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EX-31.1 - EXHIBIT 31.1 - ZST Digital Networks, Inc.v229624_ex31-1.htm
EX-32.1 - EXHIBIT 32.1 - ZST Digital Networks, Inc.v229624_ex32-1.htm
EX-31.2 - EXHIBIT 31.2 - ZST Digital Networks, Inc.v229624_ex31-2.htm
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-Q

x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2011

OR

¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File No. 000-52934

ZST DIGITAL NETWORKS, INC.
(Exact name of Registrant as specified in its charter)

Delaware
 
20-8057756
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)

206 Tongbo Street, Boyaxicheng Second Floor
Zhengzhou City, Henan Province
People’s Republic of China 450007
(Address of Principal Executive Offices) (Zip Code)

(86) 371-6771-6850
(Company’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨
 
Accelerated filer ¨
     
Non-accelerated filer ¨
 
Smaller reporting company x
(Do not check if a smaller reporting company)
   

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

As of August 3, 2011, 11,680,798 shares of Common Stock, par value $0.0001 per share, were outstanding, which number includes 107,500 shares of unvested restricted stock that are held by certain of the Company’s executive officers.

 
 

 

ZST DIGITAL NETWORKS, INC.

FORM 10-Q

For the Quarterly Period Ended June 30, 2011

INDEX

Part I
Financial Information
  1
         
 
Item 1.
Financial Statements
  1
         
   
Consolidated Balance Sheets
  2
         
   
Consolidated Statements of Income and Comprehensive Income
  3
         
   
Consolidated Statements of Cash Flows
  4
         
   
Notes to Consolidated Financial Statements
  5
         
 
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
  22
         
 
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
  33
         
 
Item 4.
Controls and Procedures
  33
         
Part II
Other Information
  34
         
 
Item 1.
Legal Proceedings
  34
         
 
Item 1A.
Risk Factors
  34
         
 
Item 2.
Unregistered Sale of Equity Securities and Use of Proceeds
  35
         
 
Item 3.
Default Upon Senior Securities
  35
         
 
Item 4.
(Removed and Reserved)
  35
         
 
Item 5.
Other Information
  35
         
 
Item 6.
Exhibits
  35
         
Signatures
  36

 
 

 

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The accompanying unaudited consolidated financial statements reflect all adjustments that, in the opinion of management, are considered necessary for a fair presentation of the financial position, results of operations, and cash flows for the periods presented. The results of operations for such periods are not necessarily indicative of the results expected for the full fiscal year or for any future period. The accompanying unaudited consolidated financial statements should be read in conjunction with the audited financial statements of ZST Digital Networks, Inc. as contained in its Annual Report on Form 10-K for the year ended December 31, 2010 filed with the Securities and Exchange Commission on March 4, 2011.

 
1

 

ZST DIGITAL NETWORKS, INC.
CONSOLIDATED BALANCE SHEETS
(In US Dollars)

   
December 31,
   
June 30,
 
   
2010
   
2011
 
         
(Unaudited)
 
             
ASSETS
           
Current assets:
           
Cash and cash equivalents
  $ 23,702,457     $ 50,248,326  
Accounts receivable
    33,490,510       27,846,141  
Inventories
    221,093       291,824  
Advance to suppliers
    7,270,379       2,025,003  
Prepaid expenses and other receivable
    1,019,629       922,270  
Deferred tax assets
    685,491       1,054,992  
                 
Total current assets
    66,389,559       82,388,556  
                 
Property, machinery, equipment and software, net
    10,544,051       10,742,759  
Intangible asset
    166,288       134,751  
                 
Total assets
  $ 77,099,898     $ 93,266,066  
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
Deferred revenue
  $ 2,741,964     $ 4,752,973  
Accruals and other payables
    263,073       267,793  
Accrued payroll and related expense
    129,281       80,611  
VAT payable
    669,682       460,617  
Franchise tax payable
    170,000       -  
Income tax payable
    1,289,974       2,679,364  
Total current liabilities
    5,263,974       8,241,358  
                 
Equity:
               
Common stock $0.0001 par value, 100,000,000 shares authorized, 11,650,442 and 11,717,942 shares issued, and 11,625,542 and 11,568,298 shares outstanding
    1,165       1,169  
Additional paid-in capital
    30,729,182       31,022,531  
Treasury stock
    (198,335 )     (493,465 )
Appropriated earnings
    5,817,035       5,817,035  
Retained earnings
    33,358,364       44,957,199  
Translation adjustment
    2,128,513       3,720,239  
Total equity
    71,835,924       85,024,708  
                 
Total liabilities and equity
  $ 77,099,898     $ 93,266,066  

See accompanying notes to financial statements
 
 
2

 
 
ZST DIGITAL NETWORKS, INC.
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
(In US Dollars)
 
   
Six Months Ended June 30,
   
Three Months Ended June 30,
 
   
2010
   
2011
   
2010
   
2011
 
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
   
(Unaudited)
 
                         
Revenues:
                       
Sales of products
  $ 47,993,924     $ 69,325,960     $ 31,566,021     $ 38,038,946  
Sales of services
    2,100,497       5,887,931       1,480,122       3,371,719  
Total revenue
    50,094,421       75,213,891       33,046,143       41,410,665  
                                 
Cost of sales:
                               
Cost of products sold
    37,581,909       56,334,264       24,757,120       30,977,931  
Cost of service
    91,640       291,195       42,143       187,336  
Total cost of sales
    37,673,549       56,625,459       24,799,263       31,165,267  
                                 
Gross profit
    12,420,872       18,588,432       8,246,880       10,245,398  
                                 
Selling expense
    376,279       368,107       108,974       202,610  
Research and development expenses
    330,891       298,082       95,367       167,447  
General and administrative expenses
    1,565,765       1,987,313       835,155       1,072,672  
                                 
Income from operations
    10,147,937       15,934,930       7,207,384       8,802,669  
                                 
Interest income (expense), net
    32,222       70,840       30,607       46,316  
Other income (expense)
    2,401       (7,648 )     2,401       (43 )
                                 
Income before income taxes
    10,182,560       15,998,122       7,240,392       8,848,942  
                                 
Income tax provision
    3,008,793       4,399,287       2,036,280       2,480,100  
                                 
Net income
  $ 7,173,767     $ 11,598,835     $ 5,204,112     $ 6,368,842  
                                 
Weighted average common shares outstanding – basic
    11,650,442       11,620,719       11,650,442       11,613,730  
Earnings per share – basic
    0.62       1.00       0.45       0.55  
                                 
Weighted average common shares outstanding – diluted
    11,650,442       11,620,719       11,650,442       11,613,730  
Earnings per shares – diluted
    0.62       1.00       0.45       0.55  
                                 
Comprehensive income:
                               
Net income
    7,173,767       11,598,835       5,204,112       6,368,842  
Translation adjustment
    299,422       1,591,726       249,390       1,010,600  
                                 
Comprehensive income
  $ 7,473,189     $ 13,190,561     $ 5,453,502     $ 7,379,442  

See accompanying notes to financial statements.

 
3

 

ZST DIGITAL NETWORKS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Increase (Decrease) in Cash and Cash Equivalents
(In US Dollars)
 
   
Six Months Ended June 30,
 
   
2010
   
2011
 
   
(unaudited)
   
(unaudited)
 
Cash flows from operating activities:
           
Net income
  $ 7,173,767     $ 11,598,835  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
    232,806       268,016  
Stock-based compensation
    85,721       334,634  
Deferred tax assets
    -       (369,501 )
Changes in operating assets and liabilities:
               
Accounts receivable
    (4,033,881 )     5,513,005  
Inventories
    738,848       (69,365 )
Advance to suppliers
    (1,439,433 )     5,133,717  
Prepayment and other assets
    475,485       59,652  
VAT payable
    -       (213,681 )
Accounts payable
    (702,869 )     -  
Accruals and other payable
    52,644       (215,268 )
Deferred revenue
    698,373       2,051,403  
Taxes payable
    281,860       1,417,562  
                 
Net cash provided by operating activities
    3,563,321       25,509,009  
                 
Cash flows from investing activities:
               
Additions to property, machinery, equipment and software
    (1,664,612 )     (436,408 )
                 
Cash flows from financing activities:
               
Repurchase of common stock
    -       (295,130 )
                 
Effect of changes in foreign exchange rates
    254,568       1,768,398  
                 
Net increase in cash and cash equivalents
    2,153,277       26,545,869  
                 
Cash and cash equivalents, beginning of the period
    13,627,992       23,702,457  
                 
Cash and cash equivalents, end of the period
  $ 15,781,269     $ 50,248,326  
                 
Supplemental disclosures of cash flow information:
               
Cash paid for income taxes
  $ 2,734,435     $ 3,403,533  

See accompanying notes to financial statements.

 
4

 

ZST DIGITAL NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 NOTE 1 – ORGANIZATION AND BUSINESS BACKGROUND

ZST Digital Networks, Inc. (f/k/a SRKP 18, Inc.) was incorporated in the State of Delaware on December 7, 2006.  SRKP 18, Inc. was originally organized as a “blank check” shell company to investigate and acquire a target company or business seeking the perceived advantages of being a publicly held corporation.

Zhengzhou Shenyang Technology Co., Ltd. (thereafter “ZST PRC”) was established on May 20, 1996 as a private domestic corporation located in Zhengzhou City, Henan Province, PRC with an authorized capital of RMB1.5 million. On April 8, 1999, ZST PRC increased its authorized capital from RMB1.5 million to RMB8 million.  ZST PRC gradually increased its authorized capital and invested capital to meet its operating requirement of fund.  All foreign investments made to Zhengzhou City enterprises required the approval of Zhengzhou City Bureau of Commerce.  The approval method utilized by ZST PRC to transfer proceeds from the financing was to increase its registered capital.  Therefore, as of June 30, 2011, the authorized capital and invested capital of ZST PRC were RMB260 million and RMB147.8 million, respectively.

ZST PRC has been principally engaged in supplying digital and optical network equipment to cable system operators in the Henan Province of China and has historically derived its revenue from sales of broadcasting equipment, hi-tech optical transmission devices, and telecommunication products.  It has developed a line of Internet protocol television (“IPTV”) set-top boxes that are used to provide bundled cable television, Internet and telephone services to residential and commercial customers. At present, ZST PRC’s main clients in Cable TV operations are broadcasting TV bureaus and cable network operators serving various cities and counties in Henan Province. Since the fourth quarter of 2009, ZST PRC began providing GPS location and tracking services for transport-related enterprises.

Pursuant to PRC rules and regulations relating to mergers of PRC companies with foreign entities, an offshore company controlled by PRC citizens that intends to merge with a PRC company will be subject to strict examination by the relevant PRC foreign exchange and security authorities.  To enable ZST PRC to go public, ZST management made the following restructuring arrangements: (i) established Everfair Technologies Limited (“Everfair”) as a Hong Kong holding company owned by a non-PRC citizen and indirectly controlled the operations of Everfair, (ii) had Everfair enter into an equity transfer agreement with ZST PRC by paying RMB12 million to ZST Management, (iii) established World Orient Universal Limited (“World Orient”) as a BVI holding company owned by a non PRC-citizen, (iv) had World Orient and its wholly owned subsidiary Global Asia Universal Limited (“Global Asia”), its subsidiary Everfair, and its subsidiary ZST PRC enter into a share exchange agreement with ZST Digital Networks, Inc., (v) concurrently conducted a private investment in a public entity (“PIPE”) financing, and (vi) used proceeds from the PIPE transaction to pay RMB12 million to ZST Management pursuant to an ownership transfer agreement.

