants to its initial customers. The warrants were issued upon receipt of substantial purchase orders that were preceded by a period of cooperation with CoSine in the marketing, development and refinement of its product. The fair value of these customer-related warrants was calculated to be $16,252,000. For the year ended December 31, 2001, $3,003,000 was recognized as an offset to receipts from sales in the determination of revenue. CoSine’s revenue in 2003 and 2002 was not affected by the value of warrants granted to customers.
Below is a reconciliation of revenue for the years ended December 31, 2003, 2002 and 2001 as presented in the statement of operations to show the separate components as indicated (in thousands):
Cost of Goods Sold
Cost of goods sold is comprised primarily of material, labor, overhead, shipping costs, warranty costs and inventory write-downs. In addition, cost of goods sold includes non-cash charges or credits related to equity issuances.
Research and Development
Research and development expenditures, consisting primarily of materials, labor and overhead costs for the development and testing of prototypes and salaries and related personnel costs associated with independent research, are generally charged to operations as incurred.
Statement of Financial Accounting Standards No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed,” requires the capitalization of certain software development costs subsequent to the establishment of technological feasibility. Based on CoSine’s product development process, technological feasibility is established upon the completion of a working model. Through December 31, 2003, capitalizable costs incurred after achieving technological feasibility have not been significant for any development project. Accordingly, CoSine has charged all such costs to research and development expense in the periods they were incurred.
COSINE COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Advertising Expense
Advertising costs are expensed as incurred. For the year ended December 31, 2003, the Company incurred no expense for advertising. Advertising costs amounted to $105,000 and $437,000 for the years ended December 31, 2002 and 2001, respectively.
Net Loss Per Share
Basic net loss per share is calculated based on the weighted-average number of common shares outstanding during the periods presented, less the weighted-average shares outstanding that are subject to CoSine’s right of repurchase. Diluted net loss per share would give effect to the dilutive effect of common stock equivalents consisting of stock options and warrants (calculated using the treasury stock method) and convertible preferred stock.
The following table presents the calculation of basic and diluted net loss per share for each year end (in thousands, except per share data):
During all periods presented, CoSine had stock options and warrants outstanding that could potentially dilute earnings per share in the future, but were excluded from the computation of diluted net loss per share, as their effect would have been antidilutive. These shares amounted to 1,280,000, 1,332,000 and 1,696,000 for the years ended December 31, 2003, 2002 and 2001, respectively.
Segment Reporting
CoSine operates in only one segment: IP Service Delivery Platforms. Substantially all of CoSine’s assets are located in the United States.
COSINE COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Revenues from customers by geographic region for the years ended December 31, 2003, 2002 and 2001 were as follows (in thousands):
Recent Accounting Pronouncements
In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities.” FIN 46 addresses consolidation by business enterprises of variable interest entities. Under that interpretation, certain entities known as Variable Interest Entities (“VIEs”) must be consolidated by the primary beneficiary of the entity. The primary beneficiary is generally defined as having the majority of the risks and rewards arising from the VIE. For VIEs in which a significant (but not majority) variable interest is held, certain disclosures are required. The Company has not entered into any arrangements or made any investments which qualify as a VIE in the period after January 31, 2003 and therefore the initial implementation of FIN 46 had no impact on its financial statements. For VIEs acquired before February 1, 2003, the Company is required to apply the accounting and disclosure rules set forth in FIN 46 in the first quarter of 2004. The Company has determined that the adoption of FIN 46 will not have any impact on the Company’s financial statements.
In December 2003, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 104 (“SAB 104”), “Revenue Recognition.” SAB 104 revises or rescinds portions of the interpretive guidance included in Topic 13 of the codification of staff accounting bulletins in order to make this interpretive guidance consistent with current authoritative accounting and auditing guidance and SEC rules and regulations. The
COSINE COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
adoption of SAB 104 did not have a material effect on the Company’s financial statements for the period ending December 31, 2003.
2.
Equipment and Working Capital Loans
CoSine has entered into equipment and working capital loan agreements that are secured by the assets purchased using the loans. Principal and interest are due in monthly installments through March 2004. Interest accrues at an annual rate of 14.3%. As of December 31, 2003 and 2002, total principal payments due under these agreements were $129,000 and $1,996,000 respectively. The fair value of the loans is estimated based on current interest rates available to CoSine for debt instruments with similar terms, degrees of risk and remaining maturities. The carrying value of the loans approximates their fair value.
Future minimum payments under equipment and working capital loans at December 31, 2003 are as follows (in thousands):
3.
Leases
CoSine leases its facilities under operating leases, with terms ranging from August 1998 through December 2011.
Future minimum payments for all operating leases are as follows (in thousands):
Rent expense was $3,126,000, $6,056,000 and $8,337,000 for the years ended December 31, 2003, 2002 and 2001, respectively, and is calculated on a straight-line basis.
CoSine subleased a portion of the space at one of its facilities in 2001, from which it recognized rental income of $182,000 during that year. The sublease arrangement expired on June 30, 2001.
4.
Commitments and Contingencies
As of December 31, 2003, CoSine had commitments of approximately $1,390,000 relating to purchases of raw materials and semi-finished goods. Of that amount, $329,000 related to excess inventory was accrued at December 31, 2003.
COSINE COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
On November 15, 2001, CoSine and certain of its officers and directors were named as defendants in a securities class action lawsuit filed in the United States District Court, Southern District of New York. The complaint generally alleges that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares in CoSine’s initial public offering. The complaint brings claims for the violation of several provisions of the federal securities laws against those underwriters, and also against the Company and each of the directors and officers who signed the registration statement relating to the initial public offering. Various plaintiffs have filed similar actions asserting virtually identical allegations against more than 250 other companies. The lawsuit and all other “IPO allocation” securities class actions currently pending in the Southern District of New York have been assigned to Judge Shira A. Scheindlin for coordinated pretrial proceedings. In October 2002, the individual defendants were dismissed without prejudice pursuant to a stipulation. The issuer defendants filed a coordinated motion to dismiss on common pleading issues, which the Court granted in part and denied in part in an order dated February 19, 2003. The Court’s order dismissed the Section 10(b) and Rule 10b-5 claims against the Company but did not dismiss the Section 11 claims against the Company.
