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(Editor’s Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.)

Introduction

Throughout 2013 MusclePharm stock stagnated despite continued explosive revenue growth, mostly due to the lack of positive cash flow which resulted in investor uncertainty and rampant dilution. The company worked to clean up the balance sheet and remove the negative image investors had of the company, which was explained well in this article. Now, in 2014, investors are hoping the company can emerge as a legitimate publicly traded company that can generate value for shareholders as it continues to address the growing pains that have plagued the company since inception.

On January 29th of this year MusclePharm's (OTCQB:MSLP) CEO Brad Pyatt issued a letter to shareholders that included preliminary results for 2013 as well as estimated results for 2014 and various corporate updates. I have decided to dissect the information given in this letter in order to see if MusclePharm is headed in the right direction moving forward. What I found was interesting, if not confusing.

The Numbers

The preliminary results for 2013 and estimates for 2014 were given in this table from the letter to shareholders:

20102011201220132014
Net Revenues 3,202,68717,212,63667,055,215110,000,000150,000,000
Gross Margin % 12.40%13.80%21.40%29.50%~33%
EBITDA % -569.30%-93.20%-12.30%-12.50%~2%
EPS ($408.00)($70.30)($13.00)($1.44)$0.20-$0.22
YOY Growth % 437%290%64%36%
YOY CAGR % 358%153%50%
PreliminaryEstimated

Given that we have 3 quarters of actual data for 2013, the full year estimate allows us to calculate some fairly precise estimates on what to expect from 4th quarter results. Using the same format as the preliminary 2013 results, the first 3 quarters' actual results are as follows:

Net Revenues

73,400,000

Gross Margin %

32%

EDITBA %

-11.4%

EPS

-2.07

Now, subtracting the first 9 months of revenue from the full year estimate gives us a Q4 sales estimate of $36.6M, implying just over 44% quarter over quarter revenue growth. In order to bring the company's gross margin from 32% through the first 9 months to 29.5% for the full year, MusclePharm would need its gross margin to shrink to 24.5% in the 4th quarter. This is a perplexing figure considering that margin expansion has been a talking point for the company for a while and gross margin is expected to increase to 33% through 2014.

Moving on to EBITDA, an EBITDA margin of -12.5% on $110M in sales implies EBITDA of ($13,750,000) for FY2013. Knowing that the company's EBITDA figures are almost exactly the same as operating losses, we can use the first 9 months operating loss of $8,335,192 to arrive at a Q4 EBITDA estimate of ($5,414,808). Putting all of this together, the Q4 estimated results look like this:

Q4 Estimates

Sales

36,600,000

Cost Of Goods

27,638,014

Gross Profit

8,961,986

Operating Expenses

14,376,794

EBITDA (Operating Loss)

(5,414,808)

These results are interesting to say the least. The expected 44% quarter over quarter revenue growth rate would be quite impressive, though any excitement about that should be muted by the expected decline in gross margin from the first 9 months 32% to the Q4 24.5%. Operating expenses as a percent of sales for those respective periods would decline from 43.5% to 39.3%, but OPEX as a percent of gross profit would increase from 135% in the first 3 quarters to around 160% in Q4.

If the Q4 results play out as projected, I see this as a negative. Gross margin has been expanding for years and investors do not want to see this take a step backwards in favor of maintaining an extremely high sales growth rate. Personally, I think the margin estimate is heavily erring on the side of caution, but it will be something to keep an eye on when Q4 results are released sometime in March. Another key issue to watch out for is the outstanding share count of the company, which leads me to my next point…

Addressing the Issue of Dilution

At the end of 2011 MusclePharm had 713,000 shares outstanding. As of the most recent report from November, 2013 there were 8,865,990 shares outstanding. This represents an increase of 1243% over the course of less than two years. For reference, during the same period, sales increased from $17.2M to $89.9M equating to an increase of 523%. Most of this dilution occurred in 2013 from the conversion of preferred shares to common stock:

(click to enlarge)

What should be noted is that while the market value of this dilution was valued at $42.3M, what the company actually raised from stock issuance was barely half that at just under $23M:

(click to enlarge)For the 9 months ended September 30, 2013

Essentially, shareholders were fleeced as the company issued stock to pay off liabilities.

What's even worse is that there is more dilution on the way, this time using extremely generous stock grants to pay employees:

(click to enlarge)

The 1.5M shares that will go to employees represent a ridiculous increase of 17% over the latest share count of 8,866M. These shares will be fully vested at the end of 2015, easily pushing MSLP's share count over 10M (which is likely to be higher as the company issues more shares). What makes this even more unreasonable is the fact the vast majority of these shares will go to a few executives who are already paid cash salaries:

(click to enlarge)

Yikes. And it gets worse. Going back to the CEO's letter to shareholders from January, here is one of the final paragraphs:

In conjunction with achieving our objectives and incentivizing our staff, we will be implementing an Employee Stock Incentive Plan (ESOP) in 2014 that will allow us to attract and retain qualified candidates. We intend to create stock and option awards that carry three- to four-year vesting periods. This new plan will reserve 1.5 million shares for employees, consultants and athletes and will be subject to shareholder approval.

That's right; a new employee incentive plan which adds another 1.5M shares over the next few years. I sincerely hope shareholders realize that these plans are hampering their shares' value and veto the 2014 ESOP. Enough is enough. This is a time when the company needs to focus on generating positive cash flow so that it can stop fleecing shareholders with dilution while lining executives' pockets.

Summary

All in all, the estimates given for FY2013 and the implications for Q4 are a pretty mixed bag. The projected revenue growth would be great while the decline in margins would be disappointing. Personally, I would like to see the margins at least hold steady from the rest of 2013 even at the expense of some revenue growth. Expanded margins and better cost controls would lead to positive cash flow faster than continuing to hemorrhage money for the sake of revenue growth, which would result in significantly less need to issue more shares.

Conclusion

The story of MusclePharm has long had two sides: those who are excited about the company's growth and believe sacrifices such as dilution are necessary to achieve that growth, and those who believe the company is simply a vehicle for management to profit at the expense of shareholders. I have remained in the former camp for most of my time following the company, but analysis of what MusclePharm is doing leads me to position myself on the fence of this argument. I believe the company is near a tipping point which will prove which side is right in 2014. As the company brings in more and more revenue, becomes cash flow positive, and the need for dilution decreases; it will become key to watch whether management continues to pay themselves such hefty stock compensation packages. Regardless of how much the financials continue to improve, it will not be translated into shareholder value until the share count stabilizes and management proves itself as trustworthy.

Disclosure: I am long MSLP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Mixed Results And Executive Greed Are Revealed In MusclePharm's Letter To Shareholders

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