Description

CPI CORP. (CPY) $13.36, 11/11/04

SUMMARY
One year ago alli718 posted this idea at a share price of $22.95 versus its current price of $13.36. There is a wealth of information presented in his write up and I suggest you read it as a companion to this update. Briefly, CPY is a photographic portrait company that does business through Sears. The industry is a flat to declining market—poor management hastened the decline for CPY. Two management regimes spent over a decade destroying value of a generally profitable business. CPY was the subject of a failed LBO attempt at $37 per share in 1999. There was a recent proxy battle for control of the company where outsiders won control.

The thesis of alli718’s write-up was predicated on a successful proxy fight, possibly a management change, the cessation of unprofitable business lines and the potential for a recapitalization / special dividend. In short, it all came to pass except the recap, which is still a work in process. Last week, management announced a 1MM share repurchase via Dutch Auction out of 7.75MM shares outstanding. In spite of the proxy success, the share price declined roughly 40% since the write up mostly due to the company’s recent weak performance and uncertainty about the prospects of the new management team for turning the company around (thus creating this buying opportunity). Meanwhile, the current dividend yield is 4.9% and it is selling at 5.3X LTM EBITDA (which is depressed and poised for improvement).

BUSINESS DESCRIPTION
CPI is a portrait photography company offering photography services in the
United States, Puerto Rico and Canada through Sears Portrait Studios with 1,000+ locations. The Company also operates searsphotos.com, an on-line photofinishing service as well as the vehicle for the Company's customers to archive, share portraits via email
and order additional portraits and products. Interestingly, there are 2000+ Sears stores, so there is potential for further growth.

KEY DEVELOPMENTS SINCE ALLI718 WRITE-UP IN NOVEMBER 2003
· March ’04: Proxy Solicitation Commences, Knightspoint Partners wins the motion, all of the members of CPI's Board of Directors except J. David Pierson (then Chairman and CEO) and James Clifford were removed, the size of the Board was reduced from nine to eight members and six nominees of the Knightspoint Group were elected to serve until the Company's annual meeting of stockholders.
· April ’04: CPI Corp. announced that J. David Pierson has been removed from the positions of Chairman of the Board, Chief Executive Officer and President of the Company. The Board of Directors named Jack Krings to the positions of Chief Operating Officer, President and Acting Chief Executive Officer of the Company. Mr. Krings joined CPI in October 2001 and has served as President of the Company's portrait studio division. David M. Meyer (Managing Partner of Knigtspoint Partners) was elected to succeed Mr. Pierson as Chairman of the Board.
· May ’04: CPI Corp. announced that it decided to exit its mobile photography and Mexican operations. The mobile photography business, which operated under the name Every Day Expressions, was launched late in 2002, while the first Mexican studio opened in early 2003.
· June ’04: CPI Corp. announced that it purchased 406,780 shares of its common stock in a negotiated transaction. The Company paid $14.75 per share, for a total purchase price of approximately six million dollars ($6,000,000.00). As of the close of business on June 21, 2004 prior to the share purchase, CPI had 8,156,978 shares outstanding. Furthermore, consistent with the plans to further reduce corporate overhead costs, and, in certain instances, to effectuate additional executive leadership changes, the Company effected second quarter headquarters staff reductions impacting two additional executives and 35 employees
· October ’04: CPI Corp. announced the creation of an interim Office of the Chief Executive and commenced a search for a permanent chief executive officer. In conjunction with his appointment to the new Office of Chief Executive, Mr. Krings stepped down as Acting Chief Executive Officer and resigned from the Board of Directors on October 6, 2004.
· November ’04: CPI Corp. announced that its Board of Directors approved the repurchase of up to 1,000,000 shares of its common stock, through a Dutch auction self-tender offer. The tender commenced on Friday, November 12, 2004 and extends through December 20, 2004. Depending upon market conditions just prior to the commencement of the tender offer, the tender offer price is expected to range from $11.00 to $14.00 per share, or a total of $11 million to $14 million if CPI purchases the maximum number of shares (12.9% of the shares outstanding).

