PSB Monthly Issue May 2010

| May 4, 2010

May 2010


China’s economic expansion over the past 30 years is legendary.

Since implementing sweeping economic reforms in the late 1970s, China’s economy has grown at a blistering pace.  It’s now the third largest economy in the world based on nominal GDP.

Strong economic growth in turn has boosted personal income levels.

Hundreds of millions of Chinese have been lifted out of poverty.  In 1978, a jaw dropping 62% of the population lived in poverty.  Today just 10% live below the poverty line.

Moreover, rising incomes have created a new middle class.

Around 250 million people make up China’s new middle class.  That’s about the size of the U.S population.  What’s even more amazing is China’s middle class is expected to top 600 million people by 2015.

The middle class is the future of China’s economy.

They’re expected to drive China’s personal consumption rates to the moon.  This makes sense as middle class citizens have more money to spend on items driving economic growth.

For example, they have money to buy homes, cars, appliances, clothes, and electronics.  Just last year, China knocked off the U.S. to become the world’s largest car market.  This is a trend likely to repeat itself in many different industries.

Another area where the Chinese consumer is flexing their muscles is entertainment.

China is now the world’s largest cable television market.  A whopping 172 million Chinese subscribe to cable television right now.  (The more mature U.S. market has just 145 million subscribers.)  And, 10 million new subscribers are added every year.

Looking ahead its clear annual new subscriber additions will only grow.

Urbanization and expansion of the cable TV infrastructure is increasing access to cable.  Government subsidies are helping keep subscription rates affordable.  And, rising incomes are driving an explosion of cable TV subscriptions among the rapidly growing middle class.

Here’s the key.

The growth in cable TV subscriptions is driving high growth rates in sales of cable TV set-top boxes.  Especially Internet Protocol Television (IPTV) set top boxes.  These provide bundled cable television, internet, and telephone services to commercial and residential customers.

From 2007 to 2008, China’s IPTV market more than doubled in size!  And, sales of IPTV set top boxes are expected to grow 20% a year going forward.  (That’s huge!)

Through my research, I’ve found a wonderful penny-sized Chinese company cashing in on this trend.  The company is none other than ZST Digital Networks (NASDAQ: ZSTN).

Key Investment Data

Name:  ZST Digital Networks
Ticker Symbol:  ZSTN
Market Cap:  $75 Million
Recent Price:  $6.47

PSB Rating System 4.8 Stars

Raging Revenue:  (5.0 stars) Revenue is expected to jump 15% to 25% this year.  Demand for the company’s IPTV set-top boxes and GPS systems is very strong.

Beautiful Books:  (4.8 stars) Management is forecasting a 30% to 50% surge in net income for 2010. Plus, the company’s flush with cash and carries no long term debt.

Stellar Structure:  (4.7 stars) Insiders are clearly very confident with ownership of 50% of shares outstanding.  And, there’s plenty of room for institutional buying with ownership of just 2.9%.

Valuation Verification:  (4.7 stars) The stock is badly mispriced by the market.  Based on our valuation analysis, we think the stock is worth at least $12.00 a share.  That’s upside potential of at least 85%.

Meaningful Milestones:  (4.8 stars) The company just launched a GPS monitoring business last November. Since then, they’ve signed up 5 customers.  Management sees strong demand for this business throughout 2010.

Let’s take a closer look at this amazing company.


ZSTN is the leading provider of digital and optical network equipment to cable system operators in Henan province.  The company’s main product line is Internet Protocol Television (IPTV) set-top boxes.

The company’s IPTV set top boxes offer a variety of different features.

These include an on-screen interactive program guide, pay-per-view, music, interactive audio, games, shopping services, and parental controls.  New models coming out this year will offer video on demand and digital video recorder functionality.

China’s IPTV market is small but growing very fast.

IPTV subscriptions are expected to top 8.5 million by year’s end.  That’s more than double last year’s figure.  And, by 2014, China is expected to have over 31 million IPTV subscribers.

Driving growth in IPTV are two important Chinese government policies.