In June 2003, the plaintiffs in all of the cases presented a settlement proposal to all of the issuer defendants. Under the proposed settlement, the plaintiffs will dismiss and release all claims against participating issuer defendants in exchange for a contingent payment guaranty by the insurance companies collectively responsible for insuring the issuer defendants in all of the related cases, and the assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. Under the guaranty, the insurers will be required to pay the amount, if any, by which $1 billion exceeds the aggregate amount ultimately collected by the plaintiffs from the underwriter defendants in all the cases, up to the limits of the applicable insurance policies. The Company will not be required to make any cash payments under the settlement, unless the Company’s insurer is required to pay on the Company’s behalf an amount that exceeds the Company’s insurance coverage. The Company does not believe that this circumstance will occur. In July 2003, a special committee of the Company’s Board of Directors approved the proposed settlement. The settlement is subject to acceptance by a substantial majority of the issuer defendants, and execution of a definitive settlement agreement. The settlement is also subject to approval of the court, which cannot be assured. If the settlement is not consummated, the Company intends to defend the lawsuit vigorously. However, the Company cannot predict its outcome with certainty. If the Company is not successful in its defense of this lawsuit, it could be forced to make significant payments to the plaintiffs and their lawyers, and such payments could have a material adverse effect on the Company’s business, financial condition and results of operations if not covered by the Company’s insurance carrier. Even if these claims are not successful, the litigation could result in substantial costs and divert management’s attention and resources, which could adversely affect the Company’s business, results of operations and financial position.
In the ordinary course of business, CoSine is involved in legal proceedings involving contractual obligations, employment relationships and other matters. Except as described above, CoSine does not believe there are any pending or threatened legal proceedings that will have a material impact on its financial position or results of operations.
5.
401(k) Plan
CoSine has a defined contribution benefit plan established under the provisions of Section 401(k) of the Internal Revenue Code. All employees may elect to contribute up to 20% of their compensation to the plan through salary deferrals, subject to IRS limits. CoSine may contribute a discretionary matching contribution. Since inception CoSine has made no matching contributions to the plan.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
6.
Stockholders’ Equity
Common Stock
CoSine has authorized shares of common stock for future issuance at each year end as follows (in thousands):
1997 Stock Option Plan
In October 1997, the board of directors adopted the 1997 Stock Plan (1997 Plan) for issuance of common stock and grants of options for common stock to employees, consultants and directors. Incentive stock options granted under the plan are at prices not less than the fair value of stock at the date of grant, except in the case of a sale to a person who owns stock representing more than 10% of all the voting power of all classes of stock of CoSine, in which case the purchase price will be 110% of the fair market value of the common stock on the date of grant. Nonstatutory stock options granted under the 1997 Plan are at prices not less than 85% of the fair value of stock at the date of grant, except in the case of a sale to a person who owns stock representing more than 10% of all the voting power of all classes of stock of CoSine, in which case the purchase price will be 110% of the fair market value of the common stock on the date of grant. Options granted under the 1997 Plan generally vest over four years at a rate of 25% one year from the grant date and ratably monthly thereafter and expire 10 years after the grant, or earlier upon termination. Options may be granted with different vesting terms.
The 1997 Plan also allowed for the exercise of options before vesting and the related issuance of restricted stock that is subject to right of repurchase by CoSine. The rights of repurchase generally lapse at the rate noted above. At December 31, 2003 and 2002, 3,333 and 45,952 shares of common stock were subject to repurchase at an aggregate repurchase price of $233,737 and $1,930,000 respectively. During 2003 and 2002, employees defaulted on notes receivable in the amounts of $3,840,000 and $14,701,000, respectively, secured by 84,703 shares and 325,916 shares of common stock, respectively. The shares were returned to the Company.
Effective upon the initial public offering, the 1997 Plan was terminated and the shares reserved and unissued under the 1997 Plan were reserved for issuance under the 2000 Plan.
2000 Stock Option Plan
In May 2000, the board of directors adopted the 2000 Stock Plan (2000 Plan). The 2000 Plan was approved by CoSine’s shareholders before the completion of the initial public offering. The 2000 Plan provides for the grant of incentive stock options to employees, and for the grant of nonstatutory stock options and stock purchase rights to employees, directors and consultants. Incentive stock options granted under the 2000 Plan will be at prices not less than the fair value of the common stock at the date of grant. The term of each option will be determined by the administrator of the plan, generally 10 years or less.
CoSine has authorized 2,215,779 shares of common stock for issuance under the 2000 Plan. At December 31, 2003 and 2002, a total of 1,066,640 and 1,273,467 shares were available for future options grants under the 2000 Plan, respectively.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
2002 Stock Option Plan
In January 2002, the board of directors adopted the 2002 Stock Plan (2002 Plan). The purpose of the 2002 Plan is to make available for issuance certain shares of Common Stock that have been (i) previously issued pursuant to the exercise of stock options granted under the 1997 Plan and (ii) subsequently reacquired by CoSine pursuant to repurchase rights contained in restricted stock purchase agreements or pursuant to optionee defaults on promissory notes issued in connection with the exercise of such options (Reacquired Shares). Under the terms of the 1997 Plan and the 2000 Plan, these Reacquired Shares would not otherwise have been available for reissuance. Only shares that were previously issued under the 1997 Plan and subsequently reacquired by CoSine have been or will be reserved for issuance under the 2002 Plan.
CoSine has authorized up to a maximum of 1,000,000 shares of common stock for issuance of Reacquired Shares under the 2002 Plan. At December 31, 2003, there were an aggregate of 729,598 Reacquired Shares under the 2002 Plan. At December 31, 2003 and 2002, a total of 656,538 and 558,745 shares were available for future options grants under the 2002 Plan, respectively.
The provisions of the 2002 Plan are substantially similar to those of the 2000 Plan, except that the 2002 Plan does not permit the grant of awards to officers or directors and does not permit the grant of Incentive Stock Options. The 2002 Plan provides for the grant of nonstatutory stock options to employees (excluding officers) and consultants. Stock options granted under the 2002 Plan will be at prices not less than the fair value of the common stock at the date of grant. The term of each option, generally 10 years or less, will be determined by the administrator of the Plan.
2000 Director Option Plan
In May 2000, the board of directors adopted the 2000 Director Option Plan (Director’s Plan), which was effective upon the closing of the initial public offering. At December 31, 2003, and 2002, a total of 48,000 and 40,000 shares of common stock have been authorized for issuance under the Director’s Plan. At December 31, 2003 and 2002, a total of 24,000 and 32,000 shares were available for future options grants under the Director’s Plan, respectively.
