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CPI Corp. (NYSE:CPY), the operator of Sears Portrait Studio, is a company I am surprised still exists. CPY’s secular decline has been accelerated by cyclical pressures and its locations in struggling Sears stores. These forces have turned this once highly profitable business into an anachronism.

Sales have declined to the point where, given its cost structure, cash flow is now negative. These dynamics, on a levered balance sheet, make this stock a likely zero over the next year. Despite its fall over the last two weeks, CPY still trades at 14x optimistic 2011E EBITDA. You can short the stock here with limited risk and still get a 100% return.

Industry

Going to Sears or Wal-Mart to have your family picture taken is something you would see in a black-and-white film. The advent of high-quality digital cameras at inexpensive prices has made professional quality picture taking accessible to anyone. New technology captures multiple images in a single shot and automatically combines the most appealing of those images into one picture. Unique technical knowledge and professional training is no longer a differentiator for CPY. The fact that little training is needed to be a CPY photo tech only reinforces this reality.

Company

Last week CPY announced Q3 results. It was the worst collection of bad news I have seen a company report in a while. Among other things, CPY reported: 1) double digit sales declines, 2) that it would no longer pay a dividend, 3) that it had tripped a senior debt covenant, 4) that it is almost certainly going to be delisted and 5) that prospects for its busiest Q4 were bleak.

In Q3 CPY recorded 16% and 15% same-store-sales declines in its core Sears and Wal-Mart studios and a staggering 25% decline in its recently acquired Kiddie Kandids locations. Management sited ineffective marketing as the reason for these declines, noting that mass emails were blocked by spam filters and that they were not aggressive enough on promotions. This flimsy excuse has been used in the past and demonstrates management’s effectiveness and their inability to acknowledge that the portrait studio ship is sinking.

CPY went on to say that sales for the first 5 weeks of Q4 had declined to $62M or 21% over last year. This implies total Q4 sales of $100M. Basically, far fewer people came in to have their holiday pictures taken this year. Given the high fixed cost nature of the business, this implies EBITDA of -$5M to -10M for Q4 and effectively the same total for 2011 (since YTD EBITDA is $0.9M). Even if these sales declines stabilize and CPY is able to cut $5M in overhead, EBITDA will still be running negative. Add $10M in annual capex needs and $3M in interest expense, the cash flow picture gets even darker.

Valuation

CPY has an EV of $83M with a market cap of $14M (7M s/o) and net debt of $69M ($74M in bank debt and $5M in cash). The company has recorded $0.9M in EBITDA YTD. Even if you assume CPY is able to generate $5M in Q4 EBITDA in a turnaround scenario, this equates to an EV/ EBITDA multiple of 14x on negative cash flow. These multiples are going to increase in 2012 as performance declines. Even in a strong recovery scenario of $12M EBITDA, CPY would still be trading at 7x. Overall with $74M in debt ahead of the equity, there are almost no scenarios where the equity has any value.

Catalysts

CPY tripped a covenant in Q3 and has a debt/ EBITDA ratio of 5x. If it is unable to recut it lending agreement then CPY could be forced to file for Chapter 11 protection. Even if it were renegotiate it loan, then availability and interest costs would overburden this already structurally challenged company. CPY is well below the NYSE listing requirement of $50M market cap, and will almost certainly be delisted over the next couple of months. The recent announcement by Sears that it is closing 100 to 200 stores will have meaningful effect on the CPYs operations. A potential Sears bankruptcy would have even more dire implications for CPY.

Source: CPI's Bleak Q3 Points To Dark Days Ahead