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 March 31, 2011





OR





o
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 o





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 o 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 filero

Accelerated filer oNon-accelerated filero

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).   YesoNox


As of May 5, 2011, 11,759,642 shares of Common Stock, par value $0.0001 per share, were outstanding, which number includes 130,000 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 March 31, 2011





INDEX





Part I
Financial InformationItem 1.
Financial Statements

1Consolidated Balance Sheets

2Consolidated Statements of Income and Comprehensive Income

3Consolidated Statements of Cash Flows

4Notes to Consolidated Financial Statements

5Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations

19Item 3.
Quantitative and Qualitative Disclosures About Market Risk

27Item 4.
Controls and Procedures

27Part II
Other InformationItem 1.
Legal Proceedings

28Item 1A.
Risk Factors

28Item 2.
Unregistered Sale of Equity Securities and Use of Proceeds

29Item 3.
Default Upon Senior Securities

29Item 4.
(Removed and Reserved)

29Item 5.
Other Information

29Item 6.
Exhibits

29Signatures

30





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,


March 31,2010


2011(unaudited)ASSETSCurrent assets:Cash and cash equivalents

$
23,702,457


$
40,206,698Accounts receivable


33,490,510



21,251,487Inventories


221,093



282,773Advance to suppliers


7,270,379



7,714,607Prepaid expenses and other receivable


1,019,629



996,855Deferred tax assets


685,491



798,645Total current assets


66,389,559



71,251,065Property, machinery, equipment and software, net


10,544,051



10,688,490Intangible asset


166,288



152,343Total assets

$
77,099,898


$
82,091,898LIABILITIES AND STOCKHOLDERS’ EQUITYCurrent liabilities:Deferred revenue

$
2,741,964


$
3,194,579Accruals and other payables


263,073



161,827Accrued payroll and related expense


129,281



77,473VAT payable


669,682



306,200Franchise tax payable


170,000



-Income tax payable


1,289,974



689,787Total current liabilities


5,263,974



4,429,866Equity:Common stock $0.0001 par value, 100,000,000 shares authorized, 11,650,442 and 11,710,442 shares issued, and 11,625,542 and 11,624,642 shares outstanding


1,165



1,167Additional paid-in capital


30,729,182



30,842,458Treasury stock


(198,335
)


(296,624
)Appropriated earnings


5,817,035



5,817,035Retained earnings


33,358,364



38,588,357Translation adjustment


2,128,513



2,709,639Total equity


71,835,924



77,662,032Total liabilities and equity

$
77,099,898


$
82,091,898





See accompanying notes to financial statements


2





ZST DIGITAL NETWORKS, INC.


CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME


FOR THREE MONTHS ENDED MARCH 31, 2010 AND 2011


(In US Dollars)





Three Months Ended March 31,2010


2011(unaudited)


(unaudited)Revenues:Sales of products

$
16,427,903


$
31,287,014Sales of services


620,375



2,516,212Total revenue


17,048,278



33,803,226Cost of sales:Cost of products sold


12,824,789



25,356,333Cost of services


49,497



103,859Total cost of sales


12,874,286



25,460,192Gross profit


4,173,992



8,343,034Selling expense


267,305



165,497Research and development expenses


235,524



130,635General and administrative expenses


730,610



914,641Income from operations


2,940,553



7,132,261Interest income (expense), net


1,615



24,524Other income (loss)


-



(7,605
)Income before income taxes


2,942,168



7,149,180Income tax provision


972,513



1,919,187Net income

$
1,969,655


$
5,229,993Weighted average common shares outstanding – basic


11,650,442



11,627,743Earnings per share – basic


0.17



0.45Weighted average common shares outstanding – diluted


11,650,442



11,628,328Earnings per shares – diluted


0.17



0.45Comprehensive income:Net income


1,969,655



5,229,993Translation adjustment


50,032



581,126Comprehensive income

$
2,019,687


$
5,811,119





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)





Three Months Ended March 31,2010


2011(unaudited)


(unaudited)Cash flows from operating activities:Net income

$
1,969,655


$
5,229,993Adjustments to reconcile net income to net cash provided by operating activities:Depreciation and amortization


177,478



120,017Stock-based compensation


42,624



154,559Deferred tax assets


-



(113,154
)Changes in operating assets and liabilities:Accounts receivable


6,742,705



12,141,079Inventories


355,357



(61,211
)Advance to suppliers


(188,003
)


(441,198
)Prepayment and other assets


238,293



(17,956
)VAT payable


-



(366,371
)Accounts payable


(668,999
)