The Director’s Plan will automatically grant an option to purchase 8,000 shares of common stock to each non-employee director when he or she is first elected to CoSine’s board of directors following the initial public offering. The Director’s Plan also provided that each non-employee director who had been a member of the board of directors for at least six months before the date of each annual stockholders’ meeting would receive an automatic annual grant of options to acquire 2,000 shares of common stock.
The options have an exercise price per share equal to the fair market value of common stock at the date of grant and have a term of 10 years. Initial options vest and become exercisable in four equal annual increments immediately following the date of grant. Later additional options granted vest and become exercisable on the fourth anniversary of the date of grant.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Summary Stock Option Plan Activity
Stock activity under the Stock Option Plans was as follows (in thousands, except per share data):
The following table summarizes information concerning options outstanding and exercisable at December 31, 2003 (in thousands, except per share data):
2000 Employee Stock Purchase Plan
In May 2000, the board of directors adopted the 2000 Employee Stock Purchase Plan (Purchase Plan), which was effective upon the closing of the initial public offering. The Purchase Plan qualifies under the provisions of section 423 of the 1986 Internal Revenue Code of the United States. A total of 654,185 shares are authorized for issuance under the Purchase Plan. Under the terms of the Purchase Plan, employees may
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
contribute through payroll deductions up to 10% of their compensation to purchase shares at a price equal to 85% of the lower of the fair market value of the common stock at the beginning of the offering period or at the end of the offering period.
Stock-Based Compensation
During the year ended December 31, 2000, CoSine issued stock options to employees with exercise prices that it believed represented the fair value of the stock. In March 2000, after CoSine began the initial public offering process, CoSine reevaluated the fair value of its common stock. In connection with the reevaluation, CoSine recorded deferred stock compensation for these stock option grants of $81,029,000 in the year ended December 31, 2000, representing the difference between the fair value of the common stock for financial reporting purposes and the exercise price of the underlying options. This amount is recorded as a reduction of stockholders’ equity and is being amortized over the vesting period of the individual options, generally four years, using the graded vesting method. CoSine recorded amortization of deferred stock compensation of $1,377,000, $7,273,000 and $29,691,000 for the years ended December 31, 2003, 2002 and 2001, respectively. When an employee terminates, an expense credit is recorded for any amortization that has been previously recorded as an expense in excess of vesting. For the years ended December 31, 2003 and 2002, credits of $956,000 and $8,466,000, respectively, were recorded to reverse deferred stock compensation amortization in excess of vesting. In 2003, CoSine additionally recorded a reversal of deferred stock compensation of $196,000 due to employee terminations.
During the year ended December 31, 2000, CoSine granted common stock options to non-employees at exercise prices that range from $40.00 to $95.00 per share for services provided to CoSine. These options are included in the option tables disclosed above. The options generally vest over four years at a rate of 25% one year from the grant date and ratably monthly thereafter and expire 10 years after the grant date. CoSine recognized expense of $4,000 in 2001 for these transactions, and no expense in 2003 or 2002. The fair value of these options was periodically re-measured as they vested over the performance period and was estimated using the Black-Scholes model with the following assumptions: risk-free interest rate of 5%, expected life of 10 years, a dividend yield of zero, and an expected volatility of CoSine’s common stock of 0.6.
During the year ended December 31, 2000, CoSine converted full-recourse promissory notes received from employees upon the early exercise of unvested employee stock options to non-recourse obligations. Accordingly, CoSine is required to re-measure the compensation associated with these shares until the earlier of the note being repaid or defaulted. The result of each re-measurement is deferred compensation expense, which is amortized over the remaining vesting period of the underlying options. In 2003, CoSine recorded no amortization or changes to deferred stock compensation for employee stock options exercised with non-recourse promissory notes. In 2002, CoSine recorded a reversal of deferred stock compensation of $4,916,000 due to employee terminations, a reduction of deferred compensation of $282,000 due to the re-measurement of compensation associated with these unvested shares and amortization of $173,000. In 2001, CoSine recorded a reduction deferred stock compensation due to the re-measurement of compensation associated with these unvested shares amounting to $31,586,000 and a reversal of amortization of $526,000.
On November 1, 2002, CoSine re-priced 1,091,453 outstanding employee stock options to purchase shares of CoSine’s common stock with original exercise prices ranging from $5.45 per share to $159.38 per share. These options were re-priced to $5.00 per share, $1.00 more than the fair market value of the underlying shares on the re-pricing date. Compensation associated with these options will be re-measured until they are exercised, canceled, or expire. During 2003, CoSine recorded deferred stock compensation in relation to re-priced stock options amounting to $619,000 and amortization of $797,000, as the price of CoSine’s stock at December 31, 2003 was higher than the re-priced amount. In 2003, CoSine additionally recorded a reversal of deferred stock compensation of $68,000 due to employee terminations. During 2002, CoSine recorded deferred stock compensation in relation to re-priced stock options amounting to $1,111,000 and amortization
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
of $514,000, as the price of CoSine’s stock at the end of the quarter after the November 2002 re-pricing was higher than the re-priced amount.
On July 10, 2001, CoSine re-priced 722,071 outstanding employee stock options to purchase shares of CoSine’s common stock with original exercise prices ranging from $40.00 per share to $400.00 per share. These options were re-priced to $15.50 per share, the fair market value of the underlying shares on the re-pricing date. Compensation associated with these options will be re-measured until they are exercised, canceled, or expire. During the years ended December 31, 2003, 2002 and 2001, CoSine did not record any deferred stock compensation in connection with these re-priced options, as the price of CoSine’s stock was not higher than the re-priced amount at any quarter-end during those periods.
Warrants
During the period from August 1998 to April 2000, CoSine issued warrants to purchase common stock to various consultants, lessors, lenders, service providers and customers. The warrants had a variable measurement date and, accordingly, were periodically revalued based on the guidance of Emerging Issues Taks Force Consensus No. 96-18 (EITF No. 96-18). The fair value of these warrants has been amortized over the expected life of the warrants. Except for the warrants discussed below, all of these warrants were fully amortized as of December 31, 2003 and no longer affect the Company’s financial statements.
