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 September 30, 2010





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
      filerx
            
            Smaller
      reporting company o(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




The
number of shares outstanding of the registrant’s common stock, par value $0.0001
per share, was 11,650,442 as of November 3, 2010.








ZST
DIGITAL NETWORKS, INC.





FORM 10-Q





For
the Quarterly Period Ended September 30, 2010





INDEX





Part I
              Financial
      InformationItem
      1.
              Financial
      Statements
              
              3Consolidated
      Balance Sheets
              
              4Consolidated
      Statements of Income and Comprehensive Income
              
              5Consolidated
      Statements of Cash Flows
              
              6Notes
      to Consolidated Financial Statements
              
              7Item
      2.
              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
              
              27Item
      3.
              Quantitative
      and Qualitative Disclosures About Market Risk
              
              39Item
      4.
              Controls
      and Procedures
              
              39Part II
              Other
      InformationItem
      1.
              Legal
      Proceedings
              
              40Item
      1A.
              Risk
      Factors
              
              40Item
      2.
              Unregistered
      Sale of Equity Securities and Use of Proceeds
              
              40Item
      3.
              Default
      Upon Senior Securities
              
              40Item
      4.
              (Removed
      and Reserved)
              
              40Item
      5.
              Other
      Information
              
              40Item
      6.
              Exhibits
              
              41Signatures
              
              42


2


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/A for the year ended December 31, 2009 filed with
the Securities and Exchange Commission on May 18, 2010.





3


ZST
DIGITAL NETWORKS, INC.


CONSOLIDATED
BALANCE SHEETS


(In
US Dollars)





December 31,
                                      
                                      
                                      September 30,2009
                                      
                                      
                                      2010(Unaudited)
                                      
                                      
                                      (Unaudited)ASSETSCurrent
      assets:Cash
      and cash equivalents
                                      
                                      $
                                      13,627,992
                                      
                                      
                                      $
                                      34,206,283Accounts
      receivable
                                      
                                      
                                      24,885,497
                                      
                                      
                                      
                                      27,531,519Inventories
                                      
                                      
                                      1,245,803
                                      
                                      
                                      
                                      202,284Other
      receivables
                                      
                                      
                                      -
                                      
                                      
                                      
                                      5,718Advance
      to suppliers
                                      
                                      
                                      7,399,141
                                      
                                      
                                      
                                      -Prepaid
      expenses
                                      
                                      
                                      1,064,499
                                      
                                      
                                      
                                      979,614Total
      current assets
                                      
                                      
                                      48,222,932
                                      
                                      
                                      
                                      62,925,418Property,
      machinery, equipment and software, net
                                      
                                      
                                      875,806
                                      
                                      
                                      
                                      2,421,257Intangible
      asset
                                      
                                      
                                      171,122
                                      
                                      
                                      
                                      175,124Prepaid
      expenses – long term
                                      
                                      
                                      858,609
                                      
                                      
                                      
                                      87,841Total
      assets
                                      
                                      $
                                      50,128,469
                                      
                                      
                                      $
                                      65,609,640LIABILITIES
      AND STOCKHOLDERS’ EQUITYCurrent
      liabilities:Accounts
      payable
                                      
                                      $
                                      700,940
                                      
                                      
                                      $
                                      2,650Advance
      from customers
                                      
                                      
                                      376,586
                                      
                                      
                                      
                                      1,614,153Accruals
      and other payables
                                      
                                      
                                      295,410
                                      
                                      
                                      
                                      103,007Accrued
      payroll and related expense
                                      
                                      
                                      66,370
                                      
                                      
                                      
                                      84,364VAT
      payable
                                      
                                      
                                      198,828
                                      
                                      
                                      
                                      470,325Franchise
      tax payable
                                      
                                      
                                      162,100
                                      
                                      
                                      
                                      -Income
      tax payable
                                      
                                      
                                      547,917
                                      
                                      
                                      
                                      886,594Total
      current liabilities
                                      
                                      
                                      2,348,151
                                      
                                      
                                      
                                      3,161,093Equity:Common
      stock $0.0001 par value, 100,000,000 shares authorized, 11,650,442 and
      11,650,442 shares issued and outstanding
                                      
                                      
                                      1,165
                                      
                                      
                                      
                                      1,165Additional
      paid-in capital
                                      
                                      
                                      30,677,932
                                      
                                      
                                      
                                      30,677,932Appropriated
      earnings
                                      
                                      
                                      3,328,345
                                      
                                      
                                      
                                      3,328,345Retained
      earnings
                                      
                                      
                                      13,752,791
                                      
                                      
                                      
                                      27,336,095Translation
      adjustment
                                      
                                      
                                      20,085
                                      
                                      
                                      
                                      1,105,010Total
      equity
                                      
                                      
                                      47,780,318
                                      
                                      
                                      
                                      62,448,547Total
      liabilities and equity
                                      
                                      $
                                      50,128,469
                                      
                                      
                                      $
                                      65,609,640





See
accompanying notes to financial statements.


4





ZST
DIGITAL NETWORKS, INC.


CONSOLIDATED
STATEMENTS OF INCOME AND COMPREHENSIVE INCOME


FOR
NINE MONTHS ENDED SEPTEMBER 30, 2009 AND 2010


(In
US Dollars)


Nine Months Ended
                                      September 30,
                                    
                                    
                                    Three Months Ended
                                      September 30,2009
                                    
                                    
                                    2010
                                    
                                    
                                    2009
                                    
                                    
                                    2010(
      Unaudited)
                                    
                                    
                                    (Unaudited)
                                    
                                    
                                    (
      Unaudited)
                                    
                                    
                                    (Unaudited)Revenues:Sales
      of products
                                    
                                    $
                                    70,067,184
                                    
                                    
                                    $
                                    84,418,095
                                    
                                    
                                    $
                                    28,627,644
                                    
                                    
                                    $
                                    36,424,171Sales
      of services
                                    
                                    
                                    -
                                    
                                    
                                    
                                    4,195,309
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    2,094,812Total
      revenue
                                    
                                    
                                    70,067,184
                                    
                                    
                                    
                                    88,613,404
                                    
                                    
                                    
                                    28,627,644
                                    
                                    
                                    
                                    38,518,983Cost
      of sales:Cost
      of products sold
                                    
                                    
                                    58,773,620
                                    
                                    
                                    
                                    66,050,337
                                    
                                    
                                    
                                    23,823,013
                                    
                                    
                                    
                                    28,468,428Cost
      of service
                                    
                                    
                                    -
                                    
                                    
                                    
                                    118,796
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    27,156Cost
      of sales
                                    
                                    
                                    58,773,620
                                    
                                    
                                    
                                    66,169,133
                                    
                                    
                                    
                                    23,823,013
                                    
                                    
                                    
                                    28,495,584Gross
      profit
                                    
                                    
                                    11,293,564
                                    
                                    
                                    
                                    22,444,271
                                    
                                    
                                    
                                    4,804,631
                                    
                                    
                                    
                                    10,023,399Selling
      expense
                                    
                                    
                                    85,862
                                    
                                    
                                    
                                    563,474
                                    
                                    
                                    
                                    16,619
                                    
                                    
                                    
                                    187,195Research
      and development expenses
                                    
                                    
                                    109,068
                                    
                                    
                                    
                                    369,358
                                    
                                    
                                    
                                    109,068
                                    
                                    
                                    
                                    38,467General
      and administrative expenses
                                    
                                    
                                    702,167
                                    
                                    
                                    
                                    2,515,597
                                    
                                    
                                    
                                    224,929
                                    
                                    
                                    
                                    949,832Merger
      cost
                                    
                                    
                                    566,654
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Income
      from operations
                                    
                                    
                                    9,829,813
                                    
                                    
                                    
                                    18,995,842
                                    
                                    
                                    
                                    4,454,015
                                    
                                    
                                    
                                    8,847,905Interest
      income (expense), net
                                    
                                    
                                    (128,291
                                    )
                                    
                                    
                                    52,295
                                    
                                    
                                    
                                    (55,777
                                    )
                                    
                                    
                                    20,073Other
      income (expense)
                                    
                                    
                                    (7,682
                                    )
                                    
                                    
                                    34,858
                                    
                                    
                                    
                                    (2
                                    )
                                    
                                    
                                    32,457Income
      before income taxes
                                    
                                    
                                    9,693,840
                                    
                                    
                                    
                                    19,082,995
                                    
                                    
                                    
                                    4,398,236
                                    
                                    
                                    
                                    8,900,435Income
      tax provision
                                    
                                    
                                    2,593,724
                                    
                                    
                                    
                                    5,499,691
                                    
                                    
                                    
                                    1,106,409
                                    
                                    
                                    
                                    2,490,898Net
      income
                                    
                                    $
                                    7,100,116
                                    
                                    
                                    $
                                    13,583,304
                                    
                                    
                                    $
                                    3,291,827
                                    
                                    
                                    $
                                    6,409,537Weighted
      average common shares outstanding – basic
                                    
                                    
                                    8,089,414
                                    
                                    
                                    
                                    11,650,442
                                    
                                    
                                    
                                    8,354,826
                                    
                                    
                                    
                                    11,650,442Earnings
      per share – basic
                                    
                                    
                                    0.88
                                    
                                    
                                    
                                    1.17
                                    
                                    
                                    
                                    0.39
                                    
                                    
                                    
                                    0.55Weighted
      average common shares outstanding – diluted
                                    
                                    
                                    8,256,341
                                    
                                    
                                    
                                    11,650,442
                                    
                                    
                                    
                                    8,527,444
                                    
                                    
                                    
                                    11,650,442Earnings
      per shares – diluted
                                    
                                    
                                    0.86
                                    
                                    
                                    
                                    1.17
                                    
                                    
                                    
                                    0.39
                                    
                                    
                                    
                                    0.55Comprehensive
      income:Net
      income
                                    
                                    
                                    7,100,116
                                    
                                    
                                    
                                    13,583,304
                                    
                                    
                                    
                                    3,291,827
                                    
                                    
                                    
                                    6,409,537Translation
      adjustment
                                    
                                    
                                    (551,056
                                    )
                                    
                                    
                                    1,084,925
                                    
                                    
                                    
                                    87,602
                                    
                                    
                                    
                                    785,503Comprehensive
      income
                                    
                                    $
                                    6,549,060
                                    
                                    
                                    $
                                    14,668,229
                                    
                                    
                                    $
                                    3,379,429
                                    
                                    
                                    $
                                    7,195,040





See
accompanying notes to financial statements.


