Last month ZST Digital Networks (NASDAQ:ZSTN) reported its Q3 results. Yet again, the company reported glowing results, indicating that total revenue for the period was $38.5 million, an increase of 34.6% compared to Q3 ’09, and net income grew to $6.4 million, an increase of 94.7% compared to Q3 ’09.
As discussed in our previous analysis of ZSTN, we prefer to look at the balance sheet and cash flow statement to assess the real quality of this business. After a closer examination of this quarter’s results, we continue to have concerns and a cautionary stance on this company’s operations.
The Curious Case of Quarterly Cash Flow
According to CFO John Chen:
“We ended the quarter with a strong balance sheet, with cash and cash equivalents increasing significantly over the previous quarter as a result of an influx of collections from products and services delivered earlier in the year, in line with our normal cash collection cycle.”
Upon closer examination of this statement, we find some inconsistencies that beg further investigation. To illustrate, as of Sept. 30, 2010, total accounts receivables were $27.5 million, a very modest decrease of only 4.9% from $28.9 million as of June 30, 2010. However, accounts receivable are still higher by $2.6 million or 10% from the beginning of the year.
So how did cash increase significantly as the company has indicated? To answer this question precisely, we have to take a closer look into the cash generated from operations, which entails looking into changes in the working capital accounts (current assets, and liabilities).
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The Curious Case of Advances to Suppliers
We will focus our attention on the items shaded in gray as areas of interest. As can be seen from the table, the company’s largest source of cash this year has been from a sudden reversal last quarter in the account called “Advances to Suppliers.” So what exactly is this line item? According to the company’s recently filed 10Q in Note 4:
“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.”
Other disclosures in the company’s 10-K include the following language:
“We typically need to place certain deposits and advances with our suppliers on a portion of the purchase price in advance and for some suppliers we must maintain a deposit for future orders.”
Given the magnitude of this advance and sudden reversal this quarter, we would have expected a more detailed discussion from the company about this change. After all, this one account change represents almost 35% of the cash from operations for the entire year. Unfortunately, due to lack of disclosure by the company on this issue, we are left with more questions than answers. If, as described, the advances are to be applied to invoices when goods are received, then why is the company receiving the money back? Does this reversal indicate problems and/or troubles with its two main suppliers? Has the company lost major customers, and no longer needing to receive supplies for future orders, and thus receiving its advances/deposits back? Also, why does the reported YTD cash inflow of $7,249,152 differ from our calculated amount of $7,399,141? It’s easy enough to verify by looking at the 12/31/09 Advances to Supplier account. It appears to be sloppiness on the part of the company, which can’t even get its own numbers correct, across almost all reported amounts. This casts further doubt on the reliability of this company’s financials.
Perhaps the answer to the foregoing discussion of the Advances to Suppliers account is better understood by looking at inventories. ZSTN’s inventories continue to fall at an alarming rate. Yet again, they’ve decreased from $502k last quarter, to a mere $202k this quarter. If we are correct that the company is having problems with its suppliers, then it would make sense that it cannot build new inventories. After all, a company growing as fast as ZSTN surely must build some inventories to sustain all of its superior growth in sales and earnings that it is reporting to investors. However, ZSTN grew revenues by $5m from $33m in 2Q’10 to $38m in 3Q’10, while inventories fell by $300k. At this rate, ZSTN will deplete all inventories and be the only distributor in the world that we are aware of to grow sales without holding a single dollar of inventory.
According to the company’s 10-K Risk Factors
“Cancellations or reductions of customer orders could result in the loss of anticipated sales without allowing us sufficient time to reduce our inventory and operating expenses. Furthermore, because we depend on a small number of customers for the vast majority of our sales, the magnitude of the ramifications of these risks is greater than if our sales were less concentrated with a small number of customers. As a result of our lack of long-term purchase orders and purchase commitments we may experience a rapid decline in our sales and profitability.”
ZSTN’s decision to wind down and not restock its inventories may signal its expectation of losses of customers. We are very wary of the trend of declining inventories, and think it’s a potential indication of problems the company is either currently facing or expects to face in the near future.
The Curious Case of ZSTN’s Accounts Payable
Our interest also was piqued when ZSTN reported this quarter that its accounts payable balance was a mere $2,650. Curiously, this is the exact same amount the company reported the prior quarter at 6/30/10. In other words, ZSTN did not incur a single dollar of incremental amounts payable in three months of operations, all while reporting growing sales and earnings. How is this possible? We don’t have an answer to this question, but we certainly welcome an explanation from the company.
The Curious Case of ZSTN’s $1 Million Share Repurchase Program
Another curious matter is the company’s announcement on Aug. 24, 2010, of an initiation of a $1 million share repurchase program.
In a press release, the chairman was quoted as saying:
"The Board's authorization of the share repurchase program reflects our confidence in the favorable growth outlook for ZST. As we enter the second half of 2010, the demand for our products and services remains robust, supported by the continued expansion of our end markets. In addition, our strong second quarter 2010 results and the rapid development of our commercial GPS products give us confidence in the long-term growth prospects of our business. As such, we believe that current share price levels do not fully reflect the fundamental strength of our business and outlook. We remain committed to maximizing long-term shareholder value, and believe that our stable financial position and healthy balance sheet will allow us to execute a share repurchase program while continuing to invest in our business.”
On the day of this announcement, ZSTN’s share price closed at $6.26 per share, not far from its 52-week low of $4.43 per share. Given the foregoing announcement that ZSTN believed its share price was cheap, investors would naturally believe the company would be actively buying it at the current price. However, as we recently learned this quarter, the company’s actions speak louder than its words. According to the company's quarterly statement of cash flows, we find no indication of any share repurchases in the past nine months, which are typically contained in the cash flows from financing section of the statement. While we acknowledge that the announcement of share repurchase program does not legally bind the company to take action, we are clearly disappointed ZSTN could not commit to buying 1 single share at prices it acknowledged didn’t accurately reflect their value.
Conclusion: Still More Questions Than Answers
We have illustrated more than a few unusual developments with ZSTN’s quarterly report that exacerbates our concerns with the company’s financials and business prospects. We continue to have grave concerns with the company’s balance sheet and cash flow changes that could signal big problems in the quarters to come. Unfortunately, the company does not disclose enough information to investors to accurately assess these impacts on its future prospects. As a result, we stand by our previous conclusions that ZSTN’s business remains deceptive and not an investment worth making.
Disclosure: Short ZSTN.
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