In August 1998, in connection with a facilities lease arrangement, CoSine issued warrants to purchase 15,792 shares of series A preferred stock. The warrants were exercisable at any time at no cost to the holder and expired on the earlier of five years following the issue date or a corporate reorganization. The warrants had a variable measurement date and accordingly they are periodically revalued based on the guidance of EITF No. 96-18. The warrants vested over a period of one year and their fair value was calculated to be $767,000 at December 31, 1999 using the Black-Scholes valuation method, utilizing a volatility factor of 0.6, risk-free interest rate of 5%, and an initial expected life of five years. The fair value of the warrants is being amortized over the term of the lease. These warrants were exercised in June 2000 and converted into 63,642 shares of common stock upon the completion of the initial public offering in September of 2000. At December 31, 2003 and 2002, CoSine had $435,000 and $497,000, respectively, of unamortized warrant charges related to the facilities lease.
At December 31, 2003 and 2002, warrants to purchase 30,488 and 3,750 shares of common stock at $7.38 per share and $80.00 per share, respectively, were outstanding.
7.
Related Parties
As of December 31, 2003 and 2002, CoSine had non-recourse promissory notes receivable of $600,000 and $775,000, respectively, from officers of CoSine for the payment of stock option exercises. The remaining note is secured by a pledge of CoSine’s common stock and has an annual interest rate of 6.77%. The note and interest accrued but unpaid are due and payable during 2008. During 2003, one officer, whose employment with CoSine terminated, defaulted on the payment of a non-recourse loan amounting to $175,000, secured by 4,375 shares of common stock. During 2002, four officers, whose employment with CoSine terminated, defaulted on the payment of non-recourse loans amounting to $2,485,000, secured by 67,156 shares of common stock.
As of December 31, 2003 and 2002, CoSine had non-recourse promissory notes receivable secured by a pledge of CoSine’s common stock totaling $6,059,000 and $9,756,000, respectively, from non-officer employees of CoSine for the payment of stock option exercises. Yearly interest on the notes ranges from 6.09% to 6.77%. The notes are due and payable at the earliest of 10 years from the date of loan, the date of the employee’s termination or the date the shares are sold. During 2003 and 2002, non-officer employees defaulted
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
on notes receivable in the amounts of $3,665,000 and $12,216,000, respectively, secured by 80,981 shares and 264,907 shares of common stock, respectively.
8.
Income Taxes
The provisions for income taxes of $287,000, $509,000 and $837,000 for the years ended December 31, 2003, 2002 and 2001, respectively, are comprised entirely of foreign corporate income taxes. The difference between the provisions for income taxes and the amounts computed by applying the federal statutory income tax rate to the losses before income taxes are explained below (in thousands):
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of CoSine’s deferred tax assets are as follows (in thousands):
Financial Accounting Standards Board Statement Number 109, “Accounting for Income Taxes” provides for the recognition of deferred tax assets if realization of the deferred tax assets is more likely than not. Based upon the weight of available evidence, which includes CoSine’s historical operating performance and the reported cumulative net losses in all prior years, CoSine has provided a full valuation allowance against its net deferred tax assets. The valuation allowance increased by $40,055,000 in 2003 and by $20,448,000 in 2002. The valuation allowance at December 31, 2003 includes approximately $150,000 relating to equity issuances, compared to approximately $13,719,000 at December 31, 2002. The decrease during fiscal 2003 relates primarily to a reduction in the expected future tax benefits from previously issued stock options.
As of December 31, 2003, CoSine had federal net operating loss carryforwards of approximately $276,000,000, which will begin to expire in 2018 if not utilized and state net operating loss carryforwards of approximately $129,000,000, which will begin to expire in 2007 if not utilized. As of December 31, 2002, CoSine had federal net operating loss carryforwards of approximately $232,000,000, which will begin to expire
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
in 2013 if not utilized and state net operating loss carryforwards of approximately $101,000,000, which will begin to expire in 2007 if not utilized.
As of December 31, 2003, CoSine also had federal and state research and development tax credit carryforwards of approximately $7,113,000 and $7,967,000, respectively. As of December 31, 2002, CoSine also had federal and state research and development tax credit carryforwards of approximately $3,100,000 and $3,490,000, respectively. The federal tax credit carryforwards will expire at various dates beginning in 2013, if not utilized. The State credits do not expire.
During fiscal 2003, the Company liquidated certain subsidiary, resulting in a capital loss carryforward of approximately $69,470,000. These losses may only be offset against future capital gains and will expire in fiscal 2008 if not utilized.
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.
9.
Restructuring and Impairment Charges
May and March 2003 Restructuring
In May and March 2003, CoSine’s senior management communicated additional reductions in its workforce related to employees in its 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. Amounts related to the workforce reduction and the other items are expected to be paid through June of 2004.
Activity related to the May and March 2003 restructurings for the year ended December 31, 2003 was as follows, (in thousands):
October 2002 Restructuring
In October 2002, CoSine’s senior management approved a restructuring plan to reduce its worldwide workforce. Employees were notified in October 2002 that certain job functions would be eliminated and that particular termination benefits would be paid to affected employees. As a result of the workforce reduction, 73 employees were designated for termination in the restructuring program. Most of the terminations took place in the fourth quarter of 2002. The employees affected by the workforce reduction were from all functional groups and were located in offices in the United States, Europe and Asia. Amounts related to the worldwide workforce reduction were paid out through September of 2003. In addition, during the first quarter of 2003, CoSine concluded negotiations to settle obligations associated with Redwood City, California leased facilities it exited during 2002 and made a payment of $8,104,000.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Activity related to the October 2002 restructuring for the years ended December 31, 2003 and 2002 was as follows, (in thousands):
May 2002 Restructuring
In May 2002, CoSine’s senior management approved a restructuring program to reduce its worldwide workforce, close certain sales offices, exit certain facilities and dispose of or abandon certain property and equipment. Employees were notified in May 2002 that certain job functions would be eliminated and that particular termination benefits would be paid to affected employees. As a result of the workforce reduction, 146 employees were designated for termination in the restructuring program. Most of the terminations took place in the second quarter of 2002, with the remainder taking place in the third quarter of 2002. The employees in the workforce reduction were from all functional groups and were located in offices in the United States, Europe and Asia. 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. The Company also wrote down certain property and equipment to its expected realizable value as the assets have been either sold, disposed of or otherwise abandoned.
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 CoSine’s assessment of market conditions and the related effect on its business plan, the Company concluded that indicators of impairment of its long-lived assets were present during the second and third quarters of 2002. Accordingly, the Company performed an impairment test of the carrying value of its
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
long-lived assets, consisting primarily of property and equipment, in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Based on an undiscounted cash flow analysis, the cash flows expected to be generated by CoSine’s long-lived assets during their estimated remaining useful lives were not sufficient to recover the net book value of the assets. Consequently, the Company obtained a valuation report outlining the estimated fair value of the assets, based on quoted market prices, from an independent appraiser and recorded an impairment charge of $15,512,000 to write the carrying value of its long-lived assets held for use down to their fair values in the second and third quarters of 2002. In addition, property and equipment that was idled or abandoned was written down by approximately $3,248,000 to its estimated net realizable value.