5





ZST
DIGITAL NETWORKS, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS


Increase
(Decrease) in Cash and Cash Equivalents


(In
US Dollars)





Nine Months Ended September 30,2009
                                
                                
                                2010(Unaudited)
                                
                                
                                (Unaudited)Cash
      flows from operating activities:Net
      income
                                
                                $
                                7,100,116
                                
                                
                                $
                                13,583,304Adjustments
      to reconcile net income to net cash provided by (used in) operating
      activities:
                                
                                
                                -
                                
                                
                                
                                -Depreciation
      and amortization
                                
                                
                                59,891
                                
                                
                                
                                256,282Imputed
      interest
                                
                                
                                31,413
                                
                                
                                
                                -Changes
      in operating assets and liabilities:
                                
                                
                                -
                                
                                
                                
                                -Accounts
      receivable
                                
                                
                                (13,312,163
                                )
                                
                                
                                (2,604,359
                                )Inventory
                                
                                
                                (719,414
                                )
                                
                                
                                1,022,278Advance
      to suppliers
                                
                                
                                (418,140
                                )
                                
                                
                                7,249,152Prepayments
      and other assets
                                
                                
                                (49,577
                                )
                                
                                
                                844,070Accounts
      payable
                                
                                
                                6,871,307
                                
                                
                                
                                (712,445
                                )Accruals
      and other payable
                                
                                
                                (123,746
                                )
                                
                                
                                (61,217
                                )Advance
      from customers
                                
                                
                                -
                                
                                
                                
                                1,261,952Taxes
      payable
                                
                                
                                434,388
                                
                                
                                
                                345,157Net
      cash provided by(used in) operating activities
                                
                                
                                (125,921
                                )
                                
                                
                                21,184,174Cash
      flows from investing activities:Additions
      to fixed assets
                                
                                
                                (755,458
                                )
                                
                                
                                (1,778,924
                                )Additions
      to intangible assets
                                
                                
                                (214,234
                                )
                                
                                
                                -Net
      cash used in investing activities
                                
                                
                                (969,692
                                )
                                
                                
                                (1,778,924
                                )Cash
      flows from financing activities:Repayments
      for short term bank loans
                                
                                
                                (2,476,720
                                )
                                
                                
                                -Net
      proceeds from sale of preferred stock
                                
                                
                                3,533,955
                                
                                
                                
                                -Net
      cash received from financing activities
                                
                                
                                1,057,235
                                
                                
                                
                                -Effect
      of changes in foreign exchange rates
                                
                                
                                297,882
                                
                                
                                
                                1,173,041Net
      increase in cash and cash equivalents
                                
                                
                                259,504
                                
                                
                                
                                20,578,291Cash
      and cash equivalents, beginning of the year
                                
                                
                                1,134,954
                                
                                
                                
                                13,627,992Cash
      and cash equivalents, end of the period
                                
                                $
                                1,394,458
                                
                                
                                $
                                34,206,283Supplemental
      disclosures of cash flow information:Cash
      paid for interest
                                
                                $
                                184,784
                                
                                
                                $
                                -Cash
      paid for income taxes
                                
                                
                                2,249,228
                                
                                
                                
                                5,247,337





See
accompanying notes to financial statements.


6


ZST
DIGITAL NETWORKS, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
1 – ORGANIZATION AND BUSINESS BACKGROUND




SRKP 18,
Inc. (“SRKP 18”) was incorporated in the State of Delaware on December 7,
2006.  SRKP 18 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
Shengyang Technology Co., Ltd. ( “ZST PRC”) was established on May 20, 1996 as a
private domestic corporation located in Zhengzhou City, Henan Province, People’s
Republic of China (“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 funds.  All
foreign investments made to Zhengzhou City enterprises require 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 September 30, 2010, the authorized capital
and invested capital of ZST PRC were RMB260 million and RMB147.8 million,
respectively.





ZST PRC
is principally engaged in two business lines: (1) supplying digital and optical
network equipment to cable system operators in the Henan Province of China and
(2) providing GPS location and tracking services in the Henan Province of
China.  ZST PRC derives a part of 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 are broadcasting TV
bureaus and cable network operators serving various cities and counties in Henan
Province.  In the near future, ZST PRC plans to joint venture with
cable network operators to provide bundled television programming, Internet and
telephone services to residential customers in cities and counties located in
Henan Province of China.  Since the fourth quarter of 2009, ZST PRC
began providing GPS location and tracking services to mainly local logistics and
transportation companies.  In March 2009, ZST PRC entered into a
network access right agreement with the Henan Subsidiary of China Unicom that
allows it to use the China Unicom wireless network for providing GPS location
and tracking services to ZST PRC’s customers.





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, the ZST Management (as defined below) 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 the ZST Management in exchange
for their equity interests in ZST PRC, (iii) established World Orient Universal
Limited (“World Orient”) as a BVI holding company owned by a non PRC-citizen and
indirectly controlled the operations of World Orient, (iv) had World Orient and
its wholly-owned subsidiary, Global Asia Universal Limited (“Global Asia”),
Global Asia’s wholly-owned subsidiary, Everfair, and Everfair’s wholly-owned
subsidiary, ZST PRC, enter into a share exchange agreement with SRKP 18, (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 the ZST Management pursuant to the equity transfer agreement.





World
Orient was incorporated in the 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.


7


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 an equity transfer agreement with the ZST
Management.  Pursuant to the equity transfer agreement, Everfair
agreed to pay the ZST Management 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 closed a share exchange transaction (the “Share
Exchange”) pursuant to which SRKP 18 (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. (“ZST Digital”) by which ZST Digital would be able to
make payment of RMB12 million to the ZST Management pursuant to the equity
transfer agreement.





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, 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.  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 and Mr. Zhong Bo was appointed as Chairman of the Board and Chief
Executive Officer of ZST Digital.  Hereafter, ZST Digital 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 (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 (the legal acquiree of ZST Digital)
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.


8


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
nine-month period ended September 30, 2010 are not necessarily indicative of the
results that may be expected for the year ending December 31, 2010.





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 dollar (“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 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:


9


ZST
DIGITAL NETWORKS, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
2 – SUMMARY OF ACCOUNTING POLICIES (Continued)





Revenue
Recognition (Continued)





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.





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 box sales contracts, the Company has
allowed its customers to hold back 10% of the 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 netting 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 ranging from 12 to 24 months, which are 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 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.


10


ZST
DIGITAL NETWORKS, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
2 – SUMMARY OF ACCOUNTING POLICIES (Continued)





Revenue
Recognition (Continued)





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.





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 its 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 related to GPS devices, the Company has a policy that provides coverage
on repairs of its 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
the Company.  The Company estimates the costs to service its
obligations based on historical experience and expectation of future
conditions.  The Company did not incur warranty costs for the
nine-month period ended September 30, 2010 and for the year ended December
31, 2009.  Based on these facts, the Company records 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 September 30, 2010 and December 31,
2009.


11


ZST
DIGITAL NETWORKS, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
2 – SUMMARY OF ACCOUNTING POLICIES (Continued)





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.





Advertising
Costs





Advertising
costs are expensed 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
                
                
                5
      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





In the
latter part of 2009, the Company purchased certain technical know-how related to
GPS business for $190,136.  The Company recorded the acquired know-how
as intangible asset and amortized the acquisition cost over five years using the
straight-line method.


12


ZST
DIGITAL NETWORKS, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
2 – SUMMARY OF ACCOUNTING POLICIES (Continued)





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.  Government subsidies in
supporting research and development activities received and recognized during
the nine months ended September 30, 2009 and 2010 were $0 and $14,747
respectively.





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.  The 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.


13


ZST
DIGITAL NETWORKS, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
2 – SUMMARY OF ACCOUNTING POLICIES (Continued)





Fair
Value of Financial Instruments (Continued)





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.





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 $15,466,577 at December 31, 2009 and $30,491,571 at September 30,
2010, respectively.


14


ZST
DIGITAL NETWORKS, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
2 – SUMMARY OF ACCOUNTING POLICIES (Continued)





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 a 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 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.





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 warrants to purchase
156,250 shares of the Company’s common stock issued to underwriters in
connection with the public offering conducted in October 2009 with the exercise
price at $10.00 per share are anti-dilutive for computing earnings per share
purpose.  The stock option to purchase 25,000 shares of the Company’s
common stock issued to a corporate officer with the exercise price at $8.00 per
share are anti-dilutive for computing earnings per share
purpose.


15


ZST
DIGITAL NETWORKS, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
2 – SUMMARY OF ACCOUNTING POLICIES (Continued)





Recently
Issued Accounting Pronouncements Adopted





FASB ASU
2009-05





Effective
January 1, 2010, the Company adopted Accounting Standards Update ("ASU")
No. 2009-05, "Measuring Liabilities at Fair Value," which amends the
guidance in ASC 820, Fair Value Measurements and Disclosures, to provide
guidance on fair value measurement of liabilities.  If a quoted price
in an active market is not available for an identical liability, ASU 2009-05
requires companies to compute fair value by using quoted prices for an identical
liability when traded as an asset, quoted prices for similar liabilities
when traded as an asset or another valuation technique that is consistent with
the guidance in ASC 820.  ASU 2009-05 will be effective for interim
and annual periods beginning after its issuance.  The adoption of ASU
2009-05 did not have any impact on the Company’s financial
statements.





