Genius Brands (NASDAQ:GNUS) stock is down almost 77% from its 52-week high of $11.73, with shares trading at just $2.72 as of Wednesday's close. But while the company's valuation looks more reasonable at these levels, there's still more downside in this struggling children's entertainment company.

Investors should avoid Genius Brands until management can demonstrate a track record of delivering value to shareholders. Right now, investors face equity dilution because of Genius Brands' cash-burning business model, capital raises, and stock-based compensation. A recent production deal with Arnold Schwarzenegger will make the problem worse.

Representation of a 401k burning

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Cheap for a reason

Equity dilution is a major risk for penny stock investors. Low-priced, thinly traded companies like Genius Brands can take advantage of their share price volatility to issue more shares and dilute the positions of earlier stockholders. This strategy helps unprofitable growth companies sustain their losses, but it can also allow unscrupulous managers to prolong the life of an unviable business to juice their personal incomes with salaries and stock-based compensation.

Genius Brands has a long track record of dilutive capital raises, often at prices significantly below the market price of the stock.

The company had four separate dilutive capital raises in May for proceeds of $30 million, $9 million, $2.8 million, and $5.4 million, respectively. The new shares were issued at prices between $0.35 and $1.50, which is significantly lower than the stock's $2.72 price tag at the time of writing. By issuing new shares below their market price, Genius Brands allows new investors to immediately profit from their shares -- at the expense of existing shareholders.

The Schwarzenegger deal brings more dilution

Genius Brands has several major television projects going live in the near term. This includes a new animated children's series called Stan Lee's Superhero Kindergarten, which is expected to premiere in 2021 on Amazon Prime. Schwarzenegger, whose Hollywood career goes back some 50 years, will be starring in and co-producing the show through his production company Oak Productions, along with Genius Brands and Alibaba Group subsidiary POW! Entertainment.

Schwarzenegger's company will receive stock warrants as an advance on its profit participation in the show. The warrants will allow Oak Productions to purchase approximately 2.16 million shares of Genius Brands common stock at an exercise price of $1.39 per share on May 25, 2021, or the day the Superhero Kindergarten premiers -- whichever comes earlier.

Genius Brands is also giving MSA Advisors a warrant to purchase 125,899 shares as compensation for its advisory services to the show.

Genius Brands' decision to issue these warrants may help the company keep its cash outflows in check, but it will lead to massive equity dilution over the long-term, which could destroy shareholder value and cause the stock to underperform. Genius Brands' management has a long track record of dilution -- the company reported $14.2 million in outstanding warrant derivative liability on its balance sheet in the first quarter.

Takeaway

Investors should avoid Genius Brands stock because management isn't prioritizing shareholder value. The company is issuing an alarming amount of new shares and warrants, and this will probably cause the stock to underperform over the long term due to equity dilution.