April and September 2001 Restructuring
In April and September of 2001, CoSine’s senior management approved restructuring programs to reduce its worldwide workforce, close certain sales offices, exit certain facilities and idle certain property and equipment. Employees affected by the April 2001 program were notified and terminated in April 2001. With respect to the September 2001 program, notification was given to employees in September 2001 that certain job functions would be eliminated and that particular termination benefits would be paid to affected employees.
Activity related to the April and September 2001 restructurings for the years ended December 31, 2002 and 2001 was as follows (in thousands):
As a result of the workforce reductions, approximately 55 employees were terminated in the second quarter of 2001, and approximately 50 employees were designated for termination in the third quarter of 2001 restructuring program and were then terminated in the fourth quarter of 2001. The employees in both workforce reductions were from all functional groups and were primarily located in the Redwood City, California offices. Certain property and equipment has been written down to its expected realizable value.
Amounts related to the worldwide workforce reduction were paid out through mid-2002, and lease commitments were paid out over the respective lease terms through mid-2002.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not applicable.
Item 9A.
Item 9A.
Controls and Procedures
Evaluation of Disclosure Controls and Procedures. The Securities and Exchange Commission defines the term “disclosure controls and procedures” to mean a company’s controls and other procedures that are designed to ensure that information required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms. While our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives, the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions regardless of how remote. Our chief executive officer and chief financial officer have concluded, based on the evaluation of the effectiveness of the disclosure controls and procedures by our management, with the participation of our chief executive officer and chief financial officer, as of the end of the period covered by this report, that our disclosure controls and procedures were effective for this purpose, except as noted below under “Changes in Internal Controls.”
Changes in Internal Controls. During the fourth quarter of fiscal year 2003, there were no changes in our internal control over financial reporting that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. However, we intend to continue to refine our internal controls on an ongoing basis. Our management and our independent auditors have reported to our Audit Committee certain matters involving internal controls that our independent auditors consider to be reportable conditions, but not material weaknesses, under standards established by the American Institute of Certified Public Accountants. The first reportable condition relates to the control processes related to revenue recognition. The annual audit process identified instances of a lack of timely communication between the sales and finance departments for certain contractual terms and instances of incorrect interpretation of the accounting literature for a certain type of transaction. The revenue recognition items related to this reportable condition were adjusted in connection with the preparation of the audited financial statements for the year ended December 31, 2003. The second reportable condition relates to the December 31, 2003 financial close process. Certain adjustments were identified in the annual audit process, related to stock-based compensation amortization, a balance sheet adjustment for a specific fixed asset capitalization, foreign income tax accruals and inventory reserves. In addition, there were instances where accounting analyses did not include evidence of a timely review. The adjustments related to these matters were made by the Company in connection with the preparation of the audited financial statements for the year ended December 31, 2003.
Given these reportable conditions, management devoted additional resources to resolving questions that arose during our year-end audit. As a result, we are confident that our consolidated financial statements for the year ended December 31, 2003 fairly present, in all material respects, our financial condition and results of operations.
The reportable conditions have been discussed in detail among management, our Audit Committee and our independent auditors, and we are committed to addressing and resolving these matters fully and promptly, by putting in place the personnel, processes, technology and other resources appropriate to support our revenue recognition and financial close processes. We have completed a full review of our revenue recognition policy and practices and have implemented a number of process improvements. We intend to complete a review of our financial close process and define and implement needed improvements in the quarter ending March 31, 2004.
PART III
Item 10.
Item 10.
Directors and Executive Officers of the Registrant
DIRECTORS
The names of our directors and their ages, titles and biographies as of March 25, 2004 appear below. Our board of directors has determined that each of our outside directors (Messrs. Green, Spreng and Abbe) are “independent directors” as defined in the applicable Nasdaq listing standards and meet all additional independence requirements set forth in SEC rules for membership on the Audit Committee.
Donald Green has served as Chairman of CoSine since March 2002 and as a Director since June 1999. Mr. Green was a co-founder of Advanced Fibre Communications, Inc., a provider of multi-service access solutions for the telecommunications industry, and served as its Chairman of the Board from May 1999 until his retirement in September 2001, and also served as Chief Executive Officer from May 1992 to May 1999. Mr. Green is also a Director of TCSI Corporation, a software company. Mr. Green holds a higher national certificate in electrical engineering from Willesdon Technical College.
R. David Spreng has served as a director of CoSine since December 1998. Mr. Spreng has served as the Managing General Partner of Crescendo Venture Management, LLC since September 1998. Mr. Spreng served as President of IAI Ventures, Inc. from March 1996 to September 1998 and served in various capacities at Investment Advisers, Inc. since 1989. Mr. Spreng is also a Director of Allied Riser Communications Corporation, a broadband communications services provider; Oplink Communications, Inc., a designer, developer and manufacturer of fiber optic components; and Tut Systems, Inc., a developer of multi-service broadband access systems. Mr. Spreng holds a B.S. in finance and accounting from the University of Minnesota.
Stephen Goggiano has served as a Director and Chief Executive Officer of CoSine since March 2002. He served as Chief Operating Officer from December 1999 to March 2002 and assumed the position of President in April 2001. Prior to joining CoSine, Mr. Goggiano held various positions at SGI, formerly known as Silicon Graphics, Inc., a provider of computing systems and software, from 1989 to 1999. These positions included Senior Vice President and General Manager of SGI’s Server and Supercomputer division, and Senior Vice President of Worldwide Manufacturing and Customer Service. Mr. Goggiano holds a B.S. in Business from San Jose State University.
Charles J. Abbe has served as a Director of CoSine since August 2000. Until his retirement in June 2001, Mr. Abbe has served as President and Chief Operating Officer of JDS Uniphase Corporation, a designer, developer and manufacturer of fiber optic products, since April 2000, following the merger of Optical Coating Laboratory, Inc. with JDS Uniphase in February of the same year. Mr. Abbe served as Optical Coating Laboratory’s President and Chief Executive Officer from April 1998 to March 2000, as its President from November 1997 to April 1998 and as its Vice President and General Manager for North America and Asia from April 1996 to November 1997. From 1991 to 1996, Mr. Abbe held several senior executive positions with Raychem Corporation, a materials science company, including Senior Vice President, Electronics Sector. Mr. Abbe currently serves as a Director of Cymer, Inc., a semi-conductor equipment company; the chairman of Nova Crystals, Inc., a manufacturer of fiber optics components; and a director of Xponent, Inc., a manufacturer of fiber optics components. Mr. Abbe holds a B.S. and an M.S. in chemical engineering from Cornell University and an M.B.A. from Stanford University.