The first policy requires cable systems to transition from analog to digital by 2015.  As this transition unfolds, many subscribers will upgrade to premium cable services which require a set-top box.  Given the bundling advantages, IPTV should capture a growing share of this market.

At least one analyst believes the transition to digital will drive 20%+ annual growth rates for IPTV in China.

The government’s other policy is to accelerate convergence of the country’s telecom, broadcast, and internet operators.  IPTV is the technology that accomplishes this goal.  Remember, IPTV set-top boxes provide cable TV, internet, and telephone services through a single device.

ZSTN is perfectly positioned to capitalize on the scorching growth of IPTV.

They dominate the Henan market (China’s largest province).  ZSTN has an eye-popping 63% market share of set-top boxes in the premium cable subscriber category. And, by doing business with over 30 different TV broadcasting stations and cable network operators, ZSTN has developed strong brand recognition.

While IPTV is a strong growth driver, the company expects huge growth from their newest business line.

ZSTN recently launched a Global Positioning System (GPS) business.  They’re offering commercial customers a nuts to bolts GPS monitoring system.  The system includes all the necessary hardware and 24/7 monitoring services.

ZSTN’s GPS system is ideal for trucking companies and other entities with vehicle fleets.  With this system, a company can track employees and equipment in real time. This helps in preventing work violations and employee theft.

The growth potential in GPS is astronomical.

China’s GPS market is still in its infancy.  Of the 168 million vehicles on the road in 2008, less than 10% had any type of GPS system installed.  Compare that to Japan where 60% of vehicles have GPS.  Clearly, the market opportunity in GPS is absolutely huge.

Another good thing about the GPS business is the profit margins.

They’re much higher than ZSTN’s current margins of 17%.  For example, GPS hardware margins are between 20% and 30%.  And, GPS service margins are over 60%.  You can see how GPS could significantly boost the company’s bottom line and cash flow.

ZSTN signed its first GPS customer in November 2009.  And, they’ve signed four more since then.  Management believes “momentum will continue to build in 2010.”

Let’s now take a peek at the company’s financials.


ZSTN grew at a phenomenal pace in 2009.

Revenue soared 81% to just over $100 million.  Strong demand for the company’s IPTV set-top boxes drove the increase.  Net income jumped 67% to $10.2 million.  And earnings increased nearly 10% to $1.14 a share.

Management expects more solid growth in 2010.

The company’s CEO recently said, “Looking ahead, we believe demand in the IPTV and GPS markets remains strong….”  As such, management’s forecasting revenue to increase 15% to 25%.  And, they’re expecting net income to rocket 30% to 50% higher!

ZSTN also has a very strong balance sheet.

The company’s sitting on a cash hoard of $13.6 million.  Short-term liquidity is of no concern with current assets 20x current liabilities.  And, the company has no long-term debt.


Of course, an investment in ZSTN does involve some risks.

One risk is the company’s dependence on their top five customers for over 30% of sales.  The loss of any one of these customers could hurt the company’s business.

Another risk is the company’s aggressive growth strategy.  If they’re unable to secure financing for acquisitions and new product development, the business could suffer.

A third risk is the company’s heavy reliance on IPTV set-top box sales.  Any disruption to this business could hurt the company’s results.


ZSTN shares offer terrific upside potential.

The company is perfectly positioned to grow by leaps and bounds this year.  Demand for the company’s IPTV set-top boxes and GPS systems is very strong.  And, the company can leverage their strong balance sheet to drive growth.

Despite this strong growth outlook, the shares are badly misvalued by the market.

At a recent price of $6.47, the shares are trading at just 5.5x the 2010 estimate of $1.20.  And, the stock’s P/E on the 2011 estimate of $1.52 is a paltry 4.4x.

These are extremely low P/E ratios for a company growing as fast as ZSTN.  Moreover, industry peers are trading at 13x estimated 2010 earnings.

Using a conservative P/E of 10x, ZSTN is worth at least $12.00 a share.  That’s potential upside of 85%.