FASB ASU
2009-13





In
October 2009, the FASB issued ASU No. 2009-13, “Revenue Recognition:
Multiple-Deliverable Revenue Arrangements” (ASU 2009-13).  This update
removes the criterion that entities must use objective and reliable evidence of
fair value in separately accounting for deliverables and provides entities with
a hierarchy of evidence that must be considered when allocating arrangement
consideration.  The new guidance also requires entities to allocate
arrangement consideration to the separate units of accounting based on the
deliverables’ relative selling price.  The Company has adopted ASU No.
2009-13 for the year ended December 31, 2009. The adoption of ASU No.
2009-13 did not have any impact on the Company’s financial
statements.





FASB ASU
2009-17





Effective
January 1, 2010, the Company adopted ASU No. 2009-17, “Consolidations (Topic
810) – Improvements to Financial Reporting by Enterprises Involved with Variable
Interest Entities,” which codifies FASB Statement No. 167, “Amendments to FASB
Interpretation No. 46(R).”  The ASU changes how a reporting entity
determines when an entity that is insufficiently capitalized or is not
controlled through voting (or similar rights) should be
consolidated.  The determination of whether a reporting entity is
required to consolidate another entity is based on, among other things, the
other entity’s purpose and design and the reporting entity’s ability to direct
the activities of the other entity that most significantly impact the other
entity’s economic performance.  The adoption of ASU 2009-05 did not
have any impact on the Company’s financial statements.





FASB ASU
2010-01





Effective
January 1, 2010, the Company adopted ASU No. 2010-01 ─ “Accounting for
Distributions to Shareholders with Components of Stock and Cash.”  The
amendments in this Update clarify that the stock portion of a distribution to
shareholders that allows them to elect to receive cash or stock with a potential
limitation on the total amount of cash that all shareholders can elect to
receive in the aggregate is considered a share issuance that is reflected in EPS
prospectively and is not a stock dividend for purposes of applying Topics 505
and 260 (Equity and Earnings Per Share).  The amendments in this
update are effective for interim and annual periods ending on or after December
15, 2009, and should be applied on a retrospective basis. The adoption of this
ASU did not have a material impact on its consolidated financial
statements.


16


ZST
DIGITAL NETWORKS, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
2 – SUMMARY OF ACCOUNTING POLICIES (Continued)





Recently
Issued Accounting Pronouncements Adopted (Continued)





FASB ASU
2010-02





Effective
January 1, 2010, the Company adopted ASU No. 2010-02 – “Accounting and Reporting
for Decreases in Ownership of a Subsidiary – a Scope
Clarification.”  The amendments in this Update affect accounting and
reporting by an entity that experiences a decrease in ownership in a subsidiary
that is a business or nonprofit activity.  The amendments also affect
accounting and reporting by an entity that exchanges a group of assets that
constitutes a business or nonprofit activity for an equity interest in another
entity.  The amendments in this update are effective beginning in the
period that an entity adopts SFAS No. 160, “Non-controlling Interests in
Consolidated Financial Statements – An Amendment of ARB No. 51.”  If
an entity has previously adopted SFAS No. 160 as of the date the amendments in
this update are included in the Accounting Standards Codification, the
amendments in this update are effective beginning in the first interim or annual
reporting period ending on or after December 15, 2009. The amendments in this
update should be applied retrospectively to the first period that an entity
adopted SFAS No. 160.  The adoption of this ASU did not have
a material impact on the Company’s consolidated financial
statements.





FASB ASU
2010-09





In
February 2010, FASB issued ASU No. 2010-9 –Amendments to Certain Recognition and
Disclosure Requirements.  This update addresses certain implementation
issues related to an entity’s requirement to perform and disclose
subsequent-events procedures, removes the requirement that public companies
disclose the date of their financial statements in both issued and revised
financial statements.  According to the FASB, the revised statements
include those that have been changed to correct an error or conform to a
retrospective application of U.S. GAAP.  The amendment is effective
immediately.  The adoption of this ASU did not have a
material impact on the Company’s consolidated financial
statements.


17


ZST
DIGITAL NETWORKS, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
2 – SUMMARY OF ACCOUNTING POLICIES (Continued)





Recently
Issued Accounting Pronouncements Not Yet Adopted





FSAB ASU
2010-06





In
January 2010, FASB issued ASU No. 2010-06 – Improving Disclosures about Fair
Value Measurements. This update provides amendments to Subtopic 820-10 that
requires new disclosure as follows:





(1)
Transfers in and out of Levels 1 and 2. A reporting entity should disclose
separately the amounts of significant transfers in and out of Level 1 and Level
2 fair value measurements and describe the reasons for the
transfers.


(2)
Activity in Level 3 fair value measurements.  In the reconciliation
for fair value measurements using significant unobservable inputs (Level 3), a
reporting entity should present separately information about purchases, sales,
issuances, and settlements (that is, on a gross basis rather than as one net
number).





This
update provides amendments to Subtopic 820-10 that clarifies existing
disclosures as follows:





(1) Level
of disaggregation. A reporting entity should provide fair value measurement
disclosures for each class of assets and liabilities.  A class is
often a subset of assets or liabilities within a line item in the statement of
financial position. A reporting entity needs to use judgment in determining the
appropriate classes of assets and liabilities.





(2)
Disclosures about inputs and valuation techniques.  A reporting entity
should provide disclosures about the valuation techniques and inputs used to
measure fair value for both recurring and nonrecurring fair value
measurements.





Those
disclosures are required for fair value measurements that fall in either Level 2
or Level 3.  The new disclosures and clarifications of existing
disclosures are effective for interim and annual reporting periods beginning
after December 15, 2009, except for the disclosures about purchases, sales,
issuances, and settlements in the roll forward of activity in Level 3 fair value
measurements. These disclosures are effective for fiscal years beginning after
December 15, 2010, and for interim periods within those fiscal years. The
Company is currently evaluating the impact of this ASU, however, the Company
does not expect the adoption of this ASU to have a material impact on its
consolidated financial statements.





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 and is not
expected to have a material impact on the Company’s consolidated financial
position or results of operations.





Reclassification





Certain
line items presented on the comparative financial information have been
reclassified to conform to the presentation of current financial
statements.


18


ZST
DIGITAL NETWORKS, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
3 – ACCOUNTS RECEIVABLES





The
accounts receivables are as follows:





December 31,
                        
                        
                        September 30,2009
                        
                        
                        2010(Unaudited)
                        
                        
                        (Unaudited)Accounts
      receivables
                        
                        $
                        18,982,676
                        
                        
                        $
                        21,602,336Accounts
      receivables ─ 10% hold back
                        
                        
                        5,902,821
                        
                        
                        
                        5,929,183$
                        24,885,497
                        
                        
                        $
                        27,531,519Provision
                        
                        
                        -
                        
                        
                        
                        -Accounts
      receivable, net
                        
                        $
                        24,885,497
                        
                        
                        $
                        27,531,519





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





December 31,
                      
                      
                      September 30,2009
                      
                      
                      2010(Unaudited)
                      
                      
                      (Unaudited)1-30
      days
                      
                      $
                      10,443,577
                      
                      
                      $
                      12,008,08931-60
      days
                      
                      
                      8,539,099
                      
                      
                      
                      9,594,247$
                      18,982,676
                      
                      
                      $
                      21,602,336





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.





For the
year ended December 31, 2009, advances of $7,399,141 represents advances mainly
made to two suppliers accounting for 55% and 45%, respectively.  As of
September 30, 2010, there were no prepayments made to suppliers due to the
Chinese National Holiday. Prepayments were made after the holiday ended on
October 7, 2010.


19


ZST
DIGITAL NETWORKS, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
5 – INVENTORIES





The
inventories are as follows:




December 31,
                      
                      
                      September 30,2009
                      
                      
                      2010(Unaudited)
                      
                      
                      (Unaudited)Products
      for sale
                      
                      $
                      1,245,803
                      
                      
                      
                      202,284Less:
      Provisions
                      
                      
                      -
                      
                      
                      
                      -Inventories,
      net
                      
                      $
                      1,245,803
                      
                      
                      $
                      202,284





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





NOTE
6 — MACHINERY, EQUIPMENT AND SOFTWARE





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





December 31,
                              
                              
                              September 30,2009
                              
                              
                              2010(Unaudited)
                              
                              
                              (Unaudited)Machinery
      and equipment
                              
                              $
                              89,203
                              
                              
                              $
                              91,159Electronic
      equipment
                              
                              
                              323,992
                              
                              
                              
                              186,782Office
      equipment
                              
                              
                              39,503
                              
                              
                              
                              40,370Vehicles
                              
                              
                              193,317
                              
                              
                              
                              317,688Software
                              
                              
                              453,402
                              
                              
                              
                              463,344Advance
      for purchasing office space
                              
                              
                              -
                              
                              
                              
                              1,663,553$
                              1,099,417
                              
                              
                              $
                              2,762,896Accumulated
      depreciation
                              
                              
                              (223,611
                              )
                              
                              
                              (341,639
                              )$
                              875,806
                              
                              
                              $
                              2,421,257





The
depreciation and amortization for nine months ended September 30, 2009 and 2010
were $59,891 and $256,282, respectively.





On March
12, 2010, the Company paid RMB11.13 million (approximately $1.7 million) for
purchasing an office space located in Zhengzhou City, Henan Province, PRC, which
is still under construction and will be available for use at the end of
2010.





NOTE
7 – EQUITY TRANSACTION





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


20


ZST
DIGITAL NETWORKS, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
7 – EQUITY TRANSACTION (Continued)





Common
Stock Transactions in 2009





On
January 9, 2009, SRKP 18. (“SRKP 18”) closed a share exchange transaction (the
“Share Exchange”) pursuant to which SRKP18 (i) issued 806,408
(post-reverse-split) shares of its common stock to acquire 100% equity ownership
of World Orient Universal Limited (“World Orient”), which is the 100% parent of
Global Asia Universal Limited (“Global Asia”), which is the 100% parent of
Everfair Technologies Limited (“Everfair”), which is the 100% parent of
Zhengzhou Shenyang Technology Company Limited (“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.