The board of directors currently has an Audit Committee, which is composed of Messrs. Abbe, Green and Spreng and is chaired by Mr. Green. The Audit Committee oversees the accounting and financial
reporting processes of the Company and the audit of its financial statements, reviews the Company’s internal accounting procedures, appoints, compensates, retains and oversees the independent accountants, reviews and approves all audit and non-audit services performed by the independent accountants, reviews with the independent accountants the scope and results of their annual examination of the Company’s consolidated financial statements, and performs the other functions specified in the Audit Committee Charter. The board of directors has determined that Mr. Abbe is an “audit committee financial expert” as defined in SEC rules.
EXECUTIVE OFFICERS
The information required by this item with respect to our executive officers is set forth in Item 1 of this report on page 10.
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934 requires the Company’s directors and executive officers, and persons who own more than 10 percent of a registered class of the Company’s equity securities, to file with the Securities and Exchange Commission initial reports of ownership and reports of changes in ownership of Common Stock and other equity securities of the Company. Officers, directors and greater than 10 percent stockholders are required by the regulations of the Securities and Exchange Commission to furnish the Company with copies of all Section 16(a) forms they file. To the Company’s knowledge, based solely on review of the copies of such reports furnished to the Company and written representations that no other reports were required, during the fiscal year ended December 31, 2003 all Section 16(a) filing requirements applicable to its officers, directors and greater than 10 percent beneficial owners were complied with, except that on October 21, 2003, Vinton Cerf, Donald Green, Charles J. Abbe and R. David Spreng each filed a Form 4 reporting the automatic grant on May 6, 2003 of a stock option for the purchase of 2,000 shares of the Company’s common stock under the Company’s 2000 Director Option Plan, on November 26, 2003, Stephen Goggiano, Terry Gibson and Robert Iannucci each filed a Form 4 reporting stock option grants on May 6, 2003 under the Company’s 2000 Stock Plan for the purchase of 90,000 shares, 46,000 shares and 46,000 shares, respectively, and on December 10, 2003, Jill Bresnahan filed a Form 4 reporting stock option grants on May 6, 2003 under the Company’s 2000 Stock Plan for the purchase of 37,000 shares.
CODE OF ETHICS
The Company has adopted a code of ethics that applies to our principal executive officer, principal financial officer and controller. Our code of ethics satisfies the requirements set forth in Item 406 of Regulation S-K and is posted on our Internet website (www.cosinecom.com). The Company intends to disclose any amendments to its code of ethics on its Internet website.
Item 11.
Item 11.
Executive Compensation
EXECUTIVE COMPENSATION
The following table summarizes the total compensation awarded to, earned by, or paid for services rendered to the Company in all capacities during each of the fiscal years ended December 31, 2003, 2002 and
2001, respectively, by each person who served as an executive officer of the Company at any time during 2003 (the “Named Executive Officers”).
Summary Compensation Table
(1)
Mr. Goggiano served as President and Chief Operating Officer in fiscal year 2001 and was appointed to the board of directors and named Chief Executive Officer on March 3, 2002.
(2)
Ms. Bresnahan resigned as Senior Vice President, General Counsel and Secretary effective September 5, 2003.
(3)
Mr. Gibson began employment with the Company on January 7, 2002.
(4)
Mr. Iannucci resigned as Senior Vice President, Engineering effective November 14, 2003.
(5)
Mr. Jalaba began employment with the Company on August 4, 2003.
(6)
Includes the grant of options in 2002 for the purchase of 90,000 shares, the subsequent re-pricing of those options in November of 2002, and the re-pricing of options granted prior to 2002 for the purchase of an aggregate of 40,000 shares.
(7)
Includes the grant of options in 2002 for the purchase of 20,000 shares, the subsequent re-pricing of those options in November of 2002, and the re-pricing of options granted prior to 2002 for the purchase of an aggregate of 36,000 shares.
(8)
Includes the grant of options in 2002 for the purchase of 30,000 shares and the subsequent re-pricing of those options in November of 2002.
(9)
Includes the grant of options in 2002 for the purchase of 30,000 shares and the subsequent re-pricing of those options in November of 2002.
(10)
Represents relocation expenses paid to Ms. Bresnahan.
(11)
Represents severance payments paid to Mr. Iannucci in connection with the termination of his employment on November 14, 2003.
Stock Option Grants
The following table provides information relating to stock options awarded to each of the Named Executive Officers during the year ended December 31, 2003.
Stock Option Grants in 2003
(1)
Potential realizable value is based on the assumption that the Common Stock of the Company appreciates at the annual rate shown (compounded annually) from the date of grant until the expiration of the ten-year option term. These numbers are calculated based on the requirements of the Securities and Exchange Commission and do not reflect the Company’s estimate of future stock price growth. The actual realizable value depends on the market value of the Common Stock on the exercise date. No gain to the optionee is possible without an increase in the price of the Common Stock. All assumed values are before taxes and do not include dividends.
(2)
This option vests and becomes exercisable with respect to 25% of the shares subject to the option on one year from the grant date and with respect to an additional 1/48th of the shares subject to the option each month thereafter until fully vested.
Stock Option Exercises in 2003 and 2003 Year End Values
The following table sets forth certain information regarding the exercise of stock options by the Named Executive Officers during the fiscal year ended December 31, 2003 and stock options held as of December 31, 2003 by the Named Executive Officers.
Aggregate Stock Option Exercises in Last Fiscal Year
and Fiscal Year End Option Values
(1)
Based on the fair value of the underlying securities on the date of exercise minus the exercise price. Values are stated on a pre-tax basis.
(2)
Based on the closing sales price of $7.38 of the underlying securities as of December 31, 2003 as reported on the Nasdaq National Market minus the exercise price. Values are stated on a pre-tax basis.
DIRECTOR COMPENSATION
Each non-employee director receives a quarterly retainer in the amount of $2,000. In addition, each non-employee director receives $1,000 for attending a board meeting in person, $500 for attending a committee meeting in person, and $250 for attending a board or committee meeting by telephone. We do not compensate directors for committee meetings held together with a board meeting. We reimburse directors for travel and other expenses incurred in attending board and committee meetings.