RECENT BUSINESS TRENDS
In the company’s most recent announcement regarding the share repurchase, management also provided an update on business trends. Sales, which had declined 12% for the first half of ’04 versus the same time period in ’03, have had a slight improvement. Though the Q3’04 numbers are not out yet, in that release, management announced that year over year, sales for the quarter were only down 4% (and had been down as much as 13% for the first week of the third quarter). The catalyst was increasing store hours, which had been a criticism of Knightspoint in the proxy fight (less hours open meant fewer sittings). Of course there is a corresponding expense for more hours worked which is an 8% increase in studio employment expense.

RECENT ANNOUNCEMENT OF DEBT REFINANCING
In conjunction with the recent Dutch Auction announcement mentioned above, the company is pursing a $60MM ($30MM Term and $30MM Revolver) debt agreement which is currently being negotiated but is not yet closed. Funding the Dutch Auction is dependent on closing this agreement. If you assume that the company needs roughly $10MM in cash for working capital, that leaves approximately $25MM in debt capacity either for a special dividend, further repurchases or digital upgrades for their studios.

PCA COMPARISON
The best comparable is PCA, Inc. which services all of Wal-Mart. The company was taken private in 1998 and has over 2,200 in-store studios plus a mobile business—twice the size of the CPI.

The company is private but has public debt and thus files with the SEC. As of August 1, 2004, the company had $235MM of debt, representing about 5X ’03 EBITDA—important to note if CPI management continues to look for ways to recapitalize the company. At CPY’s current depressed levels of $21.5MM of EBITDA, the company could potentially sustain $100MM of debt versus the current $25.6MM or proposed $60MM. One other important comparison to make is that their EBITDA margins have consistently been in the 14% range. CPY’s TTM EBITDA margin is 7.5%--plenty of room for improvement.

Though a dated comparable, PCA was purchased for $276MM (debt and equity) in 1998. Using actual ’98 results, the deal was consummated at 7.21X EV / EBITDA or 1.14 EV / Sales. Using Valueline estimates for ‘04 (you could adjust up for all the initiatives or down for the trends) and before the Dutch Auction, you get a valuation around $45 per share. Obviously a buyout multiple depends on the financing environment, competition for deals among private equity shops, the relative health of the target company and the current economy, but it is a relevant data point.


VALUATION

Current Capital Structure:
Current Share Price: $13.36
Shares Outstanding: 7.75MM
Market Cap: $103.5MM

Cash Balance as of 7/24/04: $14.8MM
Total Debt as of 7/24/04: $25.6MM
Enterprise Value: $114.3MM

LTM as of 7/24/04
Revenues: $288.2MM
EBITDA: $21.5MM
Net Income: ($13.1MM)
EV / LTM EBITDA: 5.3 X
LTM EPS: ($1.31) / Share (excluding special items)
P/E: NM

P / BV: 3.8 X
P / TBV: 3.8 X


RISKS TO THE INVESTMENT
· Sears: In this investment, you are dependent on their traffic and general fiscal health which is not stellar. In addition, the recent announcement that Vornado has a large stake calls into question the future of their real estate and underperforming stores. It could be a shrinking real estate base.
· Macro Trends: With the advent of digital photography, perhaps portraits will become a self service endeavor in the not too distant future jeopardizing the business.
· Declining same store sales and average selling price: This business is in a turnaround and it may not be successful
· Leverage: They may not be successful in levering up further and thus no special dividend, or perhaps just as worse, they get it done and it introduces more risk
· Share price after the successful proxy solicitation: I cannot account for the precipitous decline even after the generally good news. DePrince Race and Zollo blew out seemingly even after the proxy win—maybe they know something.
· It is a seasonal business—a great deal of the operating profit is generated during the holiday season which makes it subject to the economy and intense competition for disposable income.
· New management: The business essentially has a financial person at the helm which is a mixed blessing. Capital allocation is likely to be strong, operations, which is an issue here, may continue to suffer or get worse.
· Shares are thinly traded which makes reasonable entry and exit a risk.

CONCLUSION
This is a combination of a special situation and a value play. A few patient investors waited a long time to unlock value inherent in the company. Many of the steps required to make that happen have occurred and yet because of the decline in the health of the business, the share price went the other way. I believe we will see value creation under this new management regime both by improving operations and prudent capital allocation and perhaps additional compensation via a special dividend (or ultimately, another run at a buyout).

Catalyst

CATALYSTS
1. Successful share repurchase
2. Improved operating metrics
3. Potential special dividend
4. Potentially the company gets taken private