Description

Summary:

CPI Corp. (NYSE: CPY) owns and operates over 1,000 Sears portrait studios across the US, Canada and Puerto Rico, offering child, adult and family portraits. The stock has been a perennial value trap (stock trades at same level as in 1992!) because the business doesn’t grow and the company has been run by management teams who have made value-destroying capital allocation decisions. I believe a very recent proxy solicitation filed by a credible activist shareholder group will likely be successful given a very concentrated ownership group (5 top holders control more than 50% of stock) that seems to have run out of patience with current management. I believe the shares will continue to trade higher, even if the proxy contest is unsuccessful, as this ownership group is increasingly vocal in demanding management focus on valuation creation as opposed to growth. With the company trading at a cheap valuation (4.4x normalized EBITDA and 5.9 normalized EBITDA-Capex) and a solid debt-free balance sheet, there are many possibilities to create value including a leveraged recapitalization.

Recent History:

In February 2001, CPI’s Board of Directors brought in a new management team led by J. David Pierson, after its previous CEO Alyn V. Essman “retired”. Alyn presided over some bad investments intended to diversify CPI’s business away from Sears. These included
(i) a retail one hour photo finishing business which was sold to Eastman Kodak in 1997, (ii) a wall decor business operated by Prints Plus that was sold to former management in July 2001 and (iii) a third party software and systems consulting business that was shuttered. In addition, he attempted to take the company private in June 1999 (at $37 cash per share ) with American Securities Capital Partners, who terminated this agreement in October, 1999 (more on this later).

The Board and the new CEO (J. David) decided to hire two consultants to develop, over the course of the next nine months, a “Five-Year Growth Strategy” which the company made public in a lengthy 8-K filing in June 2002. In so doing, the new management exhibited questionable judgment on two counts: (I) it publicly disclosed, in detail, its corporate play book to its competitors and (ii) it stunned current shareholders with an audacious plan to spend $193 million in capex (the entire market cap of the company was only $136 million at the time). The stock sold off on this news, and bottomed out at $11.69 per share on May 20, 2003.

Business:

CPI’s is one of the largest players in the pre-school portrait photography market (children under six years old), which historically has grown in line with domestic births (the Census Bureau projects births will remain above 4 million annually in the U.S. for the next ten years). The growing population (Americans living longer) of grandparents (who commonly receive these portraits) should lend some stability to the business. Offsetting this, however, is the significant uncertainty associated with the realities of digital photography, which presents both a threat (substitution, although quality isn’t there yet) and opportunity (ability to reduce expense structure - e.g. no film).

According to the aforementioned 8-K filing, the Portrait business is comprised of approximately 19.9 million sittings generating upwards of $1.2 billion per year in sales (average of $63/sitting).

Competitors:

While somewhat fragmented, the domestic pre-school portrait photography market in which CPI competes is dominated by four national companies (all of which operate within host retailers): Olan Mills (Kmart), CPI Corp. (Sears), LifeTouch (JCPenney and Target) and PCA (Wal-Mart).

Following is a little sound bite on each:

Olan Mills - operates in 840 stores; aggressive on price; operates in weak host store; does not have ability to allow customers to preview photos

LifeTouch - operates in 130 Target stores and 425 JCPenney stores; Target expanding rapidly and providing high visibility studios; quickly imitates marketing programs and product enhancements.

PCA - 1,350 locations; serves 7 million customers per year; reputation for low operating costs and aggressive pricing; host growing quickly; company was LBO’d but has public debt and files financials with SEC; highly levered.

In addition, Picture People (owned by Hallmark) is a mall-based competitor with 320 stores and has a more upscale positioning. Finally, Kiddie Kandids operates approximately 60 stores within Babies ‘R US and has digital fulfillment thereby allowing for one-trip transactions.

Financials / Valuation / What’s it Worth?

The Company has an equity market capitalization of $186 million (8.1 million shares x $22.95/share) and cash of $43.985 million and debt of $34.143 million (as of 7/19/03) for an enterprise value of approximately $176 million [for simplicity I ignore a small net pension obligation as there are offsetting assets, including a tax refund, owned real estate and a $11 million preferred security from the Prints Plus sales that I do not include].

During the past five years, the company has generated the following financials (in millions):

Sales EBITDA Capex Sittings Avg/Sitting
2002 308.6 40.3 8.9 5.033 $61.06
2001 319.1 38.7 14.9 5.534 $57.59
2000 319.9 43.9 11.7 5.648 $56.44
1999 319.1 37.4 25.4 5.809 $53.80
1998 325.5 62.6 14.4 5.779 $56.00

LTM EBITDA was closer to $32.5 million ($26.5 million including roughly 6 million of nonrecurring expenses). The decline was largely because the company’s SG&A expense rose by close to $8 million in the first half of FY03 compared to FY02, despite close to $12 million of restructuring and impairment charges taken (over the past couple years) to actually reduce the company’s cost structure. This SG&A increase was largely to support expansion of the company’s strategy to expand both its mobile photography division and its expansion into Mexico. Thus, I believe the company has been under-earning and if run with a focus on the core Sears franchise, should generate roughly $40 million in EBITDA per year or a 13% margin. This compares to PCA’s business in Wal-Mart which generates north of a 15% margin and is regarded as the most efficient operator. Notably, Cash from Operations tracks EBITDA nicely, averaging approximately $33.3 million over this five year period. Capital Expenditures have averaged approximately 4.7% of sales. Given the rather loose capital allocation during this time period, I believe a more normalized EBITDA - Capex level is $30 million.