Each non-employee director who is first appointed or elected after September 26, 2000 (the date of our initial public offering) will automatically receive under our 2000 Director Option Plan an option to acquire 8,000 shares of Common Stock. These initial options will vest in four equal annual installments. Under the 2000 Director Option Plan, each non-employee director in office for at least six months before each annual meeting of stockholders will receive an additional option to acquire 2,000 shares of Common Stock. These subsequent options will vest on the fourth anniversary of the date of grant. We may also grant directors’ options or restricted stock under our 2000 Stock Plan. On October 20, 2003, upon the recommendation of management, the Compensation Committee approved a resolution increasing the annual option grant to each non-employee director from 2,000 shares to 8,000 shares, with the additional 6,000 shares to be granted under our 2000 Stock Plan. Non-employee directors received option grants during 2003 as listed in the table below. Each of these grants vests on the fourth anniversary of the date of grant.
(1)
Mr. Cerf resigned as a director effective December 31, 2003, but continues to serve as a technical advisor to the board of directors.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
The members of the Compensation Committee of the board of directors (the “Compensation Committee”) during fiscal year 2003, were Donald Green, Charles J. Abbe and R. David Spreng. Mr. Abbe serves as Chairman of the Compensation Committee. During fiscal year 2003, the Compensation Committee was composed solely of non-employee directors. None of these persons is, or has been at any time since our incorporation, one of our officers or employees or an officer or employee of any of our subsidiaries.
No executive officer of the Company has served as a member of the board of directors or compensation committee of any other entity that has or has had one or more executive officers serving as a member of our board of directors or Compensation Committee.
CHANGE OF CONTROL ARRANGEMENTS
Some options awarded under our 1997, 2000 and 2002 Stock Plans provide that the options will become fully vested and fully exercisable if, anytime within 24 months following a change of control, the option holder’s employment is terminated other than for cause or if a constructive termination of the option holder’s employment occurs. Events constituting a constructive termination include a significant reduction in the option holder’s duties, position or responsibilities without the option holder’s prior written consent. Options
containing such change of control provisions were granted to the Named Executive Officers and other employees.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management
SECURITY OWNERSHIP OF MANAGEMENT AND CERTAIN BENEFICIAL OWNERS
The following table sets forth certain information regarding the beneficial ownership of the Company’s Common Stock as of February 20, 2004, unless otherwise noted, by: (i) each person or entity who is known by the Company to own beneficially 5% or more of the Company’s outstanding Common Stock; (ii) each director of the Company; (iii) the Named Executive Officers; and (iv) all directors and executive officers of the Company who were serving on the board and/or were in office as of February 20, 2004 as a group.
*
Less than 1%.
(1)
Unless otherwise indicated, the address for each listed stockholder is c/o CoSine Communications, Inc., 1200 Bridge Parkway, Redwood City, CA 94065. Except as otherwise indicated, and subject to community property laws where applicable, the persons named in the table have sole voting and investment power with respect to all shares of Common Stock shown as beneficially owned by them.
(2)
Beneficial ownership is determined in accordance with the rules promulgated by the Securities and Exchange Commission. Under such rules, beneficial ownership includes any shares as to which the individual or entity has sole or shared voting power or investment power and any shares as to which the individual or entity has the right to acquire beneficial ownership within 60 days after February 20, 2004 (or as of April 20, 2004) through the exercise of any stock option or other right. Shares of Common Stock subject to options that are presently exercisable or exercisable within 60 days after February 20, 2004 are deemed to be beneficially owned by the person holding such options for the purpose of computing the percentage of ownership of such person, but are not treated as outstanding for the purpose of computing the percentage of any other person.
(3)
Percentage of beneficial ownership is based on 10,183,479 shares of Common Stock outstanding as of February 20, 2004, adjusted as required by rules promulgated by the Securities and Exchange Commission.
(4)
Of the 1,614,400 shares, 1,527,000 shares are directly owned by Mr. Haywood and 87,400 shares are indirectly owned by him. Of these 87,400 shares, 60,000 are indirectly owned through Mr. Haywood’s spouse and 17,000 are indirectly owned through his children. The information in this footnote is based upon the Schedule 13G filed February 11, 2004 on behalf of Mr. Haywood.
(5)
Of the 892,256 shares, 225 are directly owned by R. David Spreng, a director of CoSine; 173,857 are directly owned by Crescendo World Fund, LLC; 13,922 are directly owned by Crescendo III, GbR; 20,059 are directly owned by Crescendo III Executive Fund, LP; 675,326 are directly owned by Crescendo III, LP; 7,307 are directly owned by Eagle Ventures WF, LLC; and 1,560 are directly owned by PRISMA German American Venture Partners, GbR. The sole general partner of Crescendo World Fund, LLC is Crescendo Ventures World Fund, LLC. The sole general partner of Crescendo III, LP and Crescendo III Executive Fund, LP is Crescendo Ventures III, LLC. The general partners of Crescendo III, GbR are Crescendo Ventures III, LLC and Verbier Ventures, LLC. R. David Spreng is a managing member of Crescendo Ventures World Fund, LLC, Crescendo Ventures III, LLC, Eagle Ventures WF, LLC, and Verbier Ventures, LLC. Crescendo Capital Management, LLC, is an investment advisor of, and holds a profit interest in, PRISMA German American Venture Partners, GbR. Mr. Spreng is a managing member of Crescendo Capital Management, LLC. Mr. Spreng disclaims beneficial ownership of the shares held by Crescendo World Fund, LLC, Crescendo III, GbR, Crescendo III Executive Fund, LP, Crescendo III, LP, Eagle Ventures WF, LLC, and PRISMA German American Venture Partners, GbR, except to the extent of his pecuniary interest in the shares. The information in this footnote is based upon the Schedule 13G filed February 15, 2002 on behalf of Mr. Spreng and each of the entities named above in this footnote.
(6)
Of the 146,248 shares, 86,248 are subject to exercisable options. Of these 86,248 shares, 8,572 shares will remain unvested as of April 20, 2004. To the extent these options are exercised prior to vesting, the unvested shares acquired would be subject to certain restrictions.
(7)
Of the 8,200 shares, 5,000 are subject to an exercisable option. Of these 5,000 shares, 834 will remain unvested as of April 20, 2004. To the extent this option is exercised prior to vesting, the unvested shares acquired would be subject to certain restrictions.