World Orient was incorporated in British Virgin Islands (“BVI”) on August 12, 2008.  At December 31, 2008, World Orient had 50,000 capital shares authorized with $1.00 par value and 50,000 shares issued and outstanding.  In November 2008, World Orient acquired 100% ownership of Global Asia.

Global Asia was incorporated in BVI on August 12, 2008. At December 31, 2008, Global Asia had 50,000 capital shares authorized with $1.00 par value and 50,000 shares issued and outstanding.  In October 2008, Global Asia acquired 100% ownership of Everfair.

 
5

 

ZST DIGITAL NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 – ORGANIZATION AND BUSINESS BACKGROUND (Continued)

Everfair is a holding company incorporated in November 26, 2007 in Hong Kong with the original sole shareholder Kuk Kok Sun.  At December 31, 2008, Everfair had 10,000 capital shares authorized with HKD1.00 par value and 10,000 shares issued and outstanding.  Pursuant to a share transfer agreement, Global Asia paid Kuk Kok Sun HKD 10,000 for the ownership transfer.

In October 2008, Everfair entered into an equity transfer agreement with the original owners of ZST PRC.  Pursuant to the equity transfer agreement, Everfair agreed to pay the original owners RMB12 million for the equity transfer within three months of the approval from competent government agency.  After this equity transfer, ZST PRC became a foreign investment company with the operating life of 30 years since the approval of its establishment on November 10, 2008.

On January 9, 2009, SRKP 18, Inc. closed a share exchange transaction (the “Share Exchange”) pursuant to which SRKP 18, Inc. (i) issued 806,408 shares of its common stock to acquire 100% equity ownership of World Orient, which is the 100% parent of Global Asia, which is the 100% parent of Everfair, which is the 100% parent of ZST PRC, (ii) assumed the operations of World Orient and its subsidiaries, and (iii) changed its name from SRKP 18, Inc. to ZST Digital Networks, Inc.  In connection with the Share Exchange transaction, a PIPE transaction to raise $5 million was also under implementation between an investment bank and ZST Digital Networks, Inc. by which ZST Digital Networks, Inc. would be able to make payment of RMB12 million to the original owners of ZST PRC.

Subsequent to the closing of the Share Exchange, on January 14, 2009, Zhong Bo, Chief Executive Officer and Chairman of the Board of ZST Digital Networks, Inc., Wu Dexiu, Huang Jiankang, Sun Hui and Li Yuting (the "ZST Management"), each entered into a Common Stock Purchase Agreement pursuant to which ZST Digital issued and the ZST Management agreed to purchase an aggregate of 5,090,315 shares of our common stock at a per share purchase price of $0.6907 (the "Purchase Right") and obtained control of ZST Digital Networks, Inc..  The purchase consideration for the 5,090,315 shares would come from the proceeds raised through the PIPE transaction and the conversion of shareholder loans lent to ZST PRC.

Upon consummation of the Share Exchange and the ownership transfer transactions, ZST Management owned a majority of the issued and outstanding shares of common stock of ZST Digital Networks, Inc. and Mr. Zhong Bo was appointed as the Chairman of the Board and Chief Executive Officer of ZST Digital Networks, Inc..  Hereafter, ZST Digital Networks, Inc. and its subsidiaries, World Orient, Global Asia, Everfair, and ZST PRC shall be collectively referred throughout as the “Company”.

For accounting purposes, the above Share Exchange transaction was accounted for as a reverse merger. The Share Exchange transaction has been treated as a recapitalization of World Orient and its subsidiaries, with ZST Digital Networks, Inc. (the legal acquirer of World Orient and its subsidiaries including ZST PRC) considered the accounting acquiree and ZST PRC, the only operating company, and whose management took control of ZST Digital Networks, Inc. (the legal acquiree of ZST Digital Networks, Inc.) is considered the accounting acquirer.  The Company did not recognize goodwill or any intangible assets in connection with the Share Exchange transaction.  The financial statements of the Company are the continued financial statements of World Orient and its subsidiaries.

On October 6, 2009, the Company effected a 1-for-2.461538462 reverse stock split of the Company’s issued and outstanding shares of common stock (the “Reverse Stock Split”).  The par value and number of authorized shares of the common stock remained unchanged.  All references to number of shares and per share amounts included in these consolidated financial statements and the accompanying notes have been adjusted to reflect the reverse stock split retroactively.

 
6

 

ZST DIGITAL NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2 ─ SUMMARY OF ACCOUNTING POLICIES

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Article 10 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for fair presentation have been included. Operating results for the three and six months ended June 30, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011.

Principles of Consolidation

The financial statements include the accounts of the Company and its wholly-owned subsidiaries.  All significant inter-company accounts and transactions have been eliminated.  All of the consolidated financial statements have been prepared based on generally accepted accounting principles in the United States.

Foreign Currency Translations and Transactions

The Renminbi (“RMB”), the national currency of PRC, is the primary currency of the economic environment in which the operations of the subsidiary ZST PRC are conducted.  Hong Kong dollar is the primary currency of the economic environment in which the operations of Everfair are conducted.  The Company uses the United States dollars (“U.S. dollars”) for financial reporting purposes.

The Company translates the above two subsidiaries’ assets and liabilities into U.S. dollars using the rate of exchange prevailing at the balance sheet date, and the statement of income is translated at average rate during the reporting period.  Adjustments resulting from the translation of subsidiaries’ financial statements from the functional currency into U.S. dollars are recorded in shareholders’ equity as part of accumulated comprehensive income (loss) – translation adjustments.  Gains or losses resulting from transactions in currencies other than the functional currency are reflected in the statements of income for the reporting periods.

Revenue Recognition

The Company derives revenues principally from sale of products related to Cable TV program distribution related system which include digital Cable TV network equipment and IPTV Set-top Boxes; sale of GPS devices; provision of GPS device installation services and GPS subscription services.

Revenue is recognized when the risk and rewards are transferred, delivery has occurred or the services have been rendered, persuasive evidence of any arrangement exists, the price to the buyer is fixed or determinable and collectability is reasonably assured. These criteria as they apply to standalone sale of digital Cable TV network equipment, IPTV Set-top Boxes, and GPS devices, and the sale of GPS devices with installation service, and provision of technical services are as follows:

Sales of Digital Cable TV Network Equipment and GPS Devices

The Company recognizes revenues from the sale of digital Cable TV network equipment and GPS devices when the price of products to be sold are predetermined, the risk and rewards of ownership and title to the products have been transferred to the buyer, which coincides with delivery and acceptance of the products by the buyer.  When certain equipment requires installment service, revenue is not recognized until customer acceptance has been obtained and/or the Company has no further significant obligations with customers.

 
7

 

ZST DIGITAL NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 2 ─ SUMMARY OF ACCOUNTING POLICIES (Continued)

Revenue Recognition (Continued)

Sales of IPTV Set-Top Boxes

The Company recognizes revenues from the sale of IPTV Set-top Boxes when the price of products to be sold are predetermined, the risk and rewards of ownership and title to the products have been transferred to the buyer, which coincides with delivery and acceptance of the products by the buyer.

Pursuant to the terms of the Company’s IPTV Set-top Boxes sales contracts, the Company has allowed its customers to hold back 10% of total contract price until the end of one year after delivery of products for warranty purpose.  The Company recognizes the total contract amount as revenue based on the following reasons: i) the customer’s obligation to pay 10% of the total contract amount is not contingent on the resale of the product shipped; ii) the Company does not have significant obligation for future performance to directly bring about resale of the products shipped other than replacement of defective products due to hardware defects in materials and workmanship which, in turn, will be borne by the Company’s supplier; iii) the customer purchasing the products sold by the Company has economic substance apart from the products provided by the Company; and iv) the amount of future returns can be reasonably estimated based on the historical return experience whereas the Company does not have any historical return experience.

Revenue from selling all products is recognized net of value added tax imposed by Chinese government.

Multiple Deliverable

In October 2009, the Company started to sell GPS devices in conjunction with subscription service and installation service.  The Company generally recognizes revenue from the sale of GPS device hardware with the bundled software that is essential to the functionality of the GPS device when there are no continuing obligations upon the completion of installation.  The Company sells the subscription services to customers with terms of the service contracts offered that range from 12 to 24 months and are payable in full upon activation of the related unit or renewal of a previous service contract.  The subscription service revenues are deferred and recognized over the life of the service contract upon activation.

In instances where the Company sells a GPS device unit along with subscription service and/or installation service, the Company recognizes revenue related to the combined sale by allocating between the two or three deliverables using the relative selling price method determined by using the hierarchy of the following principles: i) vendor-specific objective evidence of fair value (“VSOE”), ii) third-party evidence of selling price (“TPE”), and iii) best estimate of the selling price (“ESP”).

Sales of Services

Revenue is recognized when services are rendered.  The prepayments received for GPS subscription services are treated as deferred revenue which will be recognized over the terms of service contracts.

 
8

 

ZST DIGITAL NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 2 ─ SUMMARY OF ACCOUNTING POLICIES (Continued)

Warranty Liabilities

The Company has a return policy where the customers must make a request within 30 days of receipt to return the products when the products delivered have more than 40% defects or the products are not delivered on time.  The Company determines that warranty costs related to products sold are minimal in monetary terms based on historical return experience.  In the event of defective product returns, the Company has the right to seek replacement of such returned units from its supplier.  Based on the purchase agreement, the supplier will replace the defective product when the defects are caused by hardware defects in materials and workmanship during manufacturing process for a period of one year.  Based on these facts, the Company records warranty cost as incurred.

Regarding warranty on GPS devices, we have a policy that provides coverage on repairs of GPS devices for a period of one year after the date of purchase. In the event that repair is needed, customers will be responsible for the cost of parts while the cost of labor will be covered by us. We estimate the costs to service our obligations based on historical experience and expectations of future conditions.

Cash and Cash Equivalents

The Company considers all highly liquid investments with maturity of three months or less to be cash equivalents.

Accounts Receivable

Accounts receivable are stated at the historical carrying amount, net of an allowance for doubtful accounts. The allowance for doubtful accounts is the Company’s best estimate of the amount of probable credit losses in the Company’s existing accounts receivable.  The Company determines the allowance based on historical write-off experience, customer specific facts and economic conditions. Provisions for doubtful accounts are charged to general and administrative expenses.

Outstanding account balances are reviewed individually for collectability.  Account balances are charged off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.  The Company has not provided a bad debt allowance as of June 30, 2011 and December 31, 2010.

Inventories

Inventories are composed of raw materials and products for sale.  Inventories are valued at the lower of cost (based on weighted average method) and the market.  Full amount provisions were made for obsolete inventories which are difficult to estimate future utilization.  Once the inventory cost is written down, the written-down costs are treated as a new cost basis for the inventory, and are not adjusted back up to the previous cost basis in future periods.  For inventories which will be used in ordinary course of production or sales, the net realizable value of the inventories is compared with their carrying value, if the net realizable value is lower than the carrying value, a provision for the difference between the net realizable value and the carrying value of the inventories was recognized.  Net realizable value is determined based on the most recent selling price of these inventories less the estimated cost to sell.