-Accruals and other payable


(34,144
)


(323,949
)Deferred revenue


183,416



455,991Taxes payable


(74,344
)


(604,968
)Net cash provided by operating activities


8,744,038



16,172,832Cash flows from investing activities:Additions to property, machinery, equipment and software


(1,640,318
)


(250,151
)Cash flows from financing activities:Repurchase of common stock


-



(98,289
)Effect of changes in foreign exchange rates


48,080



679,849Net increase in cash and cash equivalents


7,151,800



16,504,241Cash and cash equivalents, beginning of the period


13,627,992



23,702,457Cash and cash equivalents, end of the period

$
20,779,792


$
40,206,698Supplemental disclosures of cash flow information:Cash paid for income taxes

$
1,047,770


$
2,634,471





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 March 31, 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 months ended March 31, 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”).  VSOE generally exists only when the Company sells the deliverable separately and it is the price actually charged by the Company.





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. We did not incur warranty costs for the three months ended March 31, 2011 and 2010. Based on these facts, we record warranty cost as incurred.





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 March 31, 2011 and 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 yearsOffice equipment

5 yearsElectronic equipment

5 yearsVehicles

5 yearsSoftware

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 during the first quarter of 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.  The debit balance represents a credit against future collection of output VAT instead of a receivable.





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 $43,027,364 as of March 31, 2011.





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.  The securities issued and dilutive potential common shares as of March 31, 2011 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 stock option to purchase 25,000 and 12,500 shares of the Company’s common stock granted to Mr. John Chen, the predecessor CFO, on October 20, 2009 and 2010 with the exercise price at $8.00 per share and $6.72 per share respectively are anti-dilutive for computing earnings per share purpose.


3)
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.


4)
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.


5)
The 90,000 shares of restricted common stock granted to Mr. Henry Ngan on March 18, 2011 had dilution impact and the dilutive potential common shares were 4,005 shares for three months ended March 31, 2011.





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.


13


ZST DIGITAL NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE 3 ─ ACCOUNTS RECEIVABLES





The accounts receivables are as follows:





December 31,


March 31,2010


2011Accounts receivables

$
26,315,401


$
13,403,380Accounts receivables — 10% hold back


7,175,109



7,848,107$
33,490,510


$
21,251,487Provision


-



-Accounts receivable, net

$
33,490,510


$
21,251,487





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





December 31,


March 31,2010


20111-30 days

$
14,777,700


$
9,277,04031-60 days


8,992,436



3,654,41061-90 days


2,545,265



471,930$
26,315,401


$
13,403,380





Most of accounts receivables - 10% hold back, for which the customers held for one-year warranty purpose, are aged over 90 days.





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 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 March 31, 2011, advances of $7,714,607 represents advances made to three suppliers accounting for 39%, 27% and 34% 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.


14


ZST DIGITAL NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE 5 ─ INVENTORIES





The inventories are as follows:




December 31,


March 31,2010


2011Products for sale

$
221,093


$
282,773Less: Provisions


-



-Inventories, net

$
221,093


$
282,773





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,


March 31,2010


2011Machinery and equipment

$
92,409


$
99,012Electronic equipment


197,215



198,772Office equipment


48,168



48,548Vehicles


309,923



312,371Software


469,697



613,064Advance for building an employee leisure facility


248,485



264,191Advance for purchasing office spaces


9,540,909



9,616,236$
10,906,806


$
11,152,194Accumulated depreciation


(362,755
)


(463,704
)$
10,544,051


$
10,688,490





The depreciation and amortization for the first quarter of 2010 and 2011 were $168,242 and $ 100,181, 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 $7.9 million) for purchasing office space of 2,880 square meters in the same building; the building is still under construction and is expected to be available for use at the second quarter of 2011.  Total advances for the office spaces were $9,616,236 as of March 31, 2011.


15


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 $3,194,579 as of March 31, 2011 and $ 2,741,964 as of December 31, 2010.





NOTE 8 ─ COMMON STOCK TRANSACTIONS





The Company has two types of stock, common and preferred stocks.  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.





Common Stock Transactions in 2010





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 March 31, 2011, the Company repurchased 40,800 shares of its common stock at a cost of $296,624, which was recorded as treasury stock.





Common Stock Transactions in 2011





On January 1, 2011, the Company granted Mr. Zhong 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 $102,000 for the three months ended March 31, 2011 and there were 15,000 shares of common stock vested as of March 31, 2011.