On
January 14, 2009, Zhong Bo, the Company’s Chief Executive Officer and Chairman
of the Board, Wu Dexiu, Huang Jiankang, Sun Hui and Li Yuting (the “ZST
Management”), each entered into a Common Stock Purchase Agreement pursuant to
which the Company issued and the ZST Management purchased an aggregate of
5,090,315 shares of the Company’s common stock at a per share purchase price of
$0.6907 (the “Purchase Right”).  On the balance sheet of ZST PRC at
December 31, 2008, there were shareholder loans payable of approximately RMB16
million (approximately US$2,334,400 at December 31, 2008).  In
accordance with the arrangement accepted by both ZST Management and the former
stockholders of SRKP 18, ZST Management converted the above outstanding
shareholder loans of RMB16 million into 2,929,097 shares of common stock to
partially complete the obligation under the Common Stock Purchase Agreement in
May 2009.  When the private placement closed in May 2009, Everfair
paid RMB12 million to ZST Management by using a portion of the proceeds from
this private placement to purchase 100% equity of ZST PRC. In turn, ZST
Management used the same RMB12 million to fulfill the remaining obligation to
purchase 2,161,218 shares of common stock under the Common Stock Purchase
Agreement.  For cash flow purposes, the above two transaction were
deemed as non-cash transactions.  For financial reporting purpose,
these 5,090,315 shares of common stock were deemed issued in the earliest period
of financial statements presented.





At
December 31, 2008, there were 7,096,390 shares of common stock outstanding and
warrants to purchase 7,096,390 shares of common stock with an exercise price of
$0.0001 per share outstanding.  In connection with the Purchase Right,
the former stockholders of SRPK18 agreed to cancel 4,156,390 shares of common
stock and warrants to purchase 6,676,390 shares of common stock, resulting in
2,940,000 shares of common stock and warrants to purchase 420,000 shares of
common stock issued and outstanding.  After the reverse-split,
1,194,350 shares of common stock and warrants to purchase 170,629 shares of
common stock with an exercise price of $0.0002462 per share were held by the
former stockholders of SRKP 18. The aforementioned warrants to purchase
170,629 shares of common stock were exercised via cashless exercise in the
fourth quarter of 2009 pursuant to the cashless exercise provision in the
warrant document.  As a result, the Company did not receive any cash
proceeds from issuing an aggregate of 170,616 shares of its common stock to the
warrant holders and the remaining warrants to purchase an aggregate 13 shares of
common stock were forfeited.




In
October 2009, the Company completed a public offering and sold 3,125,000 shares
of its common stock at $8.00 per share.  The shares of the Company’s
common stock were sold to the public for gross proceeds of approximately $25
million. Deducting all relevant issuing cost, the net proceeds from this
offering was $22,015,483.





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.


21


ZST
DIGITAL NETWORKS, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
7 – EQUITY TRANSACTIONS (Continued)





Common
Stock Transactions in 2010





No common
stock transactions occurred during the nine months ended September 30,
2010.





Preferred
Stock Transaction in 2009





On January 5, 2009, the Company filed a Certificate of
Designations, Preferences and Rights (the “Certificate”) whereby it designated
3,750,000 shares of its preferred stock, $0.0001 par value per share, as Series
A Convertible Preferred Stock.  Each share of Series A Convertible
Preferred Stock has a stated value of $3.94 with liquidation preference at (i)
100% stated value plus (ii) any accrued and unpaid dividends, other fees or
liquidated damages owing thereon.  Each share of Series A Convertible
Preferred Stock is convertible, at the option of the holder at any time and from
time to time after the original issue date of the Series A Convertible Preferred
Stock, into one share of common stock, at a conversion price equal to the per
share purchase price, subject to adjustment as more fully described in the
Certificate.  Each share of Series A Convertible Preferred Stock has
the right to one vote per share of common stock issuable upon conversion of the
shares of Series A Convertible Preferred Stock. In accordance with the
designation certificate document, each share of Series A Convertible Preferred
Stock will be subject to certain adjustments if certain events
happen.  If the closing price of the common stock of the Company for
each of any ten consecutive trading day period exceeds $8.62 (adjusted after the
reverse split) above the effective conversion price and on such date all of the
Equity Conditions (as defined in the Certificate) are met, the Company may,
within one trading day after the end of any such period, deliver a written
notice to all Series A Convertible Preferred Stock holders to cause each holder
to convert all or part of such Series A Convertible Preferred
Stock.





During
the period from January to May 2009, the Company conducted five closings of a
private placement transaction (the “Private Placement”).  As a result
of the Private Placement, the Company sold an aggregate of 1,263,723 shares of
Series A Convertible Preferred Stock at $3.94 per share for gross proceeds of
$4,976,953.  Deducting all relevant issuing cost, the net proceeds
from the Private Placement were $3,173,634.





In
accordance with the standard of “Beneficial Conversion Feature” codified within
ASC 470, the Series A Convertible Preferred Stock does not have an embedded
beneficial conversion feature (BCF) because the effective conversion price of
such shares equals the fair value of the Company’s common stock. The Company
determined that the fair value of the common stock at $3.94 per share based on
the fact that (1) the common stock is not readily tradable in an open market at
the time of issuance, and (2) the Company has recently sold the convertible
preferred stock that is convertible into common stock at 1:1 ratio for $3.94 per
share in a private placement, therefore the market price of the common stock is
$3.94 per share. However, if in the future the Company has a dilutive issuance
of securities, as defined in the Series A Convertible Preferred Stock
Certificate of Designation, the Company must recognize a beneficial conversion
if and when a reset of the conversion price occurs.





The
Company evaluated whether or not the Series A Convertible Preferred Stock
contained any embedded conversion features that meet the definition of
derivatives under the “Embedded Derivative” standard codified within ASC 815,
and related interpretations.  The standard states that an embedded
derivative instrument shall be separated from the host contract and accounted
for as a derivative instrument pursuant to the statement if and only if all the
following criteria are met:


22


ZST
DIGITAL NETWORKS, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
7 – EQUITY TRANSACTIONS (Continued)





Preferred
Stock Transaction in 2009 (Continued)





1.
            The
      economic characteristics and risks of the embedded derivative instrument
      are not clearly and closely related to the economic characteristic and the
      risks to the host contact. (Additional guidance on applying this criterion
      to various contracts containing embedded derivative instruments is
      included in Appendix A of this
statement.)


2.
            The
      contract that embodies both the embedded derivative instrument and the
      host contract are not measured at fair value under otherwise applicable
      generally accepted accounting principles with changes in fair value
      reported in earnings as they occur.


3.
            A
      separate instrument with the same terms as the embedded derivative
      instrument would, pursuant to subtopic 10 of the standard codified within
      ASC 815, be a derivative instrument subject to the requirements of this
      statement. However, this criterion is not met if the separate instrument
      with the same terms as the embedded derivative instrument would be
      classified as a liability (or an asset in some circumstance) under the
      provisions of the standard codified within ASC 480 but would be classified
      in stockholders’ equity absent the provisions in the standard codified
      within ASC 480.





The
Series A Convertible Preferred Stock has a fixed conversion provision of 1 share
of preferred stock for 1 share of common stock and is convertible at the option
of the holder and automatically upon the occurrence of certain
events.  Based upon the above requirement of subtopic 15 of ASC 815,
it is clear that any potential embedded derivatives in the Series A Convertible
Preferred Stock are clearly and closely related and do not require bifurcation
from the host.





The
Company evaluated whether or not the Series A Convertible Preferred Stock should
be classified as a liability or equity under the standard codified within ASC
480, “Accounting for Certain Financial Instruments with Characteristics of Both
Liabilities and Equity” and EITF Topic D-98 “Classification and Measurement of
Redeemable Securities.” The Company concluded that under EITF Topic D-98,
preferred securities that are redeemable for cash or other assets are to be
classified outside of permanent equity if they are redeemable (i) at a fixed or
determinable price on a fixed or determinable date, (ii) at the option of the
holder, or (iii) upon the occurrence of an event that is not solely within the
control of the issuer.  Accordingly, the Company classified the Series
A Convertible Preferred Stock as permanent equity since there was no deemed
liquidation events that require one or more class or type of equity security to
be redeemed.





All of
the 1,263,723 shares of Series A Convertible Preferred Stock issued during the
period from January to May of 2009 were converted into 1,263,723 shares of
common stock during the fourth quarter of 2009.





Preferred
Stock Transactions in 2010





No
preferred stock transactions occurred during the nine months ended September 30,
2010.


23


ZST
DIGITAL NETWORKS, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
8 – STOCK OPTIONS





On
October 8, 2009, the Company entered into an employment agreement with John
Chen, M.D., regarding his employment by the Company as its new Chief Financial
Officer (the “Employment Agreement”). Dr. Chen’s appointment as Chief Financial
Officer was effective upon the pricing date of the Company’s public offering,
which was on October 20, 2009 (the “Effective Date”).  Pursuant to the
Employment Agreement, Dr. Chen was granted options to purchase 25,000 shares of
the common stock of the Company at an exercise price of $8.00 per share and
exercisable until October 20, 2014. The options will be immediately exercisable
but, to the extent they are exercised, will be subject to a repurchase right of
the Company which will lapse as follows: 50% of the options and shares will vest
six (6) months after the Effective Date and the remaining 50% will vest twelve
(12) months after the Effective Date.





The
Company determined the fair value of the stock options granted was $172,863
using the Black-Scholes option-pricing model with risk-free interest rate of
0.39%, warrant life is the contractual term of five years, expected volatility
of 133% and zero expected dividends. The Company amortized the fair value of
stock options granted as compensation over a period of 12 months. Accordingly,
the share-based compensation was $129,292 for the nine months ended September
30, 2010.