Based on our analysis, we see the stock trading up to at least $12.00.  Buy ZSTN now for potential gains of 85% or more.


BUY ZST Digital Networks (NASDAQ: ZSTN) up to $7.00 per share.

Recent price is $6.47.

Use a stop-loss of $3.24 on this position.

Don’t forget your position sizing and stop-loss rules.



Everyone knows “diamonds are a girl’s best friend.”  But, many people don’t realize jewelry can be an investor’s best friend too.

After last year’s downturn, the jewelry industry’s poised for a big recovery.

The jewelry business took a big hit in 2009 due to the global recession.  That’s really no big surprise.  When people are worried about losing their jobs, they tend not to spend money on expensive jewelry.

One long time jewelry store owner said business in 2009 was the worst he’s seen in the last 60 years!

My heart goes out to all of the small, independent jewelry store owners who had a tough time last year.  But, as an investor, I’m sensing a big opportunity for profits as the jewelry business recovers.

Consumer attitudes are just beginning to shift.

With the economy now on the mend, consumers are starting to spend again on luxury items like jewelry.  Sales of luxury items surged nearly 23% in March.  A huge improvement compared to March 2009 when sales plunged over 19%.

As a result, the outlook for 2010 keeps getting better and better.

Global jewelry sales are now expected to rebound nicely in 2010.  Last year sales fell 4.5% to $57.3 billion.  This year sales are forecast to jump 6% to over $60 billion. And, there could be upside to this conservative outlook.

One jewelry market didn’t see a slowdown last year.

If you guessed China… give yourself a gold star.  Gold and jewelry sales increased 10% in 2009.  Total sales were approximately $32.2 billion.  And, more of the same is expected for 2010.

So, how do we capitalize on these trends?

I’m glad you asked.  I’ve uncovered a jewelry company who’s cashing in on both the global economic recovery and the rapid growth in China.  Introducing LJ International(NASDAQ: JADE).

Key Investment Data

Name:  LJ International
Ticker Symbol:  JADE
Market Cap:  $65 million
Recent Price:  $2.66

PSB Rating System 4.9 Stars

Raging Revenue:  (4.8 stars) Revenue is expected to surge 16% in 2010 to $129 million.  The global economic recovery and strong demand in China should drive the increase.

Beautiful Books:  (5.0 stars) Earnings are expected to more than double in 2010 to $0.31 per share. Higher margins in the retail business are expected to drive greater profitability.

Stellar Structure:  (4.8 stars) Insiders are clearly confident in the company’s future with ownership of 10%.  Institutional ownership of 4% shows the stock’s on professional investors’ radar screens.

Valuation Verification:  (5.0 stars) The stock is badly mispriced by the market.  Based on our valuation analysis, we think the stock is worth at least $5.58 a share.  That’s upside potential of 110% or more.

Meaningful Milestones:  (5.0 stars) Revenue from the company’s retail stores surpassed $50 million for the first time last year.  The company accomplished this amazing milestone in less than five years.

Let’s dig a little deeper into this fascinating company.


JADE is a leading designer and manufacturer of fine jewelry in China.  They specialize in colored jewelry, but they also offer high-end pieces set in yellow gold, white gold, or sterling silver.  Many of these pieces are adorned with colored stones, diamonds, pearls, and precious stones.

The company cuts, designs, and sets all of their own jewelry.

Every piece is created at the company’s state of the art factory in Shenzhen, China. Over 3,000 craftsmen produce more than two million pieces of fine jewelry every year. They make everything a retailer needs including earrings, necklaces, pendants, rings and bracelets.

JADE operates two lines of business… wholesale and retail jewelry.

The company’s wholesale business focuses on customers in North America.

JADE sells directly to high volume customers needing specialized pieces.  These include major department stores, Macy’s and JC Penney, as well as global chain stores Wal Mart, Sam’s Club, and Carrefour.  And, JADE also supplies U.S. national jewelry store chains Zales, Sterling, and Helzberg.

You may have purchased a piece of jewelry made by JADE without even knowing it.