On March 18, 2011, the Company entered into an employment agreement with 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 of $6,457 for the three months ended March 31, 2011 without any shares vested at March 31, 2011.   The first vesting of 7,500 shares of restricted common stock will take place on June 18, 2011.





The restricted stock have no purchase cost to the grantee.  Nonvested 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 are not exercisable until at least one year from the date of issuance.


16


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 three months ended March, 31, 2011, the Company recognized a stock compensation of $4,821.  None of the options were vested as of March 31, 2011.





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.  The 25,000 shares option was granted at an exercise price of $8.00 per share with a contractual life of five year expiring on October 20, 2014; the 12,500 shares option was granted at an exercise price of $6.72 per share and with a contractual live of five years expiring on October 20, 2015. The Company determined the fair value of the option to purchase 25,000 shares of common stock granted on October 20, 2009 was $172,863 using the Black-Scholes option-pricing model based on the following assumptions: risk-free interest rate of 0.39%, expected life is the contractual term of five years, expected volatility of 133% and zero expected dividends. The fair value of the options to purchase 12,500 shares of common stock granted on October 20, 2010 was $51,250 using the Black-Scholes option-pricing model based on the following assumptions: risk-free interest rate of 5%, expected life is the contractual term of five years, expected volatility of 73% and zero expected dividends.  The options to purchase 25,000 shares of common stock fully vested on October 20, 2010 and the fair value was fully amortized as of then.  The options to purchase 12,500 shares of common stock vested on March 18, 2011 when Mr. Chen’s employment was terminated by the Company, the unamortized fair value of $48,281 was fully amortized then.





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:





Three Months Ended March 31,2010


2011Numerator:Net income attributable to the Company

$
1,969,655


$
5,229,993Net income used in computing diluted earnings per share

$
1,969,655


$
5,229,993Denominator:Weighted average common shares outstanding – basic


11,650,442



11,627,743Effect of dilutive security:Restricted common stock granted on March 18, 2011


-



585Weighted average common share outstanding – diluted


11,650,442



11,628,328Basic earnings per share

$
0.17


$
0.45Diluted earnings per share

$
0.17


$
0.45




17




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.





Three Months Ended March 31,2010


2011Sales of Cable TV Equipment:Revenue

$
14,275,092


$
24,445,422Cost


11,133,978



19,753,098Gross profit


3,141,114



4,692,324Sales of GPS Devices:Revenue


2,152,811



6,841,591Cost


1,690,811



5,603,235Gross profit


462,000



1,238,356GPS Related Service:Revenue


620,375



2,516,213Cost


49,497



103,859Gross profit


570,878



2,412,354Total revenue


17,048,278



33,803,226Total cost


12,874,286



25,460,192Overall gross profit


4,173,992



8,343,034Expenses not allocated


1,231,824



1,193,854Income before income taxes

$
2,942,168


$
7,149,180





NOTE 13 ─ SUBSEQUENT EVENTS





The Company evaluated all events or transactions that occurred after March 31, 2011 up through the date the Company issued these financial statements. During this period the Company did not have any material recognizable subsequent events.




18





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




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, GENERAL ECONOMIC AND BUSINESS CONDITIONS, CHANGES IN FOREIGN, POLITICAL, SOCIAL, AND ECONOMIC CONDITIONS, REGULATORY INITIATIVES AND COMPLIANCE WITH GOVERNMENTAL REGULATIONS, THE ABILITY TO ACHIEVE FURTHER MARKET PENETRATION AND ADDITIONAL CUSTOMERS, 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 THE COMPANY’S MOST RECENT ANNUAL REPORT ON FORM 10-K FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON MARCH 4, 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.





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”).  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.





Overview





We conduct our business principally through the operations of ZST PRC, which is based in Zhengzhou City of Henan Province where our 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 Three Months ended March 31, 2011





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





·
Total revenue for the first quarter of 2011 was $33.8 million, an increase of 98% compared to the first quarter of 2010.


·
Gross profit for the first quarter of 2011 was $8.3 million, an increase of 100% compared to the first quarter 2010.  Gross profit margin for the first quarter 2011 was 25%, compared to 24% for the first quarter 2010.


·
Net income for the first quarter 2011 was $5.2 million, an increase of 166% compared to the first quarter of 2010.


·
Net income to revenue ratio for the first quarter of 2011 was 15%, compared to 12% for the first quarter 2010.


·
Basic and diluted earnings per share were both $0.45 for the first quarter of 2011, an increase of $0.28 compared with $ 0.17 for basic earnings and diluted earnings per share for the first quarter of 2010.