 
9

 

ZST DIGITAL NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2 ─ SUMMARY OF ACCOUNTING POLICIES (Continued)

Advertising Costs

The Company expenses advertising costs as incurred and are included in selling expenses.

Shipping and Handling Expense

Shipping and handling costs are expensed as incurred and are included in selling expenses.

Property, Machinery, Equipment and Software

Plant, properties, machinery, equipment and software are recorded at historical cost, net of accumulated depreciation.  The amount of depreciation is determined using the straight-line method over the shorter of the estimated useful lives and the remaining contractual life related to leasehold improvements, as follows:

Machinery and equipment
 
5 years
 
Office equipment
 
5 years
 
Electronic equipment
 
5 years
 
Vehicles
 
5 years
 
Software
 
3 years
 

Maintenance and repairs are charged directly to expense as incurred, whereas betterment and renewals are generally capitalized in their respective property accounts.  When an item is retired or otherwise disposed of, the cost and applicable accumulated depreciation are removed and the resulting gain or loss is recognized and reflected as an item before operating income (loss).

Intangible Asset

The Company recorded the acquired know-how as intangible asset and amortized the acquisition cost over five years using the straight-line method.

Impairment of Long-Lived Assets

The Company reviews long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable through the estimated undiscounted cash flows expected to result from the use and eventual disposition of the assets.  Whenever any such impairment exists, an impairment loss will be recognized for the amount by which the carrying value exceeds the fair value.

Research and Development

Research and development costs are expensed as incurred.  Research and development expenses are offset against government subsidies received for supporting research and development efforts.  No government subsidy in supporting research and development activities was received for the six months ended June 30, 2010 and 2011.

 
10

 

ZST DIGITAL NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2 ─ SUMMARY OF ACCOUNTING POLICIES (Continued)

Share-Based Payments

The Company receives employee services in exchange for equity securities of the Company that are based on the fair value of the Company’s equity securities.  The Company uses a fair-value-based method to calculate and account for above mentioned transactions.

Value Added Tax

ZST PRC is subject to value added tax (VAT) imposed by the PRC government on its domestic product sales.  VAT rate for the Company is 17%.  The input VAT can be offset against the output VAT.  VAT payable or receivable balance presented on the Company’s balance sheets represents either the input VAT less than or larger than the output VAT.

Fair Value of Financial Instruments

The standard for “Disclosures about Fair Value of Financial Instruments,” defines financial instruments and requires fair value disclosures of those financial instruments.  The Company adopts the standard “Fair Value Measurements,” which defines fair value, establishes a three-level valuation hierarchy for disclosures of fair value measurement and enhances disclosures requirements for fair value measures. Current assets and current liabilities qualified as financial instruments and management believes their carrying amounts are a reasonable estimate of fair value because of the short period of time between the origination of such instruments and their expected realization and if applicable, their current interest rate is equivalent to interest rates currently available.  The three levels are defined as follows:

 
·
Level 1 ─ inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.
 
·
Level 2 ─ inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the assets or liability, either directly or indirectly, for substantially the full term of the financial instruments.
 
·
Level 3 ─ inputs to the valuation methodology are unobservable and significant to the fair value.

As of the balance sheet date, the estimated fair values of the financial instruments were not materially different from their carrying values as presented due to the short maturities of these instruments and that the interest rates on the borrowings approximate those that would have been available for loans of similar remaining maturity and risk profile at respective period-ends.  Determining which category an asset or liability falls within the hierarchy requires significant judgment.  The Company evaluates the hierarchy disclosures each quarter.

Comprehensive Income (Loss)

The Company adopted FASB Accounting Standards Codification 220, Comprehensive Income, which establishes standards for reporting and presentation of comprehensive income (loss) and its components in a full set of general-purpose financial statements.  The Company has chosen to report comprehensive income (loss) in the statements of income and comprehensive income.  Comprehensive income (loss) is comprised of net income and all changes to stockholders’ equity except those due to investments by owners and distributions to owners.

 
11

 

ZST DIGITAL NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2 ─ SUMMARY OF ACCOUNTING POLICIES (Continued)

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ materially from those estimates.

Appropriations to Statutory Reserve

Under the corporate law and relevant regulations in China, ZST PRC is required to appropriate a portion of its retained earnings to statutory reserve.  It is required to appropriate 10% (the proportion is 15% before 2006) of its annual after-tax income each year to statutory reserve until the statutory reserve balance reaches 50% of the registered capital.  In general, the statutory reserve shall not be used for dividend distribution purpose.

Dividends and Retained Earnings

It is the intention of the Company to reinvest earnings of its overseas subsidiaries in the operations of those subsidiaries.  Accordingly, no provision has been made for U.S. income and foreign withholding taxes that would result if such earnings were repatriated.  The amounts of earnings retained in ZST PRC were $37,330,862 as of December 31, 2010 and $50,043,995 as of June 30, 2011, respectively.

Income Taxes

The Company recognizes deferred tax liabilities and assets when accounting for income taxes.  Deferred tax assets and liabilities are recognized for the future tax consequence attributable to the difference between the tax bases of assets and liabilities and their reported amounts in the financial statements.  Deferred tax assets and liabilities are measured using the enacted tax rate expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that included the enactment date.

World Orient and Global Asia are BVI registered companies.  There is no income tax for the company domiciled in the BVI.  Accordingly, the Company’s financial statements do not present any income tax provision related to the British Virgin Islands tax jurisdiction.  Everfair is established in Hong Kong and subject to Hong Kong tax laws.  However, there is no Hong Kong based income; therefore, there is no income tax impact from Hong Kong.

ZST PRC is registered at Zhengzhou and is subjected to a unified 25% enterprise income tax rate.

ZST Digital Networks, Inc. was established under the laws of the State of Delaware and is subject to U.S. federal income tax and one state income tax.  For U.S. income tax purposes no provision has been made for U.S. taxes on undistributed earnings of overseas subsidiaries with which the Company intends to continue to reinvest.  It is not practicable to estimate the amount of additional tax that might be payable on the foreign earnings if they were remitted as dividends, or lent to the Company, or if the Company should sell its stock in these subsidiaries.

 
12

 

ZST DIGITAL NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2 ─ SUMMARY OF ACCOUNTING POLICIES (Continued)

Earnings per Share

Basic earnings per share includes no dilution and is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period.  Diluted earnings per share reflect the potential dilution of securities that could share in the earnings of an entity, similar to fully diluted earnings per share.  As of June 30, 2011, all the securities issued are anti-dilutive for computing earnings per share purpose, which were as below:

1)
The stock warrants to purchase 156,250 shares of the Company’s common stock issued to underwriters in connection with initial stock offering conducted in October 2009 with the exercise price at $10.00 per share are anti-dilutive for computing earnings per share purpose.
2)
The 60,000 shares of restricted common stock granted to Mr. Zhong Bo, Chairman of the Board of Directors, on January 1, 2011 are anti-dilutive for computing earnings per share purpose.
3)
The stock option to purchase 90,000 shares of the Company’s common stock granted to Mr. Henry Ngan, CFO of the Company, on March 18, 2011 are anti-dilutive for computing earnings per share purpose.
4)
The 90,000 shares of restricted common stock granted to Mr. Henry Ngan on March 18, 2011 are anti-dilutive for computing earnings per share purpose.

Recently Issued Accounting Pronouncements Adopted

FASB ASU 2010-13

In April 2010, the FASB issued Accounting Standards Update ("ASU") No. 2010-13, “Compensation - Stock Compensation (Topic 718): Effect of Denominating the Exercise Price of a Share-Based Payment Award in the Currency of the Market in Which the Underlying Equity Security Trades,” which addresses the classification of a share-based payment award with an exercise price denominated in the currency of a market in which the underlying equity security trades.  Topic 718 is amended to clarify that a share-based payment award with an exercise price denominated in the currency of a market in which a substantial portion of the entity’s equity securities trades shall not be considered to contain a market, performance, or service condition.  Therefore, such an award is not to be classified as a liability if it otherwise qualifies as equity classification.  The amendments in this Update should be applied by recording a cumulative-effect adjustment to the opening balance of retained earnings.  The cumulative-effect adjustment should be calculated for all awards outstanding as of the beginning of the fiscal year in which the amendments are initially applied, as if the amendments had been applied consistently since the inception of the award. ASU 2010-13 is effective for interim and annual periods beginning on or after December 15, 2010. The adoption of this ASU did not have a material impact on the Company’s consolidated financial statements.

Recently Issued Accounting Pronouncements Not Adopted Yet

FASB ASU 2011-04

In May 2011, the FASB issued Accounting Standards Update ("ASU") No. 2011-04, Fair Value Measurement (Topic 820) – Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, the amendments change the wording used to describe the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements.  ASU 2011-04 is to be applied prospectively and is effective during interim and annual periods beginning after December 15, 2011 for public companies.  The Company is currently evaluating the impact of this ASU; however, the Company does not expect the adoption of this ASU to have a material impact on its consolidation financial statements.

 
13

 

ZST DIGITAL NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 2 ─ SUMMARY OF ACCOUNTING POLICIES (Continued)

Recently Issued Accounting Pronouncements Not Adopted Yet (Continued)

FASB ASU 2011-05

In June 2011, the FASB issued Accounting Standards Update ("ASU") No. 2011-05, Comprehensive Income (Topic 220) – Presentation of Comprehensive Income, in ASU 2011-05, an entity has the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. In a single continuous statement, the entity is required to present the components of net income and total net income, the components of other comprehensive income and a total for other comprehensive income, along with the total of comprehensive income in that statement. In the two-statement approach, an entity is required to present components of net income and total net income in the statement of net income. The statement of other comprehensive income should immediately follow the statement of net income and include the components of other comprehensive income and a total for other comprehensive income, along with a total for comprehensive income. ASU 2011-05 should be applied retrospectively and is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011 for public companies.
 
 
14

 

ZST DIGITAL NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 3 ─ ACCOUNTS RECEIVABLES

The accounts receivables are as follows:

   
December 31,
   
June 30,
 
   
2010
   
2011
 
         
(Unaudited)
 
             
Accounts receivables
  $ 26,315,401     $ 19,479,581  
Accounts receivables ─ 10% hold back
    7,175,109       8,366,560  
                 
    $ 33,490,510     $ 27,846,141  
Provision
    -       -  
                 
Accounts receivable, net
  $ 33,490,510     $ 27,846,141  

The aging of the accounts receivable except for the 10% hold back are as follows:

   
December 31,
   
June 30,
 
   
2010
   
2011
 
         
(Unaudited)
 
             
1-30 days
  $ 14,777,700     $ 13,150,034  
31-60 days
    8,992,436       5,068,004  
61-90 days
    2,545,265       1,261,543  
                 
    $ 26,315,401     $ 19,479,581  

The aging of the 10% hold back accounts receivables, for which the customers held for one-year warranty purpose, are as follows:

 
 
December 31,
   
June 30,
 
   
2010
   
2011
 
         
(Unaudited)
 
             
1-90 days
  $ 2,543,109     $ 1,906,878  
90-360 days
    4,632,000       6,459,682  
                 
    $ 7,175,109     $ 8,366,560  

NOTE 4 ─ ADVANCE TO SUPPLIERS

In accordance with the purchase contracts, ZST PRC is required to make advance payments to its suppliers to purchase the IPTV set-top box and GPS devices, materials and add-on process work. The advances are applied to the total invoice balance upon satisfaction of the goods received by ZST PRC.

