Shares of struggling children's entertainment company Genius Brands (NASDAQ:GNUS) have been on a rocket-ship rally lately. On May 6, Genius announced the planned launch of its Kartoon Channel! digital network, a children's educational platform that will be hosted on several major media platforms including Amazon Prime, Apple TV, and Comcast. The news supercharged investor interest in the stock, sending shares soaring 995% from about $0.32 on May 5 to $3.45 at Thursday's close. And that's actually down from a recent high of $7.93 on June 3

While it is unclear what long-term impact Kartoon Channel! will have on Genius Brands' business over the long term, the optimism looks overblown considering the fundamental weaknesses in the company and questionable managerial decisions. Here are two reasons to sell Genius Brands stock before shares fall back down to earth. 

A one hundred dollar bill burning.

Image Source: Getty Images.

1. Poor fundamentals 

Genius Brands is nominally a growth stock, and that means investors should expect some level of cash burn until the business achieves enough scale to be profitable. But Genius Brands' growth trajectory is much less consistent than growth investors like to see. And cost of goods sold (COGS) and selling, general, and administrative (SG&A) expenses have increased at much faster rates than revenue over the past eight years.

Chart comparing Genius Brands' revenue with COGS and SG&A.

Data by Ycharts.

Genius Brands reported first-quarter earnings on May 18, and the results were a disaster. Total revenue dropped 72% year over year from $1.22 million to $334,739, while losses from operations expanded 42% from $1.25 million to $1.77 million. The poor performance is due to weakness in the Genius Brands' television and home entertainment segment, which fell from $850.1 million to $52.2 million year over year. Genius plans to boost this division through the launch of its new Kartoon Channel, but the impacts of this move are yet to be seen. And so far, the company has a limited track record of developing successful media products.

Its Rainbow Rangers show, which debuted on Nick Jr. in November 2018, has so far been unable to power sustainable revenue growth -- although management said it expected to see "significant growth over the next two years" after season two of the series was approved for the fourth quarter. The company's Llama Llama series has a similar story. The preschool show, which is hosted on Netflix, has also failed to power sustainable top-line growth despite being renewed for two seasons.

Genius Brands also reports a weak balance sheet, with $2.76 million in cash and equivalents on its books compared to $14.1 million in warrant derivative liabilities, which can eventually be converted into common stock, diluting equity. 

2. Equity dilution

Genius Brands is at high risk for equity dilution because of its massive cash burn and low stock price. Equity dilution occurs when a company raises capital by issuing additional shares. This increases the total number of shares outstanding, and puts downward pressure on the value of existing shares in the company.

On May 28, Genius Brands agreed to sell 20 million shares of common stock at $1.50 per share for proceeds of $30 million. This sale follows three other securities purchase agreements with proceeds of $9 million, $2.8 million, and $5.4 million, respectively, in May alone. The company issued these shares at prices ranging from $0.35 to $1.20, which is significantly lower than the current stock price of $5.15. 

By selling its stock for lower than the market price, Genius Brands gives the new buyers a very good incentive to buy shares in such a high-risk company. But this comes at the expense of legacy shareholders, who will face dilution if the new buyers unload their positions into the open market.

Genius Brands looks like a bad investment, and investors should consider selling the stock before it comes crashing back down to earth.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.