19




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 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 assembled products are delivered to our facilities for final system quality control testing against product specifications and product configuration, including software installation. 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.





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 services to mainly logistics and transportation companies.   There are 118 counties within Henan Province whereas we are currently serving only 33 counties.  Consequently, we believe there is opportunity for future growth.  In the future, we may expand our business activities beyond the border of Henan Province.  Since we believe that the broadcasting and TV bureau at the provincial level is planning to redesign and enhance the entire network system in the entire Henan province, opportunities to bid for these projects exist.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 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.





Recent Events





Employment Agreement with Chief Executive Officer





On December 13, 2010, the Company entered into an employment agreement with Mr. Zhong Bo, the Chief Executive Officer of the Company, effective as of January 1, 2011.  The initial term of the employment agreement will be 12 months, with automatic 12-month extensions unless either party provides 90 days written notice of termination prior to the expiration of a term. Pursuant to the employment agreement, Mr. Zhong will be entitled to an annual base salary of RMB 1,880,000 (equal to approximately US$282,000), subject to modification from time to time by written agreement between Mr. Zhong and the Company.  Payment of salary will be made on a quarterly basis, in advance of each quarter of work performed. Pursuant to the employment agreement, Mr. Zhong was also granted 60,000 shares of restricted common stock under the Company’s 2010 Omnibus Incentive Plan. The 60,000 shares of restricted common stock vest on monthly basis at 5,000 shares per month.


20


Employment Agreement with Chief Financial Officer





On March 18, 2011, the Company entered into an employment agreement with Mr. Henry H. Ngan regarding his employment by the Company as its new Chief Financial Officer.  Pursuant to the employment agreement, Mr. Ngan is entitled to an annual base salary of US$180,000.  The initial term of the employment agreement will be 24 months, with an automatic 12-month extension, unless either party provides 30 days written notice of termination prior to the expiration of a term.





In accordance with the terms of the employment agreement, Mr. Ngan was granted options on March 18, 2011 to purchase up to 90,000 shares of the common stock of the Company at an exercise price of $5.96 under the Company’s 2010 Omnibus Incentive Plan.  A total of 7,500 of the shares covered by the options will vest on each of the 12 quarterly anniversaries of the date of grant, subject to Mr. Ngan’s continued employment by the Company under the terms and conditions of the employment agreement through the respective quarterly anniversary.





In addition, pursuant to the employment agreement, Mr. Ngan was granted 90,000 restricted shares of common stock of the Company under the Company’s 2010 Omnibus Incentive Plan on March 18, 2011.  A total of 7,500 shares of the Restricted Stock Award will vest on each of the 12 quarterly anniversaries of the grant date, subject to Mr. Ngan’s continued employment by the Company under the terms and conditions of the employment agreement through the respective quarterly anniversary.





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.





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.




21




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”).  VSOE generally exists only when we sell the deliverable separately and it is the price actually charged by us.





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.





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.  We did not incur warranty costs for the three months ended March 31, 2011 and 2010. Based on these facts, we records warranty cost as incurred.





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 March 31, 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.




22


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.





Results of Operations





Comparison of Three months Ended March 31, 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:





Three Months Ended March 31,2010


2011Sales Revenue:Sales of cable TV equipment

$
14,275,092


$
24,445,422Sales of GPS devices


2,152,811



6,841,591Revenue from sales of goods


16,427,903



31,287,013Revenue from service:GPS related service


620,375



2,516,213Total revenue

$
17,048,278


$
33,803,226





Overall, our revenue was $33.8 million for the first quarter of 2011, representing an increase of $16.8 million or a 98% increase in comparison with $17.0 million for the first quarter of 2010.  Both Cable TV related business line and GPS business line contributed significantly to the significant increase in sales revenue.  Revenue from Cable TV equipment sales for the first quarter of 2011 increased by almost 71% compared to the comparable 2010 fiscal period; and revenue from sales of GPS devices and related service amounted to $9.4 million, representing an increase of $6.6 million or a 2.4 times increase in comparison to $2.8 million for the comparable period in 2010. GPS-related business contributed 39% of overall increase in sales revenue, and sales of Cable TV-related equipment contributed 61% to overall increase of sales revenue.





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 boxes.  Net revenue from these two product lines was as follows:





Three Months Ended March 31,2010


2011Sales Revenue from Cable TV products:Sales of IPTV set-top boxes

$
7,190,561


$
13,074,244Sales of cable TV network equipment


7,084,531



11,371,178Total

$
14,275,092


$
24,445,422





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 a significant increase in sales of cable TV related products which include IPTV set-top box and cable TV network equipment.