As of June 30, 2011, advances of $2,025,003 represents advances made to three suppliers accounting for 36%, 48% and 16% of total balance, respectively.  As of December 31, 2010, advances of $7,270,379 represents advances mainly made to two suppliers accounting for 53% and 45% of total balance, respectively.

 
15

 

ZST DIGITAL NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 5 ─ INVENTORIES

The inventories are as follows:
 
   
December 31,
   
June 30,
 
   
2010
   
2011
 
         
(Unaudited)
 
             
Products for sale
  $ 221,093     $ 291,824  
Less: Provisions
    -       -  
                 
Inventories, net
  $ 221,093     $ 291,824  

There was no reserve for obsolete inventory for all the periods as the Company has purchased inventory based on customers’ orders.

NOTE 6 ─ PROPERTY, MACHINERY, EQUIPMENT AND SOFTWARE

A summary of property, machinery, equipment and software at cost is as follows:

   
December 31,
   
June 30,
 
   
2010
   
2011
 
         
(Unaudited)
 
             
Machinery and equipment
  $ 92,409     $ 107,677  
Electronic equipment
    197,215       201,379  
Office equipment
    48,168       49,927  
Vehicles
    309,923       316,469  
Software
    469,697       621,108  
Advance for building and employee leisure facilities
    248,485       302,468  
Advance for purchasing office spaces
    9,540,909       9,742,400  
                 
    $ 10,906,806     $ 11,341,428  
Accumulated depreciation
    (362,755 )     (598,669 )
                 
    $ 10,544,051     $ 10,742,759  

The depreciation and amortization for the six months ended June 30, 2010 and 2011 were $232,806 and $268,016, respectively.

On March 12, 2010, the Company paid RMB11.13 million (approximately $1.7 million) for purchasing an office space of 2,100 square meters, which is located in Zhengzhou City, Henan Province, PRC; on December 30, 2010, the Company paid RMB51.84 million (approximately $8.0 million) for purchasing office space of 2,880 square meters in the same building; total advances for the office spaces were $9,742,400 as of June 30, 2011. The interior decoration plan of this office building is under discussion and the decoration work is expected to start in this August 2011.

 
16

 

ZST DIGITAL NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 7 ─ DEFERRED REVENUE

Deferred revenue related to GPS subscription services.  The Company received service fee in advance and allocated the amount to sales revenue over the terms of service contracts.  The unallocated service fee was $4,752,973 as of June 30, 2011 and $2,741,964 as of December 31, 2010.

NOTE 8 ─ COMMON STOCK TRANSACTIONS

The Company has two classes of stock, common and preferred stock.  The Company is authorized to issue 10,000,000 shares of preferred stock with par value of $0.0001 per share, of which 3,750,000 shares were designated as Series A Preferred Stock.  The Company is authorized to issue 100 million shares of common stock with par value of $0.0001 per share.

Stock Repurchase Program

On August 23, 2010, the Board of Directors authorized the Company to repurchase outstanding shares of the Company's common stock in an amount not to exceed $1 million in open market purchases, with block trades being permitted, from time to time in the discretion of the Company's management and as market conditions allow.  As of June 30, 2011, the Company repurchased 119,644 shares of its common stock at a cost of $493,465, which was recorded as treasury stock.

Restricted Stock Grants

On January 1, 2011, the Company granted Mr. Zhong Bo 60,000 shares of restricted common stock under the Company’s 2010 Omnibus Incentive Plan.  The 60,000 shares of restricted common stock shall vest on monthly basis at 5,000 shares per month.   Accordingly, the Company recognized a stock compensation of $204,000 for the six months ended June 30, 2011 and there were 30,000 shares of common stock vested as of June 30, 2011.

On March 18, 2011, the Company entered into an employment agreement with Mr. Henry Ngan as the Company’s Chief Financial Officer, effective March 18, 2011, with an initial term of a two-year period following with an automatic renewal of another year. Pursuant to the terms of this employment, Mr. Ngan was granted for 90,000 shares of restricted common stock under the Company’s 2010 Omnibus Incentive Plan on March 18, 2011.  The 90,000 shares of restricted common shares vest on a quarterly basis, with 7,500 shares vesting on the three-month anniversary of the date of grant.  Accordingly, the Company recognized stock compensation of $51,157 for the six months ended June 30, 2011 with 7,500 shares vested as of June 30, 2011.

The restricted stock have no purchase cost to the grantee.  Non-vested stock entitles the grantees to dividends, if any, and voting rights for their respective shares.  Sale or transfer of the shares is restricted until vested.  The Company issues new shares for the granting of restricted stock.

NOTE 9 ─WARRANTS

In October 2009, the Company completed a public offering and sold 3,125,000 shares of its common stock at $8.00 per share.  In connection with the public offering, on October 20, 2009, the Company issued to the underwriters warrants to purchase 156,250 shares of the Company’s common stock at an exercise price of $10 per share.  The warrants have a five-year term and became exercisable one year after the date of issuance.

 
17

 

ZST DIGITAL NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 10 ─ STOCK OPTIONS

On March 18, 2011, the Company, as indicated above, entered into an employment agreement with Mr. Ngan.  Pursuant to the employment agreement, Mr. Ngan was granted for stock options to purchase 90,000 shares of the Company’s common stock with an exercise price of $5.96 per share, which is equal to the closing trading price on the grant date, which is March 18, 2011, under the Company’s 2010 Omnibus Incentive Plan.  The options have a contractual life of ten year and vest on a quarterly basis at 7,500 shares per quarter.  The Company uses Black-Scholes Pricing Model to determine that the fair value of the options was $400,500 based on the following assumptions: the expected life was seven years, the expected volatility was 81.80%, the annual quarterly dividends rate was zero, and the discount rate was 2.64% based on the same terms of Treasury Bonds.   For the six months ended June 30, 2011, the Company recognized a stock compensation of $38,196.  As of June 30, 2011, 7,500 shares underlying the stock option were vested and exercisable, but no shares were exercised.

Pursuant to the employment agreement with Mr. John Chen, the Company’s former CFO, the Company granted Mr. Chen options to purchase 25,000 shares and 12,500 shares of the common stock of the Company on October 20, 2009 and 2010, respectively.  When Mr. Chen’s employment was terminated on March 18, 2011, the options to purchase 12,500 shares of common stock granted on October 20, 2010 vested immediately and the unamortized fair value of the option was fully amortized then. Pursuant to the Employment Agreement, all options that are vested at the time of termination of employment must be exercised within 30 days; as of June 30, 2011, no option was exercised and options granted to Mr. Chen expired.

NOTE 11 ─ EARNINGS PER SHARE

The following table sets forth the computation of basic and diluted net earnings per share for the periods as indicated:

   
Six Months Ended June 30,
 
   
2010
   
2011
 
   
(Unaudited)
   
(Unaudited)
 
Numerator:
           
Net income attributable to the Company
  $ 7,173,767     $ 11,598,835  
Net income used in computing diluted earnings per share
  $ 7,173,767     $ 11,598,835  
Denominator:
               
Weighted average common shares outstanding – basic
    11,650,442       11,620,719  
Weighted average common share outstanding – diluted
    11,650,442       11,620,719  
Basic earnings per share
  $ 0.62     $ 1.00  
Diluted earnings per share
  $ 0.62     $ 1.00  
 
   
Three Months Ended June 30,
 
   
2010
   
2011
 
             
Numerator:
           
Net income attributable to the Company
  $ 5,204,112     $ 6,368,842  
Net income used in computing diluted earnings per share
  $ 5,204,112     $ 6,368,842  
Denominator:
               
Weighted average common shares outstanding – basic
    11,650,442       11,613,730  
Weighted average common share outstanding – diluted
    11,650,442       11,613,730  
Basic earnings per share
  $ 0.45     $ 0.55  
Diluted earnings per share
  $ 0.45     $ 0.55  
 
 
18

 

ZST DIGITAL NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 12 ─ SEGMENT REPORTING

Taking into consideration of operating activities, the Company currently conducts businesses in two segments: i) Cable TV program distribution related equipment; and ii) GPS devices and services. As the Company’s current operations are based in only Henan Province of China, management believes that the following tables present useful information to chief operation decision makers for measuring business performance, financing needs, and preparing corporate budget, etc.

   
Six Months Ended June 30,
 
   
2010
   
2011
 
   
(Unaudited)
   
(Unaudited)
 
             
Sales of Cable TV Equipment:
           
Revenue
  $ 41,313,276     $ 53,707,776  
Cost
    32,297,100       43,493,049  
Gross profit
    9,016,176       10,214,727  
                 
Sales of GPS Devices:
               
Revenue
    6,680,648       15,618,184  
Cost
    5,284,809       12,841,215  
Gross profit
    1,395,839       2,776,969  
                 
GPS Related Service:
               
Revenue
    2,100,497       5,887,931  
Cost
    91,640       291,195  
Gross profit
    2,008,857       5,596,736  
                 
Total revenue
    50,094,421       75,213,891  
Total cost
    37,673,549       56,625,459  
Overall gross profit
    12,420,872       18,588,432  
Expenses not allocated
    2,238,312       2,590,310  
Income before income taxes
  $ 10,182,560     $ 15,998,122  
 
 
19

 
 
ZST DIGITAL NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 12 ─ SEGMENT REPORTING (Continued)

   
Three Months Ended June 30,
 
   
2010
   
2011
 
   
(Unaudited)
   
(Unaudited)
 
             
Sales of Cable TV Equipment:
           
Revenue
  $ 27,038,184     $ 29,262,354  
Cost
    21,163,122       23,739,951  
Gross profit
    5,875,062       5,522,403  
                 
Sales of GPS Devices:
               
Revenue
    4,527,837       8,776,593  
Cost
    3,593,998       7,237,980  
Gross profit
    933,839       1,538,613  
                 
GPS Related Service:
               
Revenue
    1,480,122       3,371,718  
Cost
    42,143       187,336  
Gross profit
    1,437,979       3,184,382  
                 
Total revenue
    33,046,143       41,410,665  
Total cost
    24,799,263       31,165,267  
Overall gross profit
    8,246,880       10,245,398  
Expenses not allocated
    1,006,488       1,396,456  
Income before income taxes
  $ 7,240,392     $ 8,848,942  
 
 
20

 

ZST DIGITAL NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 13 ─ CONTINGENT LIABILITIES

The Company and several of its directors and officers have been named as defendants in a purported securities class action lawsuit filed in the U.S. District Court for the Central District of California.  The complaint was filed on April 25, 2011 and is captioned Robert Scott v. ZST Digital Networks, Inc., et al.

