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EX-31.1 - EXHIBIT 31.1 - ZST Digital Networks, Inc.v235456_ex31-1.htm
EX-31.2 - EXHIBIT 31.2 - ZST Digital Networks, Inc.v235456_ex31-2.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-Q /A
Amendment No. 1
 
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
 
(I.R.S. Employer
incorporation or organization)
 
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.
 
 
 

 
 
EXPLANATORY NOTE

This Amendment No. 1 on Form 10-Q/A (this “Amendment”) amends information in the Quarterly Report on Form 10-Q filed by the ZST Digital Networks, Inc. (the "Company") with the Securities and Exchange Commission (the “SEC”) on August 11, 2011 (the “Original Filing”).  This Amendment only amends information in Part I, Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Part II, Item 1. Legal Proceedings.  Other than the foregoing, no other Items of the Original Filing are being amended.  As a result of this Amendment No. 1, the certifications pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 filed as exhibits to our Original Filing have been revised, as applicable to the disclosures that are amended by this Amendment, re-executed and re-filed as of the date of this Amendment.

This Amendment includes information contained in the Original Report, and, unless otherwise indicated, we have made no attempt in the Amendment to modify or update the disclosures presented in the Original Report.  The disclosures in this Amendment continue to speak as of the date of the Original Report, and do not reflect events occurring after the filing of the Original Report.  Accordingly, this Amendment should be read in conjunction with our other filings made with the SEC subsequent to the filing of the Original Report.  The filing of this Amendment shall not be deemed to be an admission that the Original Report, when made, included any untrue statement of a material fact or omitted to state a material fact necessary to make a statement not misleading.
 
 
 

 
 
ZST DIGITAL NETWORKS, INC.

FORM 10-Q/A

For the Quarterly Period Ended June 30, 2011

INDEX

Part I
Financial Information
     
           
 
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
    1  
             
Part II
Other Information
       
             
 
Item 1.
Legal Proceedings
    12  
             
 
Item 6.
Exhibits
    13  
             
Signatures
    14  
 
 
 

 
 
PART I.

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.
 
 
1

 
 
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.

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.
 
 
2

 
 
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.

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.
 
 
3

 
 
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.
 
 
4

 
 
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.
 
 
5

 
 
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. Our GPS service customers pay for the first year of service in advance.  For each year thereafter, our customers are typically required to pay us for service fees at least one month before the expiration of the service contract for the previous year.  Fee amounts for the second and subsequent years are typically set when we enter into sales and service contract with our customers in the first year.  When customers subscribe for our GPS tracking and location service, they also subscribe with China Unicom for telecommunication service related to our GPS tracking and location service.  For each year after the first year of the service contract, we are required to make a payment to China Unicom for every traffic card issued, where one traffic card is required per vehicle subscriber.  We are not required to make any such payment for the first year of the service contract.  The rate we currently pay China Unicom accounts for approximately 20% of service fee we receive from the subscriber. As a result, our gross margin for each continuing GPS service customer will decrease after the first year due to our required payment to China Unicom after the first year of each customer contract.  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.

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.
 
 
7

 
 
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.

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.
 
 
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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.

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.
 
 
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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. Our GPS service customers pay for the first year of service in advance.  For each year thereafter, our customers are typically required to pay us for service fees at least one month before the expiration of the service contract for the previous year.  Fee amounts for the second and subsequent years are typically set when we enter into sales and service contract with our customers in the first year.  When customers subscribe for our GPS tracking and location service, they also subscribe with China Unicom for telecommunication service related to our GPS tracking and location service.  For each year after the first year of the service contract, we are required to make a payment to China Unicom for every traffic card issued, where one traffic card is required per vehicle subscriber.  We are not required to make any such payment for the first year of the service contract.  The rate we currently pay China Unicom accounts for approximately 20% of service fee we receive from the subscriber. As a result, our gross margin for each continuing GPS service customer will decrease after the first year due to our required payment to China Unicom after the first year of each customer contract.  During the first half of 2011, the subscription fee paid for our customers had an adverse impact of 4% on gross margin of GPS service.
 
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.
 
 
10

 
 
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.

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.
 
 
11

 
 
Off-Balance Sheet Arrangements

We have no material off-balance sheet transactions.  

PART II.

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 the Company and certain of our current and former officers and directors violated Federal securities laws by making false and/or misleading statements and failing to disclose material adverse facts about the Company's business, operations, prospects, performance, and internal controls. Named in the complaint as individual defendants are Zhong Bo, our CEO and Chairman of the Board; Zhong Lin, our COO and a member of our Board; and John Chen and Zeng Yun Su, two former CFOs.

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 (the “Registration Statement”), 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. Specifically, the complaint alleges that the Registration Statement contained falsely stated revenue for fiscal 2008 and the first six months of fiscal 2009 and that the Company's Form 10-K for the fiscal year ended December 31, 2009 (“2009 Form 10-K") provided false revenue amounts for fiscal years 2008 and 2009. In support of its allegations, the complaint, inter alia, references an April 21, 2011 report published by an online financial news website entitled seekingalpha.com that reported that documents filed by the Company’s subsidiary Zhengzhou Shenyang Technology Company Limited with the SAIC (State Administration of Industry and Commerce) in the PRC reported revenue amounts for the applicable periods that were substantially lower than revenue reported in the Company's Registration Statement and 2009 Form 10-K.

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 complaint seeks compensatory damages, in an amount to be proven at trial including interest, reasonable litigation costs and expenses, rescission damages, and such further relief as the Court may deem proper.

On July 13, 2011, the Court entered an order appointing J. Malcolm Gray as lead plaintiff.  On August 22, 2011, the Court entered a scheduling order whereby lead plaintiff shall file an amended complaint, if any, by September 23, 2011 and the Company and the underwriters of the Company’s public offering shall answer or move to dismiss the amended complaint by November 4, 2011.  If the Company and/or the underwriters file motions to dismiss the amended complaint, lead plaintiff shall file his opposition to such motions by December 16, 2011 and the Company and/or the underwriters shall file their reply briefs in further support of their motions by January 17, 2012.

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.
 
 
12

 
 
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.
     
101.INS **
 
XBRL Instance Document
101.SCH**
 
XBRL Taxonomy Extension Schema Document
101.CAL**
 
XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF**
 
XBRL Taxonomy Extension Definitions Linkbase Document
101.LAB**
 
XBRL Taxonomy Extension Label Linkbase Document
101.PRE**
 
XBRL Taxonomy Extension Presentation Linkbase Document

*
Previously filed.
**
Previously filed.  Pursuant to SEC rules, these interactive data file exhibits shall not be deemed filed for purposes of Section 11 or 12 of the Securities Act or Section 18 of the Exchange Act or otherwise subject to the liability of those sections.
 
 
13

 
 
SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Amendment No. 1 on Form 10-Q/A to be signed on its behalf by the undersigned, thereunto duly authorized.

 
ZST DIGITAL NETWORKS, INC.
   
Date: September 22, 2011
By:
/s/  Zhong Bo
   
Zhong Bo
   
Chief Executive Officer and Chairman of the Board
     
     

Date: September 22, 2011
By:
/s/  Henry H. Ngan
   
Henry H. Ngan
Chief Financial Officer
 
 
14