NOTE
9 – EARNINGS PER SHARE





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





Nine Months Ended September 30,2009
                      
                      
                      2010(Unaudited)
                      
                      
                      (Unaudited)Numerator:Net
      income attributable to the Company
                      
                      $
                      7,100,116
                      
                      
                      $
                      13,583,304Net
      income used in computing diluted earnings per share
                      
                      $
                      7,100,116
                      
                      
                      $
                      13,583,304Denominator:Weighted
      average common shares outstanding – basic
                      
                      
                      8,089,414
                      
                      
                      
                      11,650,442Potential
      diluted shares from stock warrants granted
                      
                      
                      166,927
                      
                      
                      
                      -Weighted
      average common share outstanding – diluted
                      
                      
                      8,256,341
                      
                      
                      
                      11,650,442Basic
      earnings per share
                      
                      $
                      0.88
                      
                      
                      $
                      1.17Diluted
      earnings per share
                      
                      $
                      0.86
                      
                      
                      $
                      1.17





Three Months Ended September 30,2009
                      
                      
                      2010(Unaudited)
                      
                      
                      (Unaudited)Numerator:Net
      income attributable to the Company
                      
                      $
                      3,291,827
                      
                      
                      $
                      6,409,537Net
      income used in computing diluted earnings per share
                      
                      $
                      3,291,827
                      
                      
                      $
                      6,409,537Denominator:Weighted
      average common shares outstanding – basic
                      
                      
                      8,354,826
                      
                      
                      
                      11,650,442Potential
      diluted shares from stock warrants granted
                      
                      
                      172,618
                      
                      
                      
                      -Weighted
      average common share outstanding – diluted
                      
                      
                      8,527,444
                      
                      
                      
                      11,650,442Basic
      earnings per share
                      
                      $
                      0.39
                      
                      
                      $
                      0.55Diluted
      earnings per share
                      
                      $
                      0.39
                      
                      
                      $
                      0.55


24


ZST
DIGITAL NETWORKS, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
10 – SEGMENT REPORTING





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.





Nine Months Ended September 30,
                        
                        
                        Three Months Ended September 30,2009
                        
                        
                        2010
                        
                        
                        2009
                        
                        
                        2010(Unaudited)
                        
                        
                        (Unaudited)
                        
                        
                        (Unaudited)
                        
                        
                        (Unaudited)Sales
      of Cable TV Equipment:Revenue
                        
                        $
                        70,067,184
                        
                        
                        $
                        71,756,462
                        
                        
                        $
                        28,627,644
                        
                        
                        $
                        30,443,186Cost
                        
                        
                        58,773,620
                        
                        
                        
                        56,012,391
                        
                        
                        
                        23,823,013
                        
                        
                        
                        23,715,291Gross
      profit
                        
                        
                        11,293,564
                        
                        
                        
                        15,744,071
                        
                        
                        
                        4,804,631
                        
                        
                        
                        6,727,895Sales
      of GPS Devices:Revenue
                        
                        
                        -
                        
                        
                        
                        12,661,633
                        
                        
                        
                        -
                        
                        
                        
                        5,980,985Cost
                        
                        
                        -
                        
                        
                        
                        10,037,946
                        
                        
                        
                        -
                        
                        
                        
                        4,753,137Gross
      profit
                        
                        
                        -
                        
                        
                        
                        2,623,687
                        
                        
                        
                        -
                        
                        
                        
                        1,227,848GPS
      Related Service:Revenue
                        
                        
                        -
                        
                        
                        
                        4,195,309
                        
                        
                        
                        -
                        
                        
                        
                        2,094,812Cost
                        
                        
                        -
                        
                        
                        
                        118,796
                        
                        
                        
                        -
                        
                        
                        
                        27,156Gross
      profit
                        
                        
                        -
                        
                        
                        
                        4,076,513
                        
                        
                        
                        -
                        
                        
                        
                        2,067,656Total
      revenue
                        
                        
                        70,067,184
                        
                        
                        
                        88,613,404
                        
                        
                        
                        28,627,644
                        
                        
                        
                        38,518,983Total
      cost
                        
                        
                        58,773,620
                        
                        
                        
                        66,169,133
                        
                        
                        
                        23,823,013
                        
                        
                        
                        28,495,584Overall
      gross profit
                        
                        
                        11,293,564
                        
                        
                        
                        22,444,271
                        
                        
                        
                        4,804,631
                        
                        
                        
                        10,023,399Expenses
      (income) not allocated
                        
                        
                        1,599,724
                        
                        
                        
                        3,361,276
                        
                        
                        
                        406,395
                        
                        
                        
                        1,122,964Income
      before income taxes
                        
                        $
                        9,693,840
                        
                        
                        $
                        19,082,995
                        
                        
                        $
                        4,398,236
                        
                        
                        $
                        8,900,435





NOTE
11 – LONG TERM PREPAYMENTS





On
November 14, 2009 (the “Effective Date”), the Company entered into a Retention
Agreement with Mr. Zhong Lin, the Chief Operating Officer of the Company, a
member of Board of Directors of the Company, and son of Mr. Zhong Bo, CEO and
Chairman of the Board of Directors of the Company (the “Retention Agreement”).
Pursuant to the Retention Agreement, Mr. Zhong will receive a one-time retention
payment equal to $285,000 (the “Retention Amount”) if Mr. Zhong remains
continuously employed with the Company for a period of 24 months from the
Effective Date (the “Expiration Date”). The Company advanced the entire
Retention Amount upon the Effective Date, which will be earned ratably over a
period of 24 months. Upon the occurrence of certain termination events (the
“Disqualifying Termination Date”), Mr. Zhong will be required to return the
pro-rata amount of the Retention Amount based on a daily amortization rate of
$390.41 times the number of days remaining from the Disqualifying Termination
Date to the Expiration Date to the Company within 10 days of the Disqualifying
Termination Date. For the nine months ended September 30, 2010, the amortization
of this long-term prepayment was $106,875.


25


ZST
DIGITAL NETWORKS, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





NOTE
11 – LONG TERM PREPAYMENTS (Continued)





On
October 28, 2009, the Company entered into a Consulting Agreement (the
“Consulting Agreement”) with Finance Access, Inc. (“Finance
Access”).  In connection with the Consulting Agreement, the Company
also entered into professional services agreements with other third parties
(together with the Consulting Agreement, the “Services
Agreements”).  Pursuant to the Services Agreements, Finance Access and
the third parties agreed to provide the Company with certain professional and
business development services in order to aid and augment the Company’s business
development efforts.  The term of each of the Services Agreements is
24 months.  The Company paid an aggregate of $1.55 million as
compensation to Finance Access and the third parties, which will be amortized on
a quarterly basis over the twenty-four (24) month period at a daily rate of
$2,123.29. The amortization of this long-term prepayment was $581,250 for the
nine months ended September 30, 2010.





NOTE
12 – STOCK INCENTIVE PLAN





On August
23, 2010, at the Annual Meeting of Stockholders of the Company, the stockholders
approved the Company’s 2010 Omnibus Incentive Plan (the “Plan”).  The
Plan became effective on August 23, 2010 and will be administered by the
Compensation Committee of the Company's Board of Directors, with participation
and approval of the Board of Directors.  Awards under the Plan may
include incentive stock options, nonqualified stock options, stock appreciation
rights, restricted shares of common stock, restricted stock units, performance
share or unit awards, other stock-based awards and cash-based incentive
awards.  An aggregate of 500,000 shares of the Company's common stock
is reserved initially for issuance and available for awards under the
Plan.





NOTE
13 – SUBSEQUENT EVENTS





The
Company evaluated all events or transactions that occurred after September 30,
2010 up through the date the Company issued these financial statements. During
this period the Company did not have any material recognizable subsequent
events.


26







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




THIS
REPORT CONTAINS FORWARD-LOOKING STATEMENTS, INCLUDING STATEMENTS THAT INCLUDE
THE WORDS "BELIEVES," "EXPECTS," "ESTIMATES," "ANTICIPATES" OR SIMILAR
EXPRESSIONS.  SUCH FORWARD-LOOKING STATEMENTS INVOLVE KNOWN AND
UNKNOWN RISKS, UNCERTAINTIES AND OTHER FACTORS THAT MAY CAUSE OUR ACTUAL
RESULTS, PERFORMANCE OR ACHIEVEMENTS TO DIFFER MATERIALLY FROM THOSE EXPRESSED
OR IMPLIED BY SUCH FORWARD-LOOKING STATEMENTS.  RISK FACTORS INCLUDE,
BUT ARE NOT LIMITED TO, COSTS ASSOCIATED WITH FINANCING NEW PRODUCTS; OUR
ABILITY TO COST-EFFECTIVELY MANUFACTURE OUR PRODUCTS ON A COMMERCIAL SCALE; THE
CONCENTRATION OF OUR CURRENT CUSTOMER BASE; COMPETITION; OUR ABILITY TO COMPLY
WITH APPLICABLE REGULATORY REQUIREMENTS; POTENTIAL NEED FOR EXPANSION OF OUR
PRODUCTION FACILITY; THE POTENTIAL LOSS OF A STRATEGIC RELATIONSHIP; INABILITY
TO ATTRACT AND RETAIN KEY PERSONNEL; MANAGEMENT'S ABILITY TO EFFECTIVELY MANAGE
OUR GROWTH; DIFFICULTIES AND RESOURCE CONSTRAINTS IN DEVELOPING NEW PRODUCTS;
PROTECTION AND ENFORCEMENT OF OUR INTELLECTUAL PROPERTY AND INTELLECTUAL
PROPERTY DISPUTES; COMPLIANCE WITH ENVIRONMENTAL LAWS; CLIMATE UNCERTAINTY;
CURRENCY FLUCTUATIONS; CONTROL OF OUR MANAGEMENT AND AFFAIRS BY PRINCIPAL
STOCKHOLDERS.




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/A FILED WITH THE SECURITIES AND
EXCHANGE COMMISSION ON MAY 18, 2010 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.





Investment
in our common stock involves risk. You should carefully consider the investing
risks before deciding to invest. The market price of our common stock could
decline due to any of these risks, in which case you could lose all or part of
your investment. In assessing these risks, you should also refer to the other
information included in this report, including our consolidated financial
statements and the accompanying notes. You should pay particular attention to
the fact that we are a holding company with substantial operations in China and
are subject to legal and regulatory environments that in many respects differ
from that of the United States.  Our business, financial condition or
results of operations could be affected materially and adversely by any of the
risks discussed below and any others not foreseen. This discussion contains
forward-looking statements.





The
following discussion relates to the financial condition and results of
operations of ZST Digital Networks, Inc. (the “Company”) 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.