The complaint alleges that Company and the director and officer defendants made false and misleading statements and failed to disclose material facts about the Company’s business and prospects in violation of Federal securities laws.  Specifically, the complaint asserts claims under Sections 11, 12(a)(2), and 15 of the Securities Act of 1933, as amended, on behalf of all persons who purchased or otherwise acquired common stock of the Company pursuant or traceable to the registration statement and prospectus filed in connection with the Company's October 20, 2009 public offering, and claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended, on behalf of purchasers of the Company's common stock during the period October 20, 2009 to April 21, 2011.  The plaintiff has also asserted claims under Sections 11 and 12(a)(2) against the underwriters of the Company’s public offering, who are also named as defendants to the action.  The plaintiff seeks damages for the purported class.

Three lead plaintiff motions were filed in June 2011.  Because two of those lead plaintiff candidates subsequently withdrew their motions, there currently is only one lead plaintiff candidate motion pending.  After the Court appoints a lead plaintiff and sets a schedule for the filing of an amended complaint, if any, the Company expects to file a motion to dismiss all of the claims asserted in the complaint.

The Company strongly disputes the merits of the claims asserted against it in each of these lawsuits and intends to vigorously defend against them. At this moment, the Company is unable to make a reasonable estimate of the amount or range of loss that could result from an unfavorable outcome in these matters and consequently has not recorded a contingent liability as of June 30, 2011 with regard to this lawsuit.

NOTE 14 ─ SUBSEQUENT EVENTS

The Company evaluated all events or transactions that occurred after June 30, 2011 up through the date the Company issued these financial statements. During this period the Company did not have any material recognizable subsequent events.

 
21

 

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

Forward-Looking Statements

This Quarterly Report contains forward-looking statements.  The words “anticipated,” “believe,” “expect, “plan,” “intend,” “seek,” “estimate,” “project,” “could,” “may,” and similar expressions are intended to identify forward-looking statements.  These statements include, among others, information regarding future operations, future capital expenditures, and future net cash flow.  Such statements reflect our management’s current views with respect to future events and financial performance and involve risks and uncertainties, including, without limitation, our ability to maintain and increase revenues and sales of our products; our ability to develop and market new products; our reliance on access to the China Unicom wireless network for providing our GPS services; competitive nature of our industry; market acceptance of our products; our reliance on intellectual property, compliance and changes in the laws of the PRC that affect our operations; vulnerability of our business to general economic downturn, especially in the PRC; and various other matters, many of which are beyond our control.

Should one or more of these risks or uncertainties occur, or should underlying assumptions prove to be incorrect, actual results may vary materially and adversely from those anticipated, believed, estimated or otherwise indicated.  Consequently, all of the forward-looking statements made in this Quarterly Report are qualified by these cautionary statements and there can be no assurance of the actual results or developments.

The reader should carefully consider, together with the other matters referred to herein, the information contained under the caption "Risk Factors" in this Quarterly Report and the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 4, 2011, as amended by Amendment No. 1 on Form 10-K/A filed on August 2, 2011, for a more detailed description of these significant risks and uncertainties.  We caution the reader, however, not to unduly rely on these forward-looking statements.

This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company’s financial statements and the related notes included in this report.

Corporate Information

The following discussion relates to the financial condition and results of operations of ZST Digital Networks, Inc. (the “Company”) and its wholly-owned subsidiary World Orient Universal Limited, a company organized under the laws of the British Virgin Islands (“World Orient”), its wholly-owned subsidiary, Global Asia Universal Limited, a company organized under the laws of the British Virgin Islands (“Global Asia”), its wholly-owned subsidiary Everfair Technologies, Ltd., a company organized under the laws of Hong Kong (“Everfair”), and its wholly-owned subsidiary Zhengzhou Shenyang Technology Company Limited, a company organized under the laws of the People’s Republic of China (“ZST PRC”).

We conduct our business principally through the operations of ZST PRC, which is based in Zhengzhou City of Henan Province where the Company’s headquarter is located.   ZST PRC was established in Zhengzhou under the laws of the People’s Republic of China (the “PRC”) on May 20, 1996.  After the share exchange and stock purchase transactions incurred in January 2009, ZST PRC became a foreign investment company in China with an operating life of 30 years since November 10, 2008.  The other three companies, our wholly-owned subsidiaries World Orient, Global Asia, and Everfair, have no operating activity.

Executive Summary of Operating Results for the Second Quarter of 2011

The following executive summary is intended to provide significant highlights of the discussion and analysis that follows.

 
·
Total revenue was $41.4 million, an increase of 25% compared to the second quarter of 2010.
 
·
Gross profit was $10.2 million, an increase of 24% compared to the second quarter of 2010.  Gross profit margin was 25%, which was the same for the second quarter of 2010.
 
·
Net income was $6.4 million, an increase of 22% compared to the second quarter of 2010.
 
·
Net income to revenue ratio for the second quarter of 2011 was 15%, which was the same for the second quarter 2010.
 
·
Basic and diluted earnings per share were both $0.55, an increase of $0.10 compared to 0.45 of basic and diluted earnings per share for the second quarter of 2010.

Overview

We are principally engaged in two lines of business: (1) to supply digital and optical network equipment to cable system operators in the Henan Province of China and (2) to provide GPS location and tracking devices and services in the Henan Province of China.

 
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Cable TV-Related Business

We offer a range of cable television devices and related networking products, including Internet protocol television (“IPTV”) set-top boxes, which integrate Internet, multi-media, and communication technologies. We also offer power supplies, remote controls, and other devices and accessories. Our product sales also include a line of fiber-optic receivers, which convert fiber-optic transmissions into digital RF signals that are amplified and distributed through an optical cable system, optical transmitters that are used in the transmission of cable system front optical fiber signal, and cable transmission amplifiers, which enhance the signal quality in cable networks.

We purchase the products specified by our customers from suppliers on a turnkey basis, which means that our suppliers deliver fully assembled and tested products based on our proprietary designs. The use of this model allows us to substantially focus our resources on determining customer requirements, design, development and support of the products we are selling. This model also allows us to significantly reduce capital requirements. We work closely with our suppliers to manage costs and delivery times, and we have not experienced material delays in the delivery of products we have ordered.

We also provide installation services for system equipment ordered by local broadcasting TV bureaus and cable network operators through a network of distributors and resellers in Henan Province. Our customer base covers more than 30 regional cities and counties. In addition, we offer security and monitoring services, including design, installation, and implementation of various devices, such as coding and decoding devices, digital cameras, and matrix exchanges. Our cable services include networking in buildings.

GPS-Related Business

Since the fourth quarter of 2009, we have been providing GPS location and tracking services to third parties, mainly logistics and transportation trucking companies. In March 2009, we entered into a network access right agreement with the Henan Subsidiary of China Unicom that allows us to use the China Unicom wireless network for providing GPS location and tracking services. One of our primary goals for the GPS line of business is to continuously gain and secure market share within the Henan Province.

We expect that in the foreseeable future, the source of revenue for our business will be from (1) selling network system equipment and set-top boxes to cable system operators and (2) providing GPS location and tracking devices and services to mainly logistics and transportation companies.   For Cable TV-related business, the broadcasting and TV bureau at the provincial level has announced that it is planning to redesign and enhance the entire network system in the entire Henan province, and we believe that there are opportunities for us to bid for these projects.  For GPS-related business, there are regulations from Chinese government departments that require certain types of commercial transport vehicles to be registered on GPS platforms for government monitor ing purposes.  Based on this, we believe that the market demand for GPS device and service will consequently increase. Our current goal for the GPS line of business is to continuously gain and secure market shares within Henan Province.

We expect that our business expenses will continue to increase as expenses associated with our efforts to expand sales, marketing, product development and general and administrative capabilities in all of our businesses, as well as expenses that we incur as a US publicly-traded company, including costs associated with financial reporting, information technology, complying with federal securities laws (including the Sarbanes-Oxley Act of 2002), tax administration and human resources-related functions.  While we are striving for business growth, we also intend to focus on measures to control operational costs.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations is based upon our financial statements which have been prepared in accordance with accounting principles generally accepted in the United States.  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities.  On an on-going basis, we evaluate our estimates including the allowance for doubtful accounts, the salability and recoverability of inventory, income taxes and contingencies.  We base our estimates on historical experience and on other assumptions that we believe to be reasonable under the circumstances, the results of which form our basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions.

We are unable to predict future laws and regulations that may have material effect on operations.  We assess the impact of significant changes in laws and regulations on a regular basis and update the assumptions and estimates used to prepare our financial statements when we deem it necessary.

 
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Revenue Recognition

We derive revenues principally from the sale of products related to Cable TV program distribution systems, which include digital Cable TV network equipment and IPTV set-top boxes; sale of GPS devices; provision of GPS devices installation service and GPS subscription service.

Revenue is recognized when the risk and rewards are transferred, delivery has occurred or the services have been rendered, persuasive evidence of any arrangement exists, the price to the buyer is fixed or determinable and collectability is reasonably assured.  These criteria as they apply to standalone sale of digital Cable TV network equipment, IPTV set-top boxes, and GPS devices, and the sale of GPS devices with installation service, and provision of technical services are as follows:

Sales of Digital Cable TV Network Equipment and GPS Devices

We recognize revenues from the sale of digital Cable TV network equipment and GPS devices when the price of products to be sold are predetermined, the risk and rewards of ownership and title to the products have been transferred to the buyer, which coincides with delivery and acceptance of the products by the buyer.  When certain equipment requires installment service, revenue is not recognized until customer acceptance has been obtained and/or the Company has no further significant obligations to customers.

Sales of IPTV Set-Top Boxes

We recognize revenues from the sale of IPTV set-top boxes when the price of products to be sold are predetermined, the risk and rewards of ownership and title to the products have been transferred to the buyer, which coincides with delivery and acceptance of the products by the buyer.

Pursuant to the terms of our IPTV set-top boxes sales contracts, we have allowed our customers to hold back 10% of the total contract price for one year after the delivery of products for warranty purposes. We recognize the total contract amount as revenue based on the following reasons: (i) the customer’s obligation to pay 10% of the total contract amount is not contingent on the resale of the product shipped; (ii) we do not have significant obligation for future performance to directly bring about resale of the products shipped other than replacement of defective products due to hardware defects in materials and workmanship which, in turn, will be borne by our supplier; (iii) the customer purchasing the products sold by us has economic substance apart from the products provided by us; and (iv) the amount of future returns can be reasonably estimated based on the historical return experience; however, we do not have any historical return experience.

Revenue from selling all products is recognized netting of value added tax imposed by Chinese government.

Multiple Deliverable

In October 2009, we started to sell GPS devices in conjunction with subscription and installation service.  We generally recognize revenue from the sale of the GPS device hardware with the bundled software that is essential to the functionality of the GPS device when there are no continuing obligations upon the completion of installation.  We sell the subscription services to customers with 12-month service contracts payable in full upon activation of the related unit or renewal of a previous service contract.  The subscription services are deferred and recognized over the life of the service contract upon activation.

In instances where we sell a GPS device unit along with subscription service and/or installation service, we recognize revenue related to the combined sale by allocating between the two or three deliverables using the relative selling price method determined by using the hierarchy of the following principles: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence of selling price (“TPE”), and (iii) best estimate of the selling price (“ESP”).

Sales of Services

Revenue is recognized when services are rendered.  The prepayments received for GPS subscription services are treated as deferred revenue which will be recognized over the terms of service contacts.

