Zst Digital Networks (PINK:ZSTN)

Added to the GeoSpecial list on October 20, 2009 @ $7.61

Catalyst: Company was involved in some “hot” industries, in particular in the GPS market; track record of consistent top and bottom line growth.
Peak Performance: Reached $11.90 on January 11, 2010
Current Price: $5.35

Current road block: ZSTN’s legacy bread & butter business which supplies digital and optical network equipment to cable system operators can be considered mature, as ZTN has captured a significant percentage of its target region's market share; Margins in the legacy business have come down; For its 2010 first quarter, ZSTN’s share count increased 49.4%.

Maintaining ZSTN as a GeoSpecial is a tough call. The company's financial statements appear healthy:

• Cash stands at $20.8 million
• Account receivables have been drawn down 37.2%
• Company is debt free
• 2010 annual operating cash flow is tracking at $34.8 million
• Free cash flow is tracking at 28 million. (this figure does not assume an increase in capital investments past $7.0 million).

However, there are issues that may not excite many investors. 2010 Second quarter net income guidance of $3.0 to $3.5 million implies EPS of $0.26 to $0.30 or flat growth versus the reported second quarter 2009 EPS of $0.30. Furthermore, in observing analyst EPS estimates for the next seven quarters, only one is showing EPS growth of over 30%. The EPS growth rate for the remaining six quarters ranges between negative 12.8% to positive 23.5%. 2010 EPS is expected to grow only 5.3% to $1.20 followed by 26.7% in 2011. Yes, ZSTN's trailing and forward P/E are tiny, but will investors pick ZSTN over other stories that have better growth profiles and similar valuations? The answer may depend upon ZSTN's ability to handily exceed estimates. This is another case and point of the negative ramifications of massive dilution.

Speaking of dilution, it appears safe to assume ZSTN will tap the equity markets in the near future, giving us concerns that dilution could erode what little EPS growth the company is on track to achieve.

Excerpt from first quarter 10Q:

"The cash and cash equivalents is enough to meet our day-to-day requirements at current operating level. We may need to seek for external financing resources to supplement operating cash flows if we successfully expand our GPS related business rapidly."

Well, It seems obvious from the recent 2010 first quarter commentary that ZSTN's GPS business is exceeding expectations.

"We will continue to capitalize on these favorable trends by executing our strategy to increase sales in the IPTV set-top box market, expand our products and services, especially within the GPS market, and continue to build our brand and technology platform."

"John Chen, Chief Financial Officer of ZST, commented, "We are pleased to report revenue and net income for the quarter ahead of our guidance, supported by the continued growth of our GPS sales and services. In addition, we delivered positive operating cash flow during the quarter, further strengthening our balance sheet. We believe the growing demand for our commercial GPS products and services will continue to make 2010 a transformative year for ZST Digital."

Until the company is more specific on this topic we are compelled to remove ZSTN from the GeoSpecial list. We don’t fully understand why ZSTN will require additional capital given its current cash and cash flow position. Long-term value investors may feel ZSTN is eventually worth well more than the current price of $5.35. We do feel there is upside to company guidance and analyst estimates.  Investors who are able to make an investment decision based on 2011 estimates may be well rewarded, given ZSTN's low peg ratio. We will place the stock on the GeoSpecial on the Radar list as we monitor developments.

Rodman @ Renshaw is still bullish on ZSTN:

Maintain Market Outperform Rating (May 14, 2010) : At current levels ZSTN is trading at a P/E multiple of ~5.5x and ~4.2x to our FY2010 and FY2011 earnings estimates. This is a substantially lower multiple compared to an average of ~26x for network equipment makers and ~13x for GPS / navigation providers based on forward FY2010 consensus earnings. We believe ZSTN should at a minimum trade in line with the averages the relative growth opportunity associated with it. We are comfortable maintaining ZSTN the $14.00 price targett, which translates into a P/E multiple of ~12x and ~9x to our estimates for FY2010 and FY2011. We justify this by pointing investors to the company’s low PEG ratio of ~0.17x at these multiples based on our estimate for FY11 EPS growth.

Zst Digital Networks capped off the year 2009 with a strong fourth quarter.

• 2010 first quarter guidance which was much less than investor expectations.

"Based on the current estimates, the Company approximates that revenue for the first quarter 2010 will range between US$12 million and US$15 million." This would equate to EPS 17."

• Fourth quarter EPS results were rather dismal.

The good news is that 2010 sales and net income guidance are still bullish.

For the full year 2010, the Company estimates that:

• Revenues will range between US$115 million and US$125 million, and
• Net income will range between US$13 million and US$15 million. 

Using the current diluted share count of 9.69 million and the midpoint of ZSTN 2010 guidance, EPS would be $1.45.  

Investors may need to exercise patience as Wall Street pieces this story together. Temporary timing issues generally don’t interfere with the GeoTeam’s company analysis.  However we must be aware that ZSTN issued net income guidance but no EPS guidance. Investors could infer this to mean that the company may have to tap the capital markets in 2010.

Dilution risk is becoming a significant risk in the China space.