We
conduct our business principally through the operations of ZST PRC, which is
based in Zhengzhou City of Henan Province where the Company’s headquarters are
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.  As of September 30, 2010, ZST PRC had approximately 121
full-time employees.





The other
three wholly-owned subsidiaries of the Company, World Orient, Global Asia, and
Everfair, have no operating activity.


27




Executive
Summary of Financial Position and Operating Results





The
following executive summary is intended to provide significant highlights of the
discussion and analysis for the third quarter of 2010.





·
            Total
      revenue for the third quarter of 2010 was $38.5 million, an increase of
      35% compared to the third quarter of
2009.


·
            Gross
      profit for the third quarter of 2010 was $10.0 million, an increase of
      109% compared to the third quarter of 2009. Gross profit ratio for the
      third quarter of 2010 was 26% compared to 17% for the third quarter of
      2009.


·
            Net
      income for the third quarter of 2010 was $6.4 million, an increase of
      94.7% compared to the third quarter of
2009.


·
            Net
      income to revenue ratio for the third quarter of 2010 was 16.6% compared
      to 11.5% for the third quarter of
2009.


·
            Basic
      and diluted earnings per share were both $0.55 for the third quarter of
      2010, an increase of $0.16 compared to $0.39 for basic earnings and
      diluted earnings per share for the third quarter of
  2009.





Business
Summary





We are
principally engaged in two business lines: (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, and provide residential and
commercial customers with high definition digital multi-media service, as well a
choice of video programs offered by the network video providers on the broadband
IP network.  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 20
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 began providing GPS location and tracking services to
third parties, mainly automobile dealers. We plan to participate in the GPS
service provider business by establishing a partnership with China Unicom,
a wireless network provider.  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 to third parties.


28






We expect
that for the foreseeable future that the source of revenue for our business will
be from (1) selling network system equipment and set-top boxes to cable system
operators and residential users and (2) providing GPS location and tracking
services to mainly logistics and transportation companies.   There are
118 counties within Henan Province whereas we currently serve only 26
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 continue to gain and secure market shares within
Henan Province.





We expect
that our profitability will be adversely affected by the business 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





Retention
Agreement/Consulting and Personal Services Agreements





On
November 14, 2009 (the “Effective Date”), we entered into a Retention Agreement
with Zhong Lin, our Chief Operating Officer and a member of our board of
directors (the “Retention Agreement”).  Pursuant to the Retention
Agreement, Mr. Zhong will receive a one-time retention payment of $285,000 (the
“Retention Amount”) if he remains continuously employed for a period of 24
months from the Effective Date (the “Expiration Date”).  We advanced
the entire Retention Amount upon the Effective Date, which will be earned
ratably over a period of 24 months.  Upon the occurrence of certain
termination events (the “Disqualifying Termination Date”), Mr. Zhong will be
required to return the pro-rata amount of the Retention Amount based on a daily
amortization rate of $390.41 times the number of days remaining from the
Disqualifying Termination Date to the Expiration Date to us within 10 days of
the Disqualifying Termination Date.





On
December 30, 2009, we entered into a Consulting Agreement (the “Consulting
Agreement”) with Finance Access, Inc. (“Finance Access”).  In
connection with the Consulting Agreement, we also entered into professional
services agreements with other third parties (together with the Consulting
Agreement, the “Services Agreements”).  Pursuant to the Services
Agreement, Finance Access and the third parties agreed to provide us with
certain professional and business development services in order to aid and
augment our business development efforts.  The term of the Services
Agreement is 24 months.  We paid an aggregate of $1.55 million in
compensation to Finance Access and the third parties, which will be amortized on
a quarterly basis over the twenty-four (24) month period at a daily rate of
$2,123.29.





Stock
Incentive Plan





On August
23, 2010, at the Annual Meeting of Stockholders of the Company, the stockholders
approved the Company’s 2010 Omnibus Incentive Plan (the “Plan”).  The Plan
became effective on August 23, 2010 and will be administered by the Compensation
Committee of the Company's Board of Directors, with participation and approval
of the Board of Directors.  Awards under the Plan may include
incentive stock options, nonqualified stock options, stock appreciation rights,
restricted shares of common stock, restricted stock units, performance share or
unit awards, other stock-based awards and cash-based incentive
awards.  An aggregate of 500,000 shares of the Company's common stock
is reserved initially for issuance and available for awards under the
Plan.


29






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 stand-alone sale
of digital Cable TV network equipments, 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 Equipments and GPS Devices





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





Sales
of IPTV Set-Top Boxes





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





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





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





Multiple
Deliverables





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.


30






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 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 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 September 30, 2010 and for the year ended December
31, 2009.  Based on these facts, we record 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 September 30, 2010 and December 31, 2009.





Impairment
of Long-Lived Assets





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





Income
Taxes





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





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


31






Results
of Operations





Comparison
of Three Months Ended September 30, 2009 and 2010





Revenue





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





Three Months Ended September 30,2009
                      
                      
                      2010Sales
      revenue:Sales
      of cable TV equipment
                      
                      
                      28,627,644
                      
                      
                      
                      30,443,186Sales
      of GPS devices
                      
                      
                      -
                      
                      
                      
                      5,980,985Revenue
      from sales of goods
                      
                      
                      28,627,644
                      
                      
                      
                      36,424,171Revenue
      from service:GPS-related
      service
                      
                      
                      -
                      
                      
                      
                      2,094,812Total
      revenue
                      
                      
                      28,627,644
                      
                      
                      
                      38,518,983





Overall
our revenue was $38.5 million for the third quarter of 2010, representing an
increase of $9.9 million or a 34.6% increase in comparison to $28.6 million for
the third quarter of 2009.  The significant increase in revenue was
contributed mainly by GPS-related business, revenue from sales of GPS devices
and related service amounting to $8.1 million in the third quarter of 2010,
while we did not have GPS-related business revenue during the same period of the
prior year. GPS-related business contributed 28.2% of overall increase in sales
revenue. Sales of Cable TV-related equipment also increased in the third quarter
of 2010 and contributed 6.4% 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 are as follows:





Three Months Ended September 30,2009
                      
                      
                      2010Sales
      Revenue from Cable TV products:Sales
      of IPTV set-top boxes
                      
                      
                      13,625,522
                      
                      
                      
                      19,878,926Sales
      of cable TV network equipments
                      
                      
                      15,002,122
                      
                      
                      
                      10,564,260Total
                      
                      
                      28,627,644
                      
                      
                      
                      30,443,186





Sales of IPTV set-top
boxes





Revenue
from sales of IPTV set-top boxes was $19.9 million, an increase of $6.3 million
or 46% compared with $13.6 million for the same quarter in 2009.   We
sold only one type of High Definition IPTV set-top box in 2009; however, during
the first quarter of 2010, we launched the Standard Definition IPTV set-top box
line with a lower average selling price to capture additional market share in
rural cities and counties.





Sales
revenue from High Definition products was $14.0 million for the third quarter of
2010, which was nearly the same level as $13.6 million for the same period of
the prior year.  The sales volume of High Definition products
increased by 21.7% compared to the same period of 2009, while the average
selling price of High Definition IPTV set-top boxes decreased by approximately
15.6%, the increase in sales revenue brought by increased volumes was offset by
impact from decrease in selling prices, and total sales of High Definition
products slightly increased by $0.4 million.  Our High Definition IPTV
set-top boxes had higher selling prices when the products were first launched in
2009; in 2010, we adjusted the selling price to a lower price comparable with
market trends.





Sales
revenue from Standard Definition products was $5.9 million for the third quarter
of 2010.  Since there were no such sales in the same period of 2009,
sales of Standard Definition products in 2010 constituted a net increase in
sales of IPTV set-top boxes.  Though sales revenue from Standard
Definition products was much lower than sales from High Definition products, the
sales volume of Standard Definition products was a little higher than the sales
volume of High Definition products because the selling price of Standard
Definition products were much lower.


32






The
Chinese governmental regulation encouraged the continued integration of
telecommunications networks, Cable TV networks and the Internet in
2010.  As the terminal units of Cable TV networks, the demand for IPTV
set-top boxes increased during the integration process. As a result of this
integration process, we expanded our sales in both High Definition and Standard
Definition IPTV set-top boxes during the third quarter of 2010.





Sales of cable TV network
equipment





Sales of
cable TV network equipment amounted to $10.6 million for the third quarter of
2010, a decrease of $4.4 million or 29.3% compared to $15.0 million for the same
period of 2009.  The decrease in sales of cable TV network equipment during
the third quarter of 2010 compared to the same period of 2009 was primarily due
to the exceptional results from third quarter of 2009 as well as a continued
shift in resource allocation to the IPTV set-up box business unit.





GPS
Products:





We
entered into GPS-related business in the fourth quarter of 2009 whereas there
was no revenue from GPS operations in the third quarter of 2009.





Revenue
from sales of GPS devices and GPS-related service fees was $8.1 million for the
third quarter of 2010.  GPS related service fees amounted to $2.1
million, which include service fee from installation service and subscription
service for tracking and locating.





Cost
of Sales





Cost of
sales was driven primarily by procurement costs, given that the raw material for
our products is purchased from suppliers on a turnkey basis.  Total
cost of sales was $28.5 million in the third quarter of 2010, compared with
$23.8 million during the same period in 2009, representing an increase of
approximately $4.7 million or 19.7%.  The 19.7% increase in cost of
sales was lower than the 27.2% increase in sales revenue, which indicated an
increase in gross margin.  The primary driver for the increase in
gross profit margin was due to the fact that the recently launched GPS business
and Standard Definition IPTV set-top box sales had a higher gross margin than
both Cable TV network equipment and High-Definition IPTV set-top boxes sold
during the third quarter of 2009.





Gross
Margin





Gross
margin for the third quarter of 2010 was 26.0%, an increase of 9.2%, compared
with gross margin of 16.8% for the same period of 2009.  With the
exception of GPS-related services, which have a gross margin of 99%, the gross
margin for sales of products was 21.8% for the third quarter of 2010, which was
5% higher when compared to the same quarter in 2009.  As discussed
above, the primary driver for the increase in gross margin was secondary to the
recently launched GPS business and Standard Definition IPTV, which has a higher
gross margin than the traditional business that existed in the third quarter of
2009.