 
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Warranty Liabilities

We have a return policy where the customers must make a request within 30 days of receipt to return the products when the products delivered have more than 40% of defects or the products are not delivered on time.  We determine that warranty costs related to products sold are minimal in monetary terms based on its historical return experience.  In the event of defective product returns, we have the right to seek replacement of such returned units from its supplier.  Based on the purchase agreement, the supplier will replace the defective product when the defects are caused by hardware defects in materials and workmanship during manufacturing process for a period of one year.  Based on these facts, we record warranty cost as incurred.

Regarding warranty related to GPS devices, we have a policy that provides coverage on repairs of our GPS devices for a period of one year after date of purchase.  In the event when a repair is needed, the customers will be responsible for the cost of the parts while the cost of labor will be covered by us.  We estimate the costs to service our obligations based on historical experience and expectation of future conditions.  

Accounts Receivable

Accounts receivable are stated at the historical carrying amount, net of an allowance for doubtful accounts.  The allowance for doubtful accounts is our best estimate of the amount of probable credit losses in our existing accounts receivable.  We determine the allowance based on historical write-off experience, customer specific facts and economic conditions.  Provisions for doubtful accounts are charged to general and administrative expenses.

Outstanding account balances are reviewed individually for collectability.  Account balances are written off against the allowance after all means of collection have been exhausted and the potential for recovery is considered remote.  We have not provided a bad debt allowance as of June 30, 2011 and December 31, 2010.

Impairment of Long-Lived Assets

We review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable through the estimated undiscounted cash flows expected to result from the use and eventual disposition of the assets.  Whenever any such impairment exists, an impairment loss will be recognized for the amount by which the carrying value exceeds the fair value.

Income Taxes

We recognize deferred tax liabilities and assets when accounting for income taxes.  Deferred tax assets and liabilities are recognized for the future tax consequence attributable to the difference between the tax bases of assets and liabilities and their reported amounts in the financial statements.  Deferred tax assets and liabilities are measured using the enacted tax rate expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that included the enactment date.

ZST Digital Networks, Inc. was established under the laws of the State of Delaware and is subject to U.S. federal income tax and state franchise tax.  For U.S. income tax purposes no provision has been made for U.S. taxes on undistributed earnings of overseas subsidiaries with which we intend to continue to reinvest.  It is not practicable to estimate the amount of additional tax that might be payable on the overseas earnings if they were remitted as dividends, or lent to us, or if we should sell its stock in the subsidiaries.

 
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Results of Operations

Comparison of Three months Ended June 30, 2010 and 2011

Revenue

We are currently engaged in two main business lines: provision of Cable TV program distribution related equipment; and provision of GPS-related devices and related location and tracking services. Total revenue by business line is as follows:

   
Three Months Ended June 30
 
   
2010
   
2011
 
Cable TV related business:
           
Sales of cable TV equipments
  $ 27,038,184     $ 29,262,354  
GPS related business:
               
Sales of GPS-related devices
    4,527,837       8,776,593  
GPS related service
    1,480,122       3,371,718  
      6,007,959       12,148,311  
                 
Total revenue
  $ 33,046,143     $ 41,410,665  

Overall, our revenue was $41.4 million for the second quarter of 2011, representing an increase of $8.4 million, or a 25% increase, in comparison to $33.0 million for the second quarter of 2010.  GPS business line contributed significantly to the increase in sales revenue.  Revenue from sales of GPS-related devices and related service amounted to $12.1 million, representing an increase of $6.1 million, or a 102% increase, in comparison to $6.0 million for the comparable period in 2010.  Revenue from our Cable TV business line for the second quarter of 2011 amounted to $29.3 million, representing an increase of $2.2 million, or 8% increase, compared to $27.0 million for the comparable 2010 fiscal period.

Our Cable TV related business line and GPS related business line accounted for 71% and 29% of total sales revenue in the second quarter of 2011, while the ratios were 82% and 18% for the comparable 2010 fiscal period.  The increased proportion of GPS sales revenue reflected the rapid increase of our GPS related business.

Cable TV Related Equipment:

We sell two types of Cable TV related equipment: digital Cable TV network equipment and IPTV (Internet Protocol Television) set-top box.  Net revenue from these two product lines was as follows:

   
Three Months Ended June 30,
 
   
2010
   
2011
 
Sales Revenue from Cable TV products:
           
Sales of IPTV set-top boxes
  $ 14,275,906     $ 16,136,519  
Sales of cable TV network equipment
    12,762,278       13,125,835  
Total
  $ 27,038,184     $ 29,262,354  

Chinese governmental regulations encourage the continued integration of telecommunications networks, cable TV networks and the Internet in China.  Accordingly, many regional TV broadcast stations accelerated system-wide upgrade processes in order to conform to the government mandate of provincial-wide uniform networks.  As a result, we have achieved continuous increase in sales of cable TV related products which include IPTV set-top box and cable TV network equipment.

Sales of IPTV set-top boxes

Revenue from sales of IPTV set-top boxes was $16.1 million for the second quarter of 2011, an increase of $1.8 million, or a 13% increase, compared to $14.3 million for the second quarter in 2010;.  Total sales volume of IPTV set-top boxes in the second quarter of 2011 increased by 35% in quantity compared to the comparable period of 2010.

We currently have three types of IPTV set-top boxes: High Definition product, Standard Definition product, and Low Definition product.  The Low Definition product was recently launched in the first quarter of 2011, which has the lowest selling price compared to the other two types of product.  The selling prices of Standard Definition and High Definition product are 41% and 209% higher than the Low Definition product, respectively.  The Standard Definition product is the most popular type of IPTV set-top box and total sales of Standard Definition product accounted for 55% in quantity of total set-top box sales; but since High Definition product has the highest selling price, sales revenue from High Definition product accounted for 49% in amount of total revenue from sales of IPTV set-top boxes.

 
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Sales of cable TV network equipment

Sales of cable TV network equipment amounted to $13.1 million for the second quarter of 2011, representing an increase of $0.4 million, or a 3% increase, compared with $12.7 million for the same period of 2010.

GPS Products and Services:

We have engaged in the GPS related business since the fourth quarter of 2009, and this business has since experienced continuous growth.  Revenue from sales of GPS-related devices and GPS-related service amounted to $12.1 million for the second quarter of 2011, an increase of $6.1 million, or a 102% increase, compared with $6.0 million for the same period of 2010.

We currently provided standard GPS devices and functional GPS devices, in addition to supporting cameras and voice broadcasting devices. Overall revenue from sales of GPS-related devices amounted to $8.8 million for the second quarter of 2011, an increase of $4.2 million, or 94%, compared to $4.5 million for the same period of 2010.  During the second quarter of 2011, revenue from sales of our two types GPS devices was $5.6 million, an increase of $1.1 million, or 25%, compared with $4.5 million for the same period of 2010; the increase was attributable to a 36% increase in sales quantity, which was offset by 8% decrease in average price.  We received revenue of $3.2 million from sales of GPS supporting devices in the second quarter of 2011.

We sell GPS subscription service together with GPS-related device.  Our GPS subscription customers increased along with sales of GPS devices.  As of June 30, 2011, the number of GPS subscription customers we served increased by 283% compared with which of June 30, 2010.  Revenue from sales of GPS-related service was $3.4 million in the second quarter of 2011, an increase of $1.9 million, or 128%, compared to $1.5 million for the comparable period of the prior year.

Chinese governmental regulations have required commercial vehicles operators which operate certain types of commercial transport vehicles, including tour buses, minibuses and vehicles for the transport of hazardous materials, to register their vehicles on GPS platforms for government monitor purpose.  The regulations were recently emphasized by several government departments, and we believe that the implementation of the government regulations has increased demand in the commercial GPS service market. As a result, our revenue generated from sales of GPS products and services has experienced rapid growth.

Cost of Sales

Cost of sales was driven primarily by procurement costs, given that our products are purchased from suppliers on a turnkey basis.  Total cost of sales was $31.2 million in the second quarter of 2011, compared with $24.8 million during the same period in 2010, representing an increase of approximately $6.4 million, or a 26% increase, in cost of sales.  The 26% increase in cost of sales is in line with the increase in sales revenue.

Gross Margin

The overall gross margin for the second quarter of 2011 was 25%, same as the comparable period of 2010; while gross margin on sales of product and sales of service both decreased in the second quarter of 2011 compared to the same period of 2010.  Gross margin on sales of product was 19% in the second quarter of 2011, representing a decrease of 3%, compared to 22% for the second quarter of 2010; and gross margin on sales of service was 94%, representing a decrease of 3%, compared to 97% for the same period of the prior year.  The high-gross-margined GPS service led to a higher sales revenue proportion of 8% in the second quarter of 2011, compared to 4% in the same period of 2010; consequently, the overall gross margin remained unchanged when each of the two business segments’ gross margin was decreased.

Gross margin on sales of products decreased mainly due to significantly decreased gross margin on sales of Standard Definition IPTV set-top box.  Standard Definition IPTV set-top box was our most popular set-top box product and had much higher gross margin when it was newly launched in early 2010. In the beginning of 2011, we reset the design to add some new functions to the Standard Definition IPTV set-top box, which resulted in increased manufacturing cost, and our procurement cost increased accordingly.  Since we did not increase the selling price by the same proportion in order to retain our market share, the gross margin in sales of Standard Definition IPTV set-top box dropped substantially from 40% in the second quarter of 2010 to 19% in the same period of 2011.

 
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The decrease in gross margin on GPS service was mainly attributable to our commitment to pay subscription fees for our customers. When customers subscribed with the Company for GPS tracking and location service, they also subscribed with China Unicom for telecommunication service related to GPS tracking and location service.  The Company has committed to pay renewal subscription fees to China Unicom for its GPS service customers when the first year’s contract expired. During the second quarter of 2011, the subscription fee paid for our customers had an adverse impact of 5% on gross margin of GPS service.  The renewal subscription fee to be paid to China Unicom amounts to about 20% of the renewal subscription fee to be received from our customers; the commitment to pay subscription fee for customers would have greater impact on the Company’s gross margin level in future when the number of newly subscribed GPS customers decreases.

Selling Expense

Selling expense was $203,000 for the second quarter of 2011, representing an increase of $94,000 compared with $109,000 for the second quarter of 2010.  Selling expenses primarily include salaries, shipping costs, and after-sale service expenses.  Since our suppliers would cover most of the shipping costs, we have not incurred relatively high selling expense when our sales revenue increased substantially.

As a percentage to total revenue, selling expenses accounted for 0.5% and 0.3% for the second quarter of 2011 and 2010, respectively.

Research and Development Expense

Research and development expense was $167,000 for the second quarter of 2011, representing an increase of $72,000 compared with $95,000 for the same period of 2010.  The increase resulted from the continued focus on the commercial GPS tracking business as we continued to expand the overall scope of the segment.

As a percentage to total revenue, research and development expense accounted for 0.4% and 0.3% for the second quarter of 2011 and 2010, respectively.

General and Administrative Expense

General and administrative expense was $1.1 million for the second quarter of 2011, representing an increase of $0.3 million, or a 28% increase, compared with $0.8 million for the same period of 2010.  General and administrative expense consists mainly of salary expense, stock-based compensation, consulting service fee, legal service fee, audit related service fee and other office expenses.  The increase in general and administrative expense was primarily due to increase in salary expenses and stock-based compensation.