As a turnaround bet on current management, the shares appear cheap but should be given the numerous uncertainties (management, business model, etc). On my normalized guestimates, they are trading at 4.4x EBITDA and 5.9x EBITDA - Capex. However, the business appears to be very stable and capable of supporting a different capital structure. For example, if the company were to borrow $100 million at 10% interest and pay it out as a special dividend (or distribute via a dutch tender), the company could still generate $2/share of after tax free cash flow ($40 million EBITDA - 10 million interest - 20 million depreciation shield - 4 million taxes + 20 million depreciation shield - 10 million capex = $16 million / 8 million shares). It is conceivable the stock would trade at 10x this number yielding a total value of $20/share + $12.50/share special dividend or 42% higher than the current share price.

Interestingly, Luxoticca recently made an unsolicited bid for Cole National (NYSE: CNJ) which operates Sears Optical stores. The bid was at a 59% premium and valued the company at roughly 14x EBITDA. Ironically, CPI’s CEO was formerly the CEO at Cole National.

Positives:

• Predicable cash flow. Parents keep coming back for more portraits of their kids as the appearance of their children changes. The historical financials and competitor PCA’s financials show this is a pretty stable business. Intuitively, one might think digital technology would kill their business (e.g. the Kodak effect) but there is no comparison currently between the quality of a digital and portrait print.
• Low capital intensity business. Other than build-out of new studios and remodeling of existing facilities, capital expenditure needs should be modest. New studios can be installed quickly, generating sales immediately and providing quick cash-on-cash returns. In addition, the business requires limited investments in working capital as it grows. Sears provides daily cashiering and bookkeeping and assumption of credit card fees and credit risks.
• Cheap valuation. Company trades at 4.4x EBITDA and 5.9x EBITDA - Capex (normalized). Balance sheet with net cash provides value creation opportunities.


Negatives:

• Dependence on Sears, which has been posting lackluster sales. Comp. Store sales down 2.3% year-to-date. However, the relationship, which started in 1959 and became exclusive in 1986, is strong and contractually extends in the US until 2008. Sears receives an approximate 15% royalty on sales (approximately $45 million per year).
• Revenue flat to declining given flat birthrate. Company is dependent on parents of 0-5 year old children. The overall market isn’t growing much and Wal-Mart is growing a lot.
• Technological change. Timing and business plan behind evolution to digital technology is unclear.
• Stock is relatively illiquid. Risks associated with ownership concentration
• Proxy fight described below may distract management’s attention to the business, waste shareholder funds, and ultimately be unsuccessful

Background on Expected Catalyst:

On September 15, 2003, Knightspoint Partners filed a 13D disclosing their ownership of 8.7% of the Company. The filing describes Knighstpoint as having proposed to management that they “rein in capital spending and operating expenses”, “redirect and reduce advertising expenses”, and “sharpen management focus on the core Sears Portrait studio”, among other proposals. The Knightspoint Group is comprised of the investment banker who advised American Securities on the failed LBO (according to CPI’s CFO) and Ramius Capital, a $3.2 billion investment management firm run by ex-Lehman Brothers CEO Peter Cohen (www.ramius.com). A Lexis screen on Ramius indicated they were very active in getting Nautica Enterprises put in-play last July.

In response to this 13D filing, the Company issued a press release on November 4, 2003 indicating significant adjustments to their strategic plan including a reduction in capital spending and the possibility of returning capital to shareholders. It may prove to be too little too late.

This past Friday, Knightspoint filed with the SEC a proxy solicitation in which they seek to replace a majority of the Board with their own nominees in an effort to enhance shareholder value, including a proposal to “discharge substantial cash to shareholders through large-scale buybacks”. The filing describes in detail their conversations with and stonewalling by management. The filing notes that Section 228(a) of Delaware’s General Corporation Law provides that, unless otherwise provided in the certificate of incorporation, any action required to be taken at a meeting of stockholders may be taken without a meeting if written consents setting forth the action are delivered by, in this case, owners of half the outstanding shares. Since CPI doesn’t have a staggered Board of Directors, Knightspoint is seeking control in this manner.

According to the filing, Knightspoint owns 702,321 of the 4,050,435 shares they need for this vote to pass (abstentions are the same as a vote against). The other large holders are Van Den Berg Management (18.7% or 1.514 million shares), NewSouth Capital (11.8% or 955,468 shares) First Manhattan (5.6% or 455,500 shares), Barclays (5.5% or 446,855 shares) and DePrince, Race & Zollo (5.2% or 419,200 shares). Knightspoint needs 3,348,114 shares voted in their favor for the measure to pass. Interestingly, on the last conference call, the owner of the 18.7% block seemed quite peeved at management for spending $8 million in capital to generate $4 million in incremental revenue. I think it is logical to assume that Knightstpoint has “taken the temperature” of these other shareholders before going through this effort, especially in light of the fact that Ramius purchased the majority of their block in September, 2003 (i.e. they knew what they were getting into). However, I am not a lawyer and would assume CPI management will attempt to fight this effort.

While I believe there are a few bucks a share in the stock now that Ramius has disclosed their intention, their significant investment in the $18 per share range suggests to me they - along with the other significant shareholders - are committed to fighting to realize value here.

Catalyst

Knightspoint group proxy solicitation; see detail above.