23




Sales of IPTV set-top boxes





Revenue from sales of IPTV set-top boxes was $13.1 million for the first quarter of 2011, an increase of $5.9 million or an 82% increase compared with $7.2 million for the first quarter in 2010.  Total sales volume of IPTV set-top box in the first quarter of 2011 increased by 131% 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 49% in quantity of IPTV set-top box sales; but since High Definition product has the highest selling price, sales revenue from High Definition product accounted for 50% in amount of total sales revenue.





Compared with the same period of 2010, sales of High Definition product increased by 31% in amount and 45% in quantity in the first quarter of 2011; while sales of Standard Definition product increased by 127% in amount and 113% in quantity, respectively.  The Low Definition product, which launched in the first quarter of 2011, contributed 22% in sales quantity and 12% in sales revenue for the first quarter of 2011.





Sales of cable TV network equipment





Sales of cable TV network equipment amounted to $11.4 million for the first quarter of 2011, an increase of $4.3 million or 61% compared with $7.1 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.  Revenue from sales of GPS devices and GPS-related service amounted to $9.4 million for the first quarter of 2011, an increase of $6.6 million or 2.4 times compared with $2.8 million for the same period of 2010.





In the first quarter of 2011, GPS operations contributed to 28% of the total sales revenue.  Revenue from sales of GPS devices was $6.9 million for the first quarter of 2011 while GPS related service fees contributed $2.5 million in revenues for the same period.  GPS related services include installation service and subscription service for tracking and location.





Chinese governmental regulations have required certain types of commercial vehicles operators include passenger transportation vehicle operators and dangerous cargo transportation vehicle operators, to register their vehicles on GPS platforms for government monitor purpose.  The regulations were recently emphasized by several government departments; the implementation of the government regulations would expand commercial GPS service market demand. We believe that, as a result, revenue generated from sales of our GPS products and services has increased.





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 $25.5 million in the first quarter of 2011, compared with $12.9 million during the same period in 2010, representing an increase of approximately $12.6 million or a 98% increase in cost of sales.  The 98% increase in cost of sales is due to the increase in sales revenue.





Gross Margin





Gross margin for the first quarter of 2011 was 25% compared with gross margin of 24% for the same period of 2010.





Gross margin in sales of products decreased from 22% to 19% compared the first quarter of 2011 as compared to the same period in 2010; the decrease in gross margin primarily attributable to a decreased gross margin in sales of Standard Definition IPTV set-top box.  Gross margin in sales of Standard Definition IPTV set-top box was much higher than other products when it was newly launched in 2010. We reset the design to add some new functions to Standard Definition IPTV set-top box in 2011, which resulted in increased manufacturing cost.  Since we did not increase 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.




24




Gross margin in provision of GPS related service increased from 92% to 96% in the first quarter of 2011 as compared to the same period in 2010, which offset the impact of decreased gross margin in sales of products and brought about a slight increase of 1% in overall gross margin.  Costs for providing GPS related services are mainly fixed, with the volume increased, gross margin increased accordingly.  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.  The commitment to pay subscription expenses for customers would reduce the Company’s gross margin level in GPS service business in future.





Selling Expense





Selling expense was $165,000 for the first quarter of 2011, representing a decrease of $102,000 compared with $267,000 for the first quarter of 2010.  The decrease in selling expenses was mainly due to decrease in promotion expenses. In the first quarter of 2010, we spent $176,000 in promotion activities for the newly launched GPS business, while we did not carry out much promotion activities in the first quarter of 2011.  Except for promotion expenses, other selling expenses, including salaries, shipping costs, and after-sale service expenses, increased by 79% for the first quarter of 2011 as compared to the same period 2010.





As a percentage to total revenue, selling expenses accounted for 0.5% and 1.6% for the first quarter of 2011 and 2010, respectively.





Research and Development Expense





Research and development expense was $131,000 for the first quarter of 2011, representing a decrease of $105,000 compared with $236,000 for the first quarter of 2010.  The decrease in research and development expenses was mainly due to decreased mold expenses.  The costs of GPS molds were fully expensed in the first quarter of 2010 while there were not much mold expenses in the first quarter of 2011.  Other research and development expenses include salaries and depreciations.





As a percentage to total revenue, research and development expense accounted for 0.4% and 1.4% for the first quarter of 2011 and 2010, respectively.