In addition, the company sells jewelry through the top three TV shopping channels. These shopping channels have a combined market of $2 billion in the U.S. and $7 billion globally.

As you can see, the wholesale business offers huge growth potential as the economy recovers.

JADE’s retail business focuses on selling jewelry directly to retail customers.

They sell jewelry designed and manufactured by JADE through company-owned ENZO retail jewelry stores.  These stores are located throughout the Asia Pacific region with primary focus in China.

More than half the company’s sales have historically come from the wholesale business.  But, the focus is quickly shifting to retail.  Management views ENZO as the key long-term driver of revenue and earnings growth.

With this in mind, the company’s rapidly expanding the number of retail stores.  More stores will enable JADE to capture more market share.  At the end of 2009, JADE had 95 ENZO stores.  Management plans on adding 100 more by the end of 2011.

Clearly, JADE’s sales and earnings growth will be driven by the retail business going forward.

The company’s vertically integrated business model really sets JADE apart.  And it provides significant advantages over the competition.

All profits from value added processes are captured internally rather than shared with third party manufacturers.  This results in very competitive pricing for the retailer and enhanced profits for JADE.

Speaking of profits, let’s take a closer look at the company’s financial picture.


2009 was a mixed year for JADE.

Revenue dropped 19% to $110.5 million.  Net income surged 48% to $3.7 million.  And, earnings rose 36% to $0.15 per share.

Not a bad year all things considered.

The company’s wholesale business suffered due to the global economic recession. Customers in North America, Europe, and Japan significantly cut back on orders as their retail sales dried up.

However, JADE experienced very strong growth in the retail business.

ENZO retail revenue surged 39% to over $50 million for the year.  Strong demand in China drove the results.  And ENZO’s high gross margins… consistently over 50%… are boosting JADE’s net income.

The outlook for 2010 is even better.

Analysts are forecasting a revenue increase of 16% to $129 million.  And, they’re expecting earnings to more than double to $0.31 per share.  If the company delivers on these estimates, JADE shares are sure to soar.

The company also sports a strong balance sheet.

They’re sitting on a nice stash of $11.3 million in cash.  Short-term liquidity is very good with current assets 2.6x current liabilities.  And, long-term debt is very small at just 3% of total capital.


An investment in JADE does of course involve some risk.

One risk is JADE’s dependence on a single customer for more than 10% of revenue.  If the company loses this customer, their business would suffer.

Another risk is the company’s reliance on customer preferences.  A change in taste for certain jewelry styles or materials could hurt JADE’s business.

A third risk is the company’s need of financing to fund their growth strategy.  If JADE’s unable to secure financing, they may not be able to expand their retail business in China.


JADE is perfectly positioned for strong growth this year.

The wholesale business is poised for a turnaround as the global economy improves. And strong demand in China should drive another year of rapid growth in the retail business.

Despite the company’s strong growth outlook, JADE shares are badly mispriced by the market.

At a recent price of $2.66, JADE is trading at just 8.6x the 2010 estimate of $0.31 per share.  That’s a very low P/E ratio for a company projected to grow earnings 50% a year over the next five years.  In fact, JADE’s PEG ratio is a paltry 0.17.

This means JADE’s trading at an 83% discount to their long-term growth rate.

Even more surprising is the fact JADE’s trading for less than book value.  With a book value per share of $3.53, the company’s price to book is just 0.75.  In other words, JADE is trading at a 25% discount to their book value.

We think JADE deserves a P/E at least equal to the industry average.  With a P/E of 18x the 2010 estimate, JADE’s worth at least $5.58 per share.  That’s upside potential of 110%!

Based on our analysis, we see the stock trading up to at least $5.58 per share. Buy JADE now for potential gains of 110% or more.


BUY LJ International (NASDAQ: JADE) up to $2.93 per share.

Recent price is $2.66.

Use a stop-loss of $1.33 on this position.

Don’t forget your position sizing and stop-loss rules.


Portfolio Update

  • We adjusted our buy price for MFA Financial (MFA) to reflect a dividend of $0.24 per share paid on April 30, 2010


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