(8)
All of these shares are subject to an exercisable option.
(9)
These shares are directly owned by Ms. Bresnahan’s two minor children.
(10)
Of the 30,313 shares, 14,265 shares are owned directly by Green Venture Capital II, L.P. and indirectly by Mr. Green as the general partner of Green Venture Capital II, L.P. Mr. Green disclaims beneficial ownership of the shares owned directly by Green Venture Capital II, L.P., except to the extent of his pecuniary interest in the shares.
(11)
All of these shares are subject to an exercisable option.
(12)
Of the 1,083,476 shares, 892,256 shares are owned by Crescendo Ventures as explained in footnote 5 above, 14,265 shares are owned by Green Venture Capital as explained in footnote 10 above, and an additional 834 are restricted shares that were acquired by directors and officers pursuant to the exercise of stock options, but remain unvested as of April 20, 2004. An additional 121,873 shares are subject to options that are exercisable within 60 days of February 20, 2004. Of these 121,873 shares, 9,406 will remain unvested as of April 20, 2004. To the extent these options are exercised prior to vesting, the unvested shares acquired would be subject to certain restrictions.
EQUITY COMPENSATION PLAN INFORMATION
The following table summarizes equity compensation plans approved by shareholders and equity compensation plans that were not approved by the shareholders as of December 31, 2003:
(1)
Includes 179,498 shares subject to outstanding options under the 1997 Stock Plan, 984,564 shares subject to outstanding options under the 2000 Stock Plan, and 24,000 shares subject to outstanding options under the Director Plan.
(2)
Includes 1,066,640 shares available for future issuance under the 2000 Stock Plan, 24,000 shares available for future issuance under the Director Plan, and 455,675 shares available for future issuance under the Employee Stock Purchase Plan.
(3)
The only equity compensation plan not approved by stockholders is the 2002 Stock Plan (the 2002 Plan). The board of directors adopted the 2002 Plan in January 2002. The purpose of the 2002 Plan is to make available for issuance certain shares of Common Stock that have been (i) previously issued pursuant to the exercise of stock options granted under the 1997 Plan and (ii) subsequently reacquired by CoSine pursuant to repurchase rights contained in restricted stock purchase agreements or pursuant to optionee defaults on promissory notes issued in connection with the exercise of such options (Reacquired Shares). Under the terms of the 1997 Plan and the 2000 Plan, these Reacquired Shares would not otherwise have been available for reissuance. No shares that were not previously issued under the 1997 Plan and subsequently reacquired by CoSine have been or will be reserved for issuance under the 2002 Plan. A maximum of 1,000,000 shares may be reserved for issuance under the 2002 Plan. An aggregate of 335,791 shares were initially reserved for issuance under the 2002 Plan upon its adoption. These shares consisted of Reacquired Shares as of the date of adoption. Additional shares that become Reacquired Shares after the date of adoption of the 2002 Plan, up to a maximum of 664,209 additional shares, will also become available for issuance under the 2002 Plan. The provisions of the 2002 Plan are substantially similar to those of the 2000 Plan, except that the 2002 Plan does not permit the grant of awards to officers or directors and does not permit the grant of Incentive Stock Options. The 2002 Plan provides for the grant of nonstatutory stock options to employees (excluding officers) and consultants. Stock options granted under the 2002 Plan will be at prices not less than the fair value of the common stock at the date of grant. The term of each option, generally 10 years or less, will be determined by CoSine.
Item 13.
Item 13.
Certain Relationships and Related Transactions
INDEBTEDNESS OF MANAGEMENT
Prior to the Company’s initial public offering, all employees were allowed to pay the exercise price for their 1997 Stock Plan options with full recourse promissory notes secured by a pledge of the shares underlying the exercised options. The Company holds promissory notes from certain executive officers that elected to do so. In December 2000, the Compensation Committee approved the change of all outstanding promissory notes given by employees in connection with the exercise of options from full recourse to non-recourse. At
December 31, 2003, the principal amounts, maturity dates, and annual rates of interest of the outstanding notes executed by executive officers were as follows:
Item 14.
Item 14.
Principal Accountant Fees and Services
Aggregate fees for professional services rendered by Ernst & Young LLP during 2003 and 2002 were as follows:
(1)
Fees for audit services include fees associated with the annual audit and 10-K, the reviews of the Company’s quarterly reports on Form 10-Q, and statutory audits required internationally.
(2)
Audit-related fees principally included consultation on technical accounting matters and benefits plan audits.
(3)
Tax fees included tax compliance and tax advice.
(4)
All other fees principally included stock option advice, internal control consultation, subsidiary liquidation services, real estate advisory services and employee termination advice.
Effective May 2003, all professional services rendered by Ernst & Young LLP are required to be pre-approved by the audit committee. In fiscal year 2003, all services were pre-approved by the audit committee.
Item 15.
Item 15.
Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) The following documents are filed as part of this Annual Report on Form 10-K:
(1) Financial Statements:
(2) Financial Statement Schedules:
All other schedules are omitted as they are not applicable or the required information is shown in the Financial Statements or the notes thereto.
(3) Exhibits:
See Exhibit Index on page 80. The Exhibits listed in the accompanying Exhibit Index are filed as part of this Annual Report on Form 10-K.
(b) Reports on Form 8-K.
On October 21, 2003, the Company issued a press release in which it reported earnings for the quarter ending September 30, 2003. A copy of such press release was furnished by the Company with a Form 8-K on October 21, 2003 as Exhibit 99.1.
COSINE COMMUNICATIONS, INC.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
(1)
Represents write offs of accounts receivable. In 2003, CoSine collected a receivable previously written off.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 25, 2004.
COSINE COMMUNICATIONS, INC.
By:
/s/ STEPHEN GOGGIANO
Stephen Goggiano
President and Chief Executive Officer
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Stephen Goggiano, Marc Bocci and Terry Gibson, and each of them acting individually, his true and lawful attorneys-in-fact and agents, each with full power of substitution, for him in any and all capacities, to sign any and all amendments to this report, and to file the same, with all exhibits thereto and all other documents in connection therewith, with the Securities and Exchange Commission, granting unto each of said attorneys-in-fact, or his substitute or substitutes, and each of them, hereby ratifying and confirming all that such attorneys-in-fact, or any substitutes, may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on March 25, 2004 by the following persons in the capacities indicated.
EXHIBIT INDEX
*
Previously filed.