General and Administrative Expense





General and administrative expense was $915,000 for the first quarter of 2011, representing an increase of $184,000 or a 25% increase, compared with $731,000 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 an increase in legal service fees and stock-based compensation.  General and administrative expenses have generally increased primarily as a result of the Company becoming a publicly reporting company in the US.





As a percentage to total revenue, general and administrative expense accounted for 2.7% and 4.3% for the first quarter of 2011 and 2010, respectively.





Interest Income





Interest income was $25,000 for the first quarter of 2011, representing an increase of $23,000 compared with $2,000 for the first quarter of 2010.  Increase in interest income was due to increase in cash balances.





Income Tax Provision





Income tax provision for the first quarter of 2011 was $1.9 million, an increase of $946,000 or 97%, compared with $973,000 for the first quarter of 2010.  The increase of income tax provision was the result of the increase in income before tax, primarily driven by the increase in taxable income.





The effective income tax rate was 27% and 32% for the first quarter of 2011 and 2010, respectively.  The effective income tax rate was mainly impacted by valuation allowance for operating deficit generated in non-China entities, the impact of valuation allowance reduced in the first quarter of 2011 when operating profit from China based subsidiary increased significantly compared with 2010.





As a percentage to total revenue, income tax provision accounted for 6% for both the first quarter of 2011 and 2010, respectively.





Net Income





Net income was approximately $5.2 million for the first quarter of 2011, an increase of $3.2 million or 166%, compared with $2.0 million for the first quarter of 2010.




25




Earnings per Share





Basic earnings per share were $0.45 for the first quarter of 2011, an increase of $0.28 compared with $0.17 for the first quarter of 2010.  The increase in earnings per share was a result of an increase in net income.





Liquidity and Capital Resources





As of March 31, 2011 and December 31, 2010, we had cash and cash equivalents of $40.2 million and $23.7 million, respectively.  Our working capital was approximately $66.8 million and $61.1 million, respectively, as of March 31, 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. We did not have material capital investment commitments as of March 31, 2011. We believe that cash and cash equivalents are sufficient to meet our day-to-day operating requirements at the current level of operating activities.  We may need external financing to supplement operating cash flows if we would expand our GPS-related business significantly.





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 three months ended March 31, 2011, net cash provided by operating activities was $16.2 million, which represented an increase of $7.5 million as compared to the net cash provided by operating activities of $8.7 million for the same period of the prior year.  Of the $7.5 million increase in cash, net income contributed $3.3 million, decrease in accounts receivable contributed $5.4 million, and non-cash items and changes in other operating assets and liabilities offset the increase by $1.2 million.





The balance of accounts receivable was $21.3 million as of March 31, 2011, which represented a decrease of $12.2 million as compared balance of $33.5 million as of December 31, 2010. The decrease in accounts receivable was due to the decrease in sale revenue in the first quarter of 2011 compared with the fourth quarter of 2010.  Although our business is not seasonal in nature, the fourth quarter is always peak season and the business in first quarter is relatively low in recent years.





Net cash used in investing activities was $0.3 million for the three months ended March 31, 2011, which was payment for acquisition of fixed assets.  In the first quarter of 2010, we paid $1.6 million as advance payment for acquisition of the office space.





Net cash provided used in financing activities was $98,000 for the three months ended March 31, 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.




26




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 March 31, 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.





27


PART II.  OTHER INFORMATION





ITEM 1.  LEGAL PROCEEDINGS





We are not currently a party to any material legal proceedings.





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 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.





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.





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.




28




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, we repurchased a total of 24,900 shares of common stock at $7.97 per share.





The following table provides information relating to the Company’s repurchases of common stock during the quarter ended March 31, 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 ProgramJanuary 1 to January 31, 2011


-


$
-



-


$
801,665February 1 to February 28, 2011


-



-



-



801,665March 1 to March 31, 2011


15,900



6.18



15,900



703,376Total


15,900


$
6.18



15,900


$
703,376





ITEM 3.  DEFAULT UPON SENIOR SECURITIES





None.





ITEM 4.  (REMOVED AND RESERVED)





ITEM 5.  OTHER INFORMATION





None.





ITEM 6.  EXHIBITS





Exhibit

Number

Description of Document31.1

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.





29





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: May 10, 2011
By:
/s/ Zhong BoZhong BoChief Executive Officer and Chairman of the BoardDate: May 10, 2011
By:
/s/ Henry H. NganHenry H. Ngan

Chief Financial Officer





30