As a percentage to total revenue, general and administrative expense accounted for 2.6% and 2.5% for the second quarter of 2011 and 2010, respectively.

Interest Income

Interest income was $46,000 for the second quarter of 2011, representing an increase of $15,000 compared with $31,000 for the second quarter of 2010.  Increase in interest income was due to increase in cash balances.

Income Tax Provision

Income tax provision for the second quarter of 2011 was $2.5 million, an increase of $0.5 million compared with $2.0 million for the second quarter of 2010.  The increase of income tax provision was the result of increase in income before tax, primarily driven by increase in taxable income.

The effective income tax rate was both 28% for the second quarter of 2011 and 2010.  The effective income tax rate was mainly impacted by valuation allowance for operating deficit generated in non-China entities.

As a percentage to total revenue, income tax provision accounted for 6.0% and 6.2% for the second quarter of 2011 and 2010, respectively.

Net Income

Net income was approximately $6.4 million for the second quarter of 2011, an increase of $1.2 million, or 22%, compared with $5.2 million for the second quarter of 2010.

Earnings per Share

Basic earnings per share were $0.55 for the second quarter of 2011, an increase of $0.10 compared with $0.45 for the second quarter of 2010.

 
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Comparison of Six months Ended June 30, 2010 and 2011

Revenue

We are currently engaged in two main business lines: provision of Cable TV program distribution related equipment and provision of GPS devices and related location and tracking services. Total revenue by business line is as follows:

   
Six Months Ended June 30
 
   
2010
   
2011
 
Cable TV related business:
           
Sales of cable TV equipments
  $ 41,313,276     $ 53,707,776  
GPS related business:
               
Sales of GPS-related devices
    6,680,648       15,618,184  
GPS related service
    2,100,497       5,887,931  
      8,781,145       21,506,115  
                 
Total revenue
  $ 50,094,421     $ 75,213,891  

Overall our revenue was $75.2 million for the six months of 2011, representing an increase of $25.1 million, or a 50% increase, in comparison with $50.1 million for the same period of 2010.  Both Cable TV related business line and GPS business line contributed to the significant increase in sales revenue. Revenue from Cable TV equipment sales for the first half year of 2011 amounted to $53.7 million, representing an increase of $12.4 million, or a 30% increase, compared to $41.3 million for the comparable 2010 fiscal period; and revenue from sales of GPS-related devices and related service amounted to $21.5 million, representing an increase of $12.7 million, or a 145% increase, in comparison to $8.8 million for the comparable period in 2010.

Our Cable TV related business line and GPS related business line accounted for 71% and 29% of total sales revenue in the first half year of 2011, respectively, while the ratios were 82% and 18% for the comparable 2010 fiscal period, respectively.  The change in sales mix represents rapid growth in the GPS related business compared to Cable TV related business.

Cable TV Related Equipment:

We sell two types of Cable TV related equipment: digital Cable TV network equipment and IPTV (Internet Protocol Television) set-top box.  Net revenue from these two product lines are as follows:

   
Six Months Ended June 30,
 
   
2010
   
2011
 
Sales Revenue from Cable TV products:
           
Sales of IPTV set-top box
  $ 21,466,467     $ 29,210,763  
Sales of cable TV network equipment
    19,846,809       24,497,013  
Total
  $ 41,313,276     $ 53,707,776  

Sales of IPTV set-top box

Revenue from sales of IPTV set-top boxes was $29.2 million, an increase of $7.7 million or 36% compared with $21.5 million for the same period in 2010.  With regard to the sales volume, the number of all IPTV set-top boxes sold in the first half year of 2011, volume increased by 66% compared to the number of all boxes sold for the comparable period of 2010.

We currently have three types of IPTV set-top box: High Definition product, Standard Definition product, and Low Definition product.  The Low Definition product was recently launched in the first quarter of 2011, which has the lowest selling price compared to the other two types of product.  The selling prices of Standard Definition and High Definition product are 41% and 209% higher than the Low Definition product, respectively.  The Standard Definition product is the most popular type of IPTV set-top box and total sales of Standard Definition product accounted for 52% in quantity of total set-top box sales; but since High Definition product has the highest selling price, sales revenue from High Definition product accounted for 49% in amount of total revenue from sales of IPTV set-top boxes.

 
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Sales of cable TV network equipment

Sales of cable TV network equipment amounted to $24.5 million for the first half year of 2011, representing an increase of $4.7 million or 23% compared with $19.8 million for the same period of 2010.

GPS Products and Services:

We have engaged in the GPS related business since the fourth quarter of 2009, and this business has since experienced continuous growth.  Revenue from sales of GPS-related devices and GPS-related service amounted to $21.5 million for the first half year of 2011, an increase of $12.7 million or 145% compared with $8.8 million for the same period of 2010.

We currently provided standard GPS devices and functional GPS devices, in addition to supporting devices of cameras and voice broadcasting. Overall revenue from sales of GPS-related devices amounted to $15.6 million for the first half year of 2011, an increase of $8.9 million, or 134%, compared to $6.7 million for the same period of 2010.  During the first half year of 2011, revenue from sales of our two types GPS devices was $9.9 million, an increase of $4.6 million, or 87%, compared with $5.3 million for the same period of 2010; the increase was attributable to a 71% increase in sales quantity, which was offset by 13% decrease in average price.  We generated revenue of $5.7 million from sales of GPS supporting devices in the first half year of 2011.

We sell our GPS subscription service together with GPS-related devices.  Our GPS subscription customers increased along with sales of GPS devices.  As of June 30, 2011, the number of GPS subscription customers we served increased by 283% compared with which of June 30, 2010. Revenue from sales of GPS related service was $5.9 million in the first half year of 2011, an increase of $3.8 million, or 180%, compared to $2.1 million for the comparable period of the prior year.

Chinese governmental regulations have required commercial vehicles operators which operate certain types of commercial transport vehicles, including tour buses, minibuses and vehicles for the transport of hazardous materials, to register their vehicles on GPS platforms for government monitor purpose. The regulations were recently emphasized by several government departments, and we believe that the implementation of the government regulations has increased demand in the commercial GPS service market. As a result, our revenue generated from sales of GPS products and services has experienced rapid growth.

Cost of Sales

Cost of sales was driven primarily by procurement costs, given that our products sold are purchased from suppliers on a turnkey basis.  Total cost of sales was $56.6 million in the first six months of 2011, compared to $37.7 million during the same period in 2010, representing an increase of approximately $18.9 million, or a 50% increase. The increase in cost of sales is due to the increase in sales revenue.

Gross Margin

The overall gross margin for the first half year of 2011 was 25%, the same as 25% for the comparable period of 2010; while gross margin on sales of product and sales of service both decreased in the first half year of 2011 compared with gross margin for the compared fiscal of 2010.  Gross margin on sales of product was 19% in the first half year of 2011, representing a decrease of 3%, compared to 22% for the comparable period in 2010; and gross margin on sales of service was 95%, representing a slight decrease of 1%, compared to 96% for the same period of prior year. The high-gross-margined GPS service increased to a higher sales proportion of 8% in the first half year of 2011, compared to 4% in the same period of 2010; consequently, the overall gross margin remained unchanged when gross margin of each of two business segments was decreased.

Gross margin on sales of product decreased mainly due to significantly decreased gross margin on sales of Standard Definition IPTV set-top box.  Standard Definition IPTV set-top box was our most popular set-top box product and had much higher gross margin when it was newly launched in early 2010. In the beginning of 2011, we reset the design to add some new functions to the Standard Definition IPTV set-top box, which resulted in increased manufacturing cost, and our procurement cost increased accordingly.  Since we did not increase the selling price by the same proportion in order to retain our market share, the gross margin in sales of Standard Definition IPTV set-top box dropped substantially from 40% in the first half year of 2010 to 19% in the same period of 2011.

The decrease in GPS service gross margin was mainly attributable to our commitment to pay subscription fees for our customers. When customers subscribed with the Company for GPS tracking and location service, they also subscribed with China Unicom for telecommunication service related to GPS tracking and location service.  The Company has committed to pay renewal subscription fees to China Unicom for its GPS service customers when the first year’s contract expired. During the first half year of 2011, the subscription fee paid for our customers had an adverse impact of 4% on gross margin of GPS service.  The renewal subscription fee to be paid to China Unicom amounts to about 20% of the renewal subscription fee to be received from our customers; the commitment to pay subscription fee for customers would have greater impact on the Company’s gross margin level in future when the number of newly subscribed GPS customers decreases.

 
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Selling Expense

Selling expense was $368,000 for the first half year of 2011, a slight decrease of $8,000 compared with $376,000 for the same period of 2010.  Selling expenses primarily include salaries, shipping costs, and after-sale service expenses.  Since our suppliers would cover most of the shipping costs, we have not incurred relatively high selling expense when our sales revenue increased substantially.

As a percentage to total revenue, selling expenses accounted for 0.5% and 0.8% for the first half year of 2011 and 2010, respectively.

Research and Development Expense

Research and development expense was $298,000 for the first half year of 2011, a slight decrease of $33,000 compared with $331,000 for the same period of 2010.  When our GPS business was newly launched, there was higher R&D expense on GPS related technology at the beginning of 2010.

As a percentage to total revenue, research and development expense accounted for 0.4% and 0.7% for the first half year of 2011 and 2010, respectively.

General and Administrative Expense

General and administrative expense was $2.0 million for the first half year of 2011, representing an increase of $0.4 million, or a 27% increase, compared with $1.6 million for the same period of 2010.  General and administrative expense consists mainly of salary expense, stock-based compensation, consulting service fee, legal service fee, audit related service fee and other office expenses.  The increase in general and administrative expense was primarily due to increase in salary expenses and stock-based compensation.

As a percentage to total revenue, general and administrative expense accounted for 2.6% and 3.1% for the first half year of 2011 and 2010, respectively.

Interest Income

Interest income was $71,000 for the first half year of 2011, representing an increase of $39,000 compared with $32,000 for the same period of 2010.  Increase in interest income was due to increase in cash balances.

Income Tax Provision

Income tax provision for the first half year of 2011 was $4.4 million, an increase of $1.4 million compared with $3.0 million for the first half year of 2010.  The increase of income tax provision was the result of increase in income before tax, primarily driven by increase in taxable income.

The effective income tax rate was 27% and 30% for the first half year of 2011 and 2010.  The effective income tax rate was mainly impacted by valuation allowance for operating deficit generated in non-China entities.

As a percentage to total revenue, income tax provision accounted for 5.9% and 6.0% for the first half year of 2011 and 2010, respectively.

Net Income

Net income was approximately $11.6 million for the first half year of 2011, an increase of $4.4 million, or 62%, compared with $7.2 million for the first half year of 2010.

Earnings per Share

Basic earnings per share were $1.0 for the first half year of 2011, an increase of $0.38 compared with $0.62 for the first half year of 2010.

 
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Liquidity and Capital Resources

As of June 30, 2011 and December 31, 2010, we had cash and cash equivalents of $50.2 million and $23.7 million, respectively.  Our working capital was approximately $74.1 million and $61.1 million, respectively, as of June 30, 2011 and December 31, 2010.  The increase in cash and cash equivalents was mainly contributed by operating activities.