The
increase in gross margin on sales of products was driven mainly by sales of our
Standard Definition set-top boxes, which has a gross margin of 40% during the
third quarter of 2010.  Although the selling price of our Standard
Definition products was much lower than the selling price for our High
Definition products, the production costs of our Standard Definition products
were so much lower than the production costs of our High Definition products
that we were still able to earn a higher gross margin on these
products.  We did not have sales of Standard Definition set-top boxes
during the same period in 2009.  The gross margin in sales of GPS
device, which we launched in the fourth quarter of 2009, was 20.5% for the third
quarter of 2010, higher than the overall gross margin for the third quarter of
2009.  The gross margin of traditional products, cable TV network
equipment and High Definition IPTV set-top boxes, were 17.6% and 17.9%,
respectively, during the third quarter of 2010, representing a slight increase,
compared with 16.6% and 17.0% during the same period of 2009.





Selling
Expense





Selling
expense was $187,000 for the third quarter of 2010, representing an increase of
$170,000 compared with $17,000 for the third quarter of 2009.  Selling
expenses consist mainly of shipping costs, after-sale service, and salary of
sales staff.  Selling expenses in the third quarter of 2009 consist
mainly salary expenses.





Selling
expenses accounted for 0.5% and 0.06% of total revenue for the third quarter of
2010 and 2009, respectively.


33






Research
and Development Expense





Research
and development expense was $38,000 for the third quarter of 2010, a decrease of
$71,000 or 65.1%, compared to $109,000 in the same period of 2009. The
decrease in R&D expenses was primarily due to the higher initial resources
needed in preparation for the launch of our GPS business platform in the fourth
quarter of 2009.





As a
percentage to total revenue, research and development expense accounted for 0.1%
and 0.4% for the third quarter of 2010 and 2009, respectively.





General
and Administrative Expense





General
and administrative expense was $950,000 for the third quarter of 2010,
representing an increase of $725,000, or a 322% increase, compared with $225,000
for the same period of 2009.  General and administrative expense
consists mainly of salary expense, 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 the increase in salary expenses,
consulting service fees, legal fees, and other expenses relating to being a
publicly listed company.  We raised our employees’ salaries in October
2009, and on November 14, 2009, we entered into a 24-month Retention Agreement
with our Chief Operating Officer for a total retention bonus of $285,000, which
is amortized throughout the life of the agreement; as a result, the salary
expense for the third quarter of 2010 amounted to $341,000, compared to $58,000
during the third quarter of 2009.  The consulting fees were $197,000,
an increase of $197,000, compared with nil for the same period, mainly due to a
Consulting Agreement signed with Finance Access, Inc. and other third
parties.  On October 28, 2009, we entered into a Consulting Agreement
with Finance Access, Inc. and other third parties for a 24 months consulting
service at total consideration of $1.55 million; which was to be amortized
during the following 24 months with a quarterly amortization of approximate
$195,000.   Legal fees and other administrative expenses
increased primarily as a result of the Company becoming a publicly reported
entity.





As a
percentage to total revenue, general and administrative expense accounted for
2.5% and 0.8% for the third quarter of 2010 and 2009, respectively.





Interest
Income (Expense)





Interest
income was $20,000 for the third quarter of 2010, compared with net interest
expense of $56,000 for the third quarter of 2009.  We paid off all the
loans from the bank at the end of 2009 and no interest expense occurred in the
third quarter of 2010.





Income
Tax Provision





Income
tax provision for the third quarter of 2010 was $2.5 million, an increase of
$1.4 million or 125%, compared with $1.1 million for the third quarter of
2009.  The increase of income tax provision was the result of the
increase in income before tax, primarily driven by the increase in sales revenue
and increased gross margin.





As a
percentage to total revenue, income tax provision accounted for 6.5% and 3.9%
for the third quarter of 2010 and 2009, respectively.





Net
Income





Net
income was $6.4 million for the third quarter of 2010, an increase of $3.1
million or 94%, compared with $3.3 million for the third quarter of
2009.





Earnings
per Share





Basic
earnings per share were $0.55 for the third quarter of 2010, an increase of
$0.16 compared with $0.39 for the third quarter of 2009.  The increase
in earnings per share was a result of the increase in net income, which was
offset in part by the increase in basic weighted average shares outstanding,
which were 11,650,442 shares and 8,089,414 shares, respectively, for the third
quarter of 2010 and 2009.  Of the aforementioned 8,089,414 weighted
average shares outstanding, we included the equivalent 1,263,723 outstanding
shares from the outstanding shares of preferred stock.  The shares of
preferred stock had the same voting right and dividends rights as the shares of
common stock and the holders of these preferred shares have the right to convert
any time they want; therefore, these shares were deemed as the equivalent shares
of common stock for computing earnings per share purpose. All of the 1,263,723
shares of Series A Convertible Preferred Stock were converted into 1,263,723
shares of common stock during the fourth quarter of 2009.


34






Comparison
of Nine Months Ended September 30, 2009 and 2010





Revenue





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





Nine Months Ended September 30,2009
                      
                      
                      2010Sales
      Revenue:Sales
      of cable TV equipment
                      
                      
                      70,067,184
                      
                      
                      
                      71,756,462Sales
      of GPS devices
                      
                      
                      -
                      
                      
                      
                      12,661,633Revenue
      from sales of goods
                      
                      
                      70,067,184
                      
                      
                      
                      84,418,095Revenue
      from service:GPS-related
      service
                      
                      
                      -
                      
                      
                      
                      4,195,309Total
      revenue
                      
                      
                      70,067,184
                      
                      
                      
                      88,613,404





Overall
our revenue was $88.6 million for the nine months of 2010, representing an
increase of $18.5 million or a 26.4% increase in comparison with $70.1 million
for the same period of 2009.   The increase in revenue was contributed
mainly by our GPS line of business, which started in October 2009.  Revenue
from Cable TV-related equipment sales for the nine months increased
slightly by 2.4% compared to the same period of the prior
year.





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 are as follows:





Nine Months Ended September 30,2009
                      
                      
                      2010Sales
      Revenue from Cable TV products:Sales
      of IPTV set-top boxes
                      
                      
                      40,580,232
                      
                      
                      
                      41,345,393Sales
      of cable TV network equipment
                      
                      
                      29,486,952
                      
                      
                      
                      30,411,069Total
                      
                      
                      70,067,184
                      
                      
                      
                      71,756,462





Sales of IPTV set-top
boxes





Revenue
from sales of IPTV set-top boxes was $41.3 million, a slight increase of $0.7
million or 1.7% compared with $40.6 million for the same period in
2009.  We now provide two types of IPTV set-top boxes, High Definition
and Standard Definition, the sales of Standard Definition products were launched
in the first quarter of 2010.





The total
sales volume of High Definition and Standard Definition IPTV set-top boxes for
the nine months ended September 30, 2010 increased by 86% compared to sales
volume of the same period in 2009, during which period the sales volume included
only High Definition products.  The selling prices of our High
Definition IPTV set-top boxes were reduced in 2010 and were much lower than the
selling prices of such products when they were first launched in 2009.  The
impact of the significant increase in sales volume of IPTV set-top boxes was
offset by a significant decrease in selling prices; the selling prices of High
Definition products decreased by 17.5% compared with the prior year and the
selling prices of Standard Definition products amounted to only 38.5% of selling
prices of High Definition products.  Under the mutual effect of
significantly increased volume and decreased selling prices, revenue from sales
of IPTV set-top boxes maintained a slight increase of 1.7%.





The
Chinese governmental regulation encouraged the continued integration of
telecommunications networks, Cable TV networks and the Internet in
2010.  As the terminal units of Cable TV networks, the demand for IPTV
set-top boxes increased during the integration process. As a result of this
integration process, we expanded our sales on both High Definition and Standard
Definition IPTV set-top boxes during the third quarter of 2010.





Sales of cable TV network
equipment





Sales of
cable TV network equipment amounted to $30.4 million for the nine months of
2010, a slight increase of $0.9 million or 3.1% compared with $29.5 million for
the same period in 2009.


35




GPS
Products:





We
entered into our GPS-related line of business in the fourth quarter of 2009
whereas there was no revenue from GPS operations during the nine months of
2009.





Revenue
from sales of GPS devices was $12.7 million for the nine months of 2010
including GPS-related service fees amounting to $4.2 million in revenues for the
same period. GPS-related services include installation service and subscription
service for tracking and positioning.





Cost
of Sales





Cost of
sales was driven primarily by procurement costs, given that the raw material for
our products is purchased from suppliers on a turnkey
basis.   Total cost of sales was $66.1 million in the first three
quarters of 2010, compared to $58.8 million during the same period in 2009,
representing an increase of approximately $7.3 million or 12.4%.  The
12.4% increase in cost of sales was lower than the 26.1% increase in sales
revenue, which indicated an increase in gross margin.





The
primary driver for the increase in gross profit margin was due to the fact that
the recently launched GPS business and Standard Definition IPTV set-top boxes
sales had a higher gross margin than both Cable TV network equipments and
High-Definition IPTV set-top boxes sold during the third quarter of
2009.





Gross
Margin





Gross
margin for the first three quarters of 2010 was 25.3%, an increase of 9.2%,
compared with gross margin of 16.1% for the same period in 2009. With the
exception of GPS-related services, which have a gross margin of 97.2%, the gross
margin for sales of products was 21.8% for the first three quarters of 2010,
which was 5.7% higher when compared to the same period of 2009. As discussed
above, the primary driver for the increase in gross margin was secondary to the
recently launched GPS business and Standard Definition IPTV, which has a higher
gross margin than the traditional business existed in the third quarter of
2009.





