CPI Corp. (CPY) operates over 3,000 portrait photography studios, mainly in Wal-Mart (WMT), Sears (SHLD) and Kids R’ Us stores. The industry appears to be in secular decline and CPY has made some questionable operating decisions, but the business model is fundamentally attractive. CPY enjoys a clear market leading position and has employed admirable capital allocation in the last several years. I think it is worth a closer look.
|Price as of 7/13/2011||13.00|
|52 Week Range||11.76-31.00|
|Shares Out (MMs)||7.04|
|Market Cap (MMs)||91.5|
|Enterprise Value (MMs)||138.3|
Positives of the business model:
- Low capital intensity enables strong free cash flow. Portrait photography can almost be looked at as a service business as the inventory requirements are extremely minimal. The fixed capital requirements are modest as well due to almost all of the studios being hosted within big box retailers.
- There are tremendous benefits to scale with the photo processing usually being done in a central lab, which ships the finished photos to the stores for customer pick up. CPY has grown its studio count dramatically by acquiring the Wal Mart (PCA) and Kids R’ Us (Kiddie Kandids) businesses out of bankruptcy in 2007 and 2010, respectively.
- The conversion to digital photography has lowered the cost structure and provides enhanced revenue opportunities.
- CPY pays their retail hosts a percentage of their sales as rent as opposed to a fixed rental fee. This arrangement obviously caps some of the upside, but it limits downside exposure.
- While there is obvious risk of CPY losing their relationships with one of the retail hosts, they have long term contracts in place until 2016. They have had an exclusive contract with Sears since 1986.
Despite all of these positives the business has basically treaded water for the last 15 years earnings-wise. Revenues have grown, but only due to acquisitions. The decline in the legacy Sears business is remarkable. The Sears business did $319 million in revenue in 2001 and only $195 million in 2010 at about the same store count. CPY has managed to retain its earnings power only due to the increased store count through acquisition and the lowering of their expenses due to the conversion to digital photography.
It is hard to tell exactly how much of the business decline is industry wide and how much is company specific because none of their few remaining competitors are publicly traded. But I think it is safe to say there is a secular decline going on. Two of their major competitors, the aforementioned PCA and Kiddie Kandids, went bankrupt. A third, Picture People, recently underwent a distressed sale. The most plausible explanation for the decline seems to be that the ease of digital photography has turned more people into do-it-yourself photographers, although it is surprising that would account for all of it.
Some of the wounds are probably self inflicted as well. Over the past decade CPY decided not to compete on price, especially in their Sears business, even as the rest of the industry did. Given their scale and financial strength they probably would been able to be more price competitive to drive higher volumes without drastically hurting margins or putting the business at risk. Additionally, CPY has been criticized for not being innovative in their service and product offerings to justify the higher price point. It also hasn’t helped that Sears hasn’t exactly been the hottest retailer around.
The economic downturn has compounded CPY’s difficulties, as photo portraits are obviously a highly discretionary purchase (for most people anyway). Revenues are done 12% over the past two years, but CPY has managed to partially compensate with large cost cuts at both the COGS and SG&A levels. CPY has planned on another $20 million annually of cost savings, which is still a material 5% cut to total expenses.
The stock is cheap, trading at about 4X EBITDA and 3X levered cash flow (the company is modestly levered with $53 million in debt). The main question regarding the stock is whether that is cheap enough given the melting same store sales (last quarter down another 9% at Walmart and 16% at Sears) that have been patched over with studio acquisitions and cost cuts. It is also hard to tell to what extent their struggles over the past two years have been macroeconomic related as opposed to being caused by the continued structural decline of the low end portrait industry.
The margin of safety may be boosted by the prudent capital allocation led by Chairmen of the Board David Meyer, who was appointed as part of an activist initiative in 2004. The company’s capital allocation stance of the past few years has been to return cash flows to shareholders and avoid reinvestment in the business unless it is on very attractive terms such as the PCA and Kiddie Kandids bankruptcies. They have paid down about $50 million in debt in the past two years, and raised the dividend, which is now yielding 7.9%.
There is some potential upside with the relaunch of the Kiddie Kandids business acquired last year and a new expansion into event photography (such as weddings) with the recent acquisition of Bella Pictures. They paid no cash for Bella (they assumed the minimal operating liabilities and gave the sellers 5% equity in the new Bella venture), so we can view it as a free option to try to lever their excess photo processing capacity. Still, both of those initiatives are currently small on an absolute basis.
Balancing the attractive business model and solid capital allocation with the melting ice cube of the industry, I think the valuation is nearing a point where the stock becomes a buy. But ice cubes can melt quickly, so I don’t think the stock is cheap enough quite yet to provide a sufficient margin of safety.