Our operations were mainly financed by cash generated from operating activities. Except for budgeted investment of approximately $1 million on interior decoration of the newly acquired office building, we did not have other material capital investment commitments as of June 30, 2011. We believe that cash and cash equivalents are sufficient to meet our day-to-day operating requirements and capital expenditure at the current level of operating activities for at least the next 12 months.  In long term run, if our GPS related business expands much more sharply than anticipated, or if there are good business opportunities which may need substantial funds, we may need to seek external financing from banks or other sources; otherwise, our cash and cash equivalents would be sufficient for long term operating requirements and capital expenditures.

We have established and implemented corporate policies to manage our cash flows generated by our operating activities.  We have established strict credit policies to manage the credit we give to our customers, and we give different credit terms to different types of customers in different business lines.  For cable TV-related product sales, we typically provide 30 to 90-day credit terms; for GPS device sales, the credit terms we provide are much shorter, some customers were requested to pay in full before delivery, and all GPS subscription service fees were received on prepayment basis.  The credit terms are subject to negotiation if requested by our customers, but any adjustment must be approved by designated management.  In general, we will advance 20% of the total purchase order amount to our suppliers and pay in full within 30 days on receipts of products purchased.

For the six months ended June 30, 2011, net cash provided by operating activities was $25.5 million, which represented an increase of $21.9 million as compared to $3.6 million for the same period of the prior year.  Of the $21.9 million increase in cash provided by operating activities, increase in net income contributed $4.4 million, which was the result of increase in sales revenue; changes in accounts receivable balance contributed $9.6 million increase in cash, as we managed to reduce the accounts receivable balance when our sales revenue increased by 50%, which was mainly attributed to our increased efforts to collect on receivables from our cable TV customers; changes in advance to suppliers contributed $6.6 million in increase of cash, but this type of cash increase is only temporary since we have the policy of paying 20% of total purchase order amount in advance to our suppliers, and, as of June 30, 2011, the balance of advance to suppliers happen to be much lower than average level; and increased cash flows in operating activities.

Net cash used in investing activities was $0.4 million for the six months ended June 30, 2011, which was payment for acquisition of fixed assets.  In the period of 2010, we paid $1.7 million as advance payment for acquisition of office space; the interior decoration plan of this office building is currently under discussion and the decoration work is expected to start in this August 2011.

Net cash used in financing activities was $0.3 million for the six months ended June 30, 2011, which was payment for repurchase of the Company’s common stock. There was no financing cash flow during the same period of 2010.

Contractual Obligations

None.

Seasonality

Our business is not seasonal in nature.  The seasonal effect does not have material impact on our sales.

Off-Balance Sheet Arrangements

We have no material off-balance sheet transactions. 

 
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk

We may face some risk from potential fluctuations in interest rates, although our debt obligations are primarily short-term in nature, but some bank loans have variable rates. If interest rates have great fluctuations, our financing cost may be significantly affected.

Foreign Currency Risk

Substantially all of our operations are conducted in the PRC and our primary operational currency in Chinese Renminbi (“RMB”). As a result, currently the effect of the fluctuations of RMB exchange rates only has minimum impact on our business operations, but will be increasingly material if we introduce our products widely into new international markets. Substantially all of our revenues and expenses are denominated in RMB. However, we use the United States dollar for financial reporting purposes. Conversion of RMB into foreign currencies is regulated by the People’s Bank of China through a unified floating exchange rate system. Although the PRC government has stated its intention to support the value of the RMB, there can be no assurance that such exchange rate will not again become volatile or that the RMB will not devalue significantly against the U.S. dollar. Exchange rate fluctuations may adversely affect the value, in U.S. dollar terms, of our net assets and income derived from our operations in the PRC.

Country Risk

The substantial portion of our assets and operations are located and conducted in China. While the PRC economy has experienced significant growth in the past twenty years, growth has been uneven, both geographically and among various sectors of the economy. The Chinese government has implemented various measures to encourage economic growth and guide the allocation of resources. Some of these measures benefit the overall economy of China, but may also have a negative effect on us. For example, our operating results and financial condition may be adversely affected by government control over capital investments or changes in tax regulations applicable to us. If there are any changes in any policies by the Chinese government and our business is negatively affected as a result, then our financial results, including our ability to generate revenues and profits, will also be negatively affected.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures, which are designed to ensure that information required to be disclosed in the reports we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer, or CEO, and Chief Financial Officer, or CFO, as appropriate to allow timely decisions regarding required disclosure.

Based on an evaluation carried out as of the end of the period covered by this quarterly report, under the supervision and with the participation of our management, including our CEO and CFO, our CEO and CFO have concluded that, as of the end of such period, our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) were effective as of June 30, 2011.

Changes in Internal Control Over Financial Reporting

Based on the evaluation of our management as required by paragraph (d) of Rule 13a-15 or 15d-15 of the Exchange Act, there were no changes in our internal control over financial reporting during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 
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PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

The Company and several of its directors and officers have been named as defendants in a purported securities class action lawsuit filed in the U.S. District Court for the Central District of California.  The complaint was filed on April 25, 2011 and is captioned Robert Scott v. ZST Digital Networks, Inc., et al.  The complaint alleges that Company and the director and officer defendants made false and misleading statements and failed to disclose material facts about the Company’s business and prospects in violation of Federal securities laws.  Specifically, the complaint asserts claims under Sections 11, 12(a)(2), and 15 of the Securities Act of 1933, as amended, on behalf of all persons who purchased or otherwise acquired common stock of the Company pursuant or traceable to the registration statement and prospectus filed in connection with the Company's October 20, 2009 public offering, and claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended, on behalf of purchasers of the Company's common stock during the period October 20, 2009 to April 21, 2011.  The plaintiff has also asserted claims under Sections 11 and 12(a)(2) against the underwriters of the Company’s public offering, who are also named as defendants to the action.  The plaintiff seeks damages for the purported class.

Three lead plaintiff motions were filed in June 2011.  Because two of those lead plaintiff candidates subsequently withdrew their motions, there currently is only one lead plaintiff candidate motion pending.  After the Court appoints a lead plaintiff and sets a schedule for the filing of an amended complaint, if any, the Company expects to file a motion to dismiss all of the claims asserted in the complaint.

The Company intends to defend vigorously against each of the lawsuits. However, no assurance can be given that these matters will be resolved in the Company's favor.

ITEM 1A. RISK FACTORS

Any investment in our common stock involves a high degree of risk. Investors should carefully consider the risks described in our Annual Report on Form 10-K as filed with the SEC on March 4, 2011, as amended by Amendment No. 1 on Form 10-K/A filed on August 2, 2011, and all of the information contained in our public filings before deciding whether to purchase our common stock. Other than as set forth below, there have been no material revisions to the “Risk Factors” as set forth in our Annual Report on Form 10-K as filed with the SEC on March 4, 2011, as amended by Amendment No. 1 on Form 10-K/A filed on August 2, 2011.

Techniques employed by manipulative short sellers in Chinese small cap stocks may drive down the market price of our common stock.

Short selling is the practice of selling securities that the seller does not own but rather has, supposedly, borrowed from a third party with the intention of buying identical securities back at a later date to return to the lender. The short seller hopes to profit from a decline in the value of the securities between the sale of the borrowed securities and the purchase of the replacement shares, as the short seller expects to pay less in that purchase than it received in the sale. As it is therefore in the short seller’s best interests for the price of the stock to decline, many short sellers (sometime known as “disclosed shorts”) publish, or arrange for the publication of, negative opinions regarding the relevant issuer and its business prospects in order to create negative market momentum and generate profits for themselves after selling a stock short.

While traditionally these disclosed shorts were limited in their ability to access mainstream business media or to otherwise create negative market rumors, the rise of the Internet and technological advancements regarding document creation, videotaping and publication by weblog (“blogging”) have allowed many disclosed shorts to publicly attack a company’s credibility, strategy and veracity by means of so-called research reports that mimic the type of investment analysis performed by large Wall Street firm and independent research analysts. These short attacks have, in the past, led to selling of shares in the market, on occasion in large scale and broad base. Issuers with business operations based in China and that have limited trading volumes are susceptible to higher volatility levels than U.S. domestic large-cap stocks, and can be particularly vulnerable to such short attacks.

These short seller publications are not regulated by any governmental, self-regulatory organization or other official authority in the U.S., are not subject to the certification requirements imposed by the Securities and Exchange Commission in Regulation AC (Regulation Analyst Certification) and, accordingly, the opinions they express may be based on distortions of actual facts or, in some cases, fabrications of facts. In light of the limited risks involved in publishing such information, and the significant profit that can be made from publishing a successful short attack, unless the short sellers become subject to significant penalties, it is more likely than not that disclosed shorts will continue to issue such reports.

 
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We believe that we have been subject to such short attacks, and while we intend to strongly defend our public filings against any such short seller attacks, oftentimes we are constrained, either by principles of freedom of speech, applicable state law (often called “Anti-SLAPP statutes”), or issues of commercial confidentiality, in the manner in which we can proceed against the relevant short seller. You should be aware that in light of the relative freedom to operate that such persons enjoy, should we be targeted again for such an attack, our stock will likely suffer from a temporary, or possibly long term, decline in market price should the rumors created not be dismissed by market participants.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Stock Repurchase by Issuer

In August 2010, our Board of Directors authorized us to repurchase outstanding shares of our common stock in an amount not to exceed $1 million in open market purchases, with block trades being permitted, from time to time in the discretion of our management and as market conditions allow. During the fourth quarter of 2010 and first quarter of 2011, we repurchased 24,900 shares of common stock at an average price per share of $7.97 and 15,900 shares of common stock at an average price per share of $6.18, respectively.

The following table provides information relating to the Company’s repurchases of common stock during the quarter ended June 30, 2011.

Period
 
Total Number
of Shares
Purchased
   
Average
Price Paid
Per Share
   
Total Number
of Shares Purchased
as Part of Publicly
Announced
Program
   
Approximate Dollar
Value of Shares
that May Yet Be
Purchased Under
the Program
 
April 1 to April 30, 2011
    -     $ -       -     $ 703,376  
May 1 to May 31, 2011
    -       -       -       703,376  
June 1 to June 30, 2011
    78,844       2.50       78,844       506,535  
Total
    78,844       2.50       78,844       506,535  

ITEM 3. DEFAULT UPON SENIOR SECURITIES

None.

ITEM 4. (REMOVED AND RESERVED)

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS

Exhibit
Number
Description of Document
   
31.1
Certification of Chief Executive Officer Pursuant to Item 601(b)(31) of Regulation S-K, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
   
31.2
Certification of Chief Financial Officer Pursuant to Item 601(b)(31) of Regulation S-K, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
   
32.1
Certification of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*

*
This exhibit shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934 or otherwise subject to the liabilities of that section, nor shall it be deemed incorporated by reference in any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, whether made before or after the date hereof and irrespective of any general incorporation language in any filings.
 
 
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ZST DIGITAL NETWORKS, INC.

SIGNATURES

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

 
ZST DIGITAL NETWORKS, INC.
   
Date: August 10, 2011
By:
/s/ Zhong Bo
   
Zhong Bo
   
Chief Executive Officer and Chairman of the Board
     
     

 
Date: August 10, 2011
By:
/s/ Henry H. Ngan
   
Henry H. Ngan
Chief Financial Officer
 
 
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