The
increase in gross margin on sales of products was driven mainly by sales of
Standard Definition set-top boxes, which has a gross margin of 40.0% during the
first three quarters of 2010.  Although the selling price of our
Standard Definition products was much lower than the selling price for our High
Definition products, the production costs of our Standard Definition products
were so much lower than the production costs of our High Definition products
that we were still able to earn a higher gross margin on these
products.  We did not have sales of Standard Definition set-top boxes
during the same period in 2009.  The gross margin in sales of GPS
device, which we launched in the fourth quarter of 2009, was 20.7% for the first
three quarters of 2010, higher than the overall gross margin of third quarter of
2009.  The gross margin of traditional products, cable TV network
equipment and High Definition IPTV set-top boxes, were both 17.9% during the
first three quarters of 2010, represented an increase of 2.5% and 1.3%
respectively, compared with 15.4% and 16.6% during the same period of
2009.





Selling
Expense





Selling
expense was $563,000 for the nine months of 2010, representing an increase of
$477,000 compared to $86,000 for the same period of 2009. Selling expenses for
the nine months ended September 30, 2010 consists mainly of shipping costs,
after-sale service, and salary of sales staff, while selling expense in the same
period of 2009 contained only salary expenses and shipping costs.





As a
percentage to total revenue, selling expenses accounted for 0.6% and 0.1% for
the nine months of 2010 and 2009, respectively.





Research
and Development Expense





Research
and development expense was $369,000 for the nine months ended September 30,
2010, an increase of $260,000, compared with $109,000 in the same period of
2009. We increased investment in research and development activities during the
first nine months of 2010.





As a
percentage to total revenue, research and development expense accounted for 0.4%
and 2.0% for the nine months of 2010 and 2009, respectively.


36






General
and Administrative Expense





General
and administrative expense was $2.5 million for the nine months ended September
31, 2010, representing an increase of $1.8 million or 258%, compared to $0.7
million for the same period in 2009.  General and administrative
expense consists mainly of salary expense, consulting service fees, legal
service fees, audit related service fees and other office expenses.  The
increase in general and administrative expense was primarily due to increases in
salary expense, consulting service fees, legal fees and other expenses for
becoming a public reporting company.  We raised staff salary in October
2009, and on November 14, 2009, we entered into a 24-month Retention Agreement
with our Chief Operating Officer for a total retention bonus of $285,000 that is
amortized though the life of the agreement; as a result, the salary expense for
the nine months of 2010 amounted to $801,000, an increase of $633,000 compared
to $168,000 during the same period in 2009.  The consulting fees
increased to $652,000, an increase of $526,000 compared with $126,000 for the
same period in 2009, mainly due to a Consulting Agreement signed with Finance
Access, Inc. and other third parties.  On October 28, 2009, we entered
into a Consulting Agreement with Finance Access, Inc. and other third parties
for a 24 months consulting service at total consideration of $1.55 million;
which will be amortized during the following 24 months and the amortization
during the nine months of 2010 was approximate $581,000.   The
legal fees and other administrative expenses increased primarily as a result of
the Company becoming a publicly reported entity.





As a
percentage to total revenue, general and administrative expense accounted for
2.8% and 1.0% for the nine months of 2010 and 2009, respectively.





Merger
Cost





Merger
cost incurred for the first three quarters of 2009 was $567,000 and consisted of
expenses incurred during the process of the reverse acquisition and private
placement. There was no such merger activity and no merger cost incurred for the
first three quarters of 2010.




Interest
Income (Expense)





Interest
income was $52,000 for the nine months ended September 30, 2010, while income
expense was $128,000 for the same period of 2009.  We paid off
all bank loans in the year of 2009; therefore, no interest expense was incurred
in 2010.





Income
Tax Provision





Income
tax provision for the nine months ended September 30, 2010 was $5.5 million, an
increase of $2.9 million or 112%, compared with $2.6 million for the same
period of 2009.  The increase of income tax provision was the result
of the increase in income before tax, primarily driven by the increase in sales
revenue and increased gross margin.





As a
percentage of total revenue, income tax provision accounted for 6.2% and 3.7%
for the first half of 2010 and 2009, respectively.





Net
Income





Net
income was nearly $13.6 million for the nine months ended September 30, 2010, an
increase of $6.5 million or 91.5%, compared with $7.1 million for the same
period of 2009.





Earnings
per Share





Basic
earnings per share were $1.17 for the nine months of 2010, an increase of $0.29
compared to $0.88 for the same period in 2009.  The increase in
earnings per share was a result of an increase in net income offset partly by an
increase in basic weighted average shares outstanding, which were 11,650,442
shares and 8,354,826 shares, respectively, for the nine months ended September
30, 2010 and 2009. Of the aforementioned 8,354,826 weighted average shares
outstanding, we included the equivalent outstanding shares from the outstanding
shares of preferred stock. The shares of preferred stock had the same voting
right and dividends rights as the shares of common stock; therefore, these
shares were deemed as the equivalent shares of common stock for computing
earnings per share purpose. All of the 1,263,723 shares of Series A Convertible
Preferred Stock were converted into 1,263,723 shares of common stock during the
fourth quarter of 2009.


37






Liquidity
and Capital Resources





As of
September 30, 2010 and December 31, 2009, we had cash and cash equivalents of
$34.2 million and $13.6 million, respectively. The increase in cash and cash
equivalents was mainly attributed to operating activities, especially by net
income earned during the first three quarters of 2010. Our working capital was
approximately $59.8 million and $45.9 million as of September 30, 2010 and
December 31, 2009, respectively.





Our
operations historically have been financed through the issuance and sale of
equity securities, specifically through proceeds from private placements and
public offering of our shares of common stock.  For the nine months
ended September 30, 2010, cash provided by operating activities contributed
significantly to capital resources.  We did not have material capital
investment commitments as of September 30, 2010.  Cash and cash
equivalents are enough 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 successfully rapidly expand our
GPS-related business.





For the
nine months ended September 30, 2010, net cash provided by operating activities
was $21.1 million, representing an increase of $21.3 million as compared with
the net cash used in operating activities of $127,000 for the same period in
2009.  Among the $21.1 million net cash flow provided by operating
activities, net income of the period contributed $13.6 million; and due to the
fact that we held advancements to our suppliers till early October, decrease in
advances to suppliers contributed $7.7 million of increase in operating cash
flows.





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.





Net cash
used in investing activities was $1.7 million for the nine months ended
September 30, 2010, which was mainly the advanced payment for purchasing office
space.





There was
no financing cash flow during the first nine months of 2010, while net cash
provided by financing activities was $1.1 million during the same period in
2009.  We conducted five closings of a private placement transaction
and received net proceeds of $3.5 million for the sale of 1,263,723 shares of
Series A Convertible Preferred Stock.  Then we repaid $2.4 million in
short term bank loans using the proceeds from the private
placement.




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.


38






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 not effective as of September 30, 2010.





Our
controls and procedures were primarily adversely affected by the lack of
experience within the company in complying with the requirements of a publicly
reporting entity.  With the exception of our CFO, our current internal
accounting department responsible for financial reporting of the Company, on a
consolidated basis, is relatively new to U.S. GAAP and the related internal
control procedures required of U.S. public companies. Although our accounting
staff is professional and experienced in accounting requirements and procedures
generally accepted in the PRC, management has determined that they require
additional training and assistance in US GAAP matters.  Management has
determined that our internal audit function is also significantly deficient due
to insufficient qualified resources to perform internal audit
functions.  We have engaged a third-party internal controls
consultant to assist the Company to address issues of timeliness and
completeness in financial reporting when we are preparing SEC filings. We are
currently in the process of validating the recommendations made by the internal
controls consultant, and we envision that our internal controls and procedures
will be effective by the end of 2010.





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.


39






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/A as
filed with the SEC on May 18, 2010 and all of the information contained in our
public filings before deciding whether to purchase our common stock. There
have been the following material changes to the “Risk Factors” as set forth
in our Annual Report on Form 10-K/A as filed with the SEC on May 18,
2010:





We
intend to grant shares of or stock options to purchase shares of our common
stock to various of our officers, directors and employees pursuant to our 2010
Omnibus Incentive Plan for which we will incur significant non-cash charges
which will negatively affect our results of operations and which may cause the
market price of our common stock to drop significantly, even if our business is
doing well.





At our
annual meeting of stockholders held on August 23, 2010, our stockholders
approved the ZST Digital Networks, Inc. 2010 Omnibus Incentive Plan covering
five hundred thousand (500,000) shares of our common stock.  We may
issue various types of awards under the plan, including, but not limited to,
stock options and restricted shares of common stock. Grants or other stock
awards pursuant to the plan will cause us to incur significant non-cash
equity-based compensation charges. This non-cash charge will be amortized over
the vesting period of the awards. These non-cash charges will negatively impact
our results of operations, specifically our net income and net income per
share.  Additionally, any future awards made pursuant to the plan
could have a significant adverse effect on the trading price of our common
stock, especially if a significant volume of the stock issued is sold into the
public market. Further, the issuance of any stock awards pursuant to the plan
will have a dilutive impact on other stockholders by decreasing their ownership
percentage of our outstanding common stock. An adverse impact on the trading
price of our common stock may negatively affect our ability to use to our
securities to raise capital or to acquire other companies using our
securities.





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





In
October 2009, we completed our public offering of common stock in which we sold
3,125,000 shares of common stock at an issue price of $8.00 per share.  The
SEC declared the registration statement for the public offering, File No.
333-160343, effective on October 20, 2009. We raised a total of approximately
$25 million in gross proceeds from our public offering, or approximately
$22 million in net proceeds after deducting underwriting discounts and
commissions of approximately, other offering costs, and related expenses of
approximately $3 million.  As of November 3, 2010, we have used
approximately $18 million of such proceeds for working capital purposes to
finance our existing operations.





ITEM
3.  DEFAULT UPON SENIOR SECURITIES





None.




ITEM
4.  (REMOVED AND RESERVED)




ITEM
5.  OTHER INFORMATION




None.


40






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.


41






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:  November
      3, 2010
            By:
            /s/
      Zhong BoZhong
      BoChief
      Executive Officer and Chairman of the BoardDate:  November
      3, 2010
            By:
            /s/
      John ChenJohn
      Chen
              Chief
      Financial Officer




42