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CPI Corp. (NYSE:CPY)

Q2 2008 Earnings Call

August 26, 2008 11:00 am ET

Executives

Grace Fuentes – Assistant General Counsel

Dale E. Heins – Senior Vice President, Chief Financial Officer

Renato Cataldo – Chief Executive Officer, President

Analysts

Will Hamilton – SMH Capital

John Shrever – Granite Point Capital

Austin Rute – BLH Capital

Jim Pouliot – Century Management

Operator

Welcome to the CPI Corp. second quarter fiscal year 2008 conference call. (Operator Instructions)

Grace Fuentes

I am Grace Fuentes, the assistant general counsel for CPI Corp. We would like to thank you all for joining us for our second quarter fiscal year 2008 conference call.

By now you should have received a copy of the press release that we issued last evening. If you need a copy you may go to our website at www.cpicorp.com to obtain a copy of the release.

Dale Heins, CPI’s chief financial officer and senior vice president of finance, will present management’s overview and respond to questions. He will be joined by Renato Cataldo, our CEO, in fielding questions.

Before I turn the call over to Dale and Renato I would like to caution all listeners that certain statements made during this conference call which are not historical may be deemed forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Although CPI believes the expectations reflected in any forward-looking statements are based on reasonable assumptions we can give no assurance that the expectations will be attained. Factors and risks that could cause actual results to differ materially from the expectations are detailed in last night’s press release and from time to time in our filings with the Securities and Exchange Commission.

The information and statements made during this call are made as of the date of the call. Listeners to any replay should understand that the passage of time alone will diminish the qualities of statement.

Finally, the content of the call is the property of CPI. Any replay or transmission of the call may be done only with our consent.

It is now my pleasure to turn the call over to Dale Heins.

Dale E. Heins

Like many other retailers and service providers that operate in a discretionary spending segment of the economy, our second quarter results reflect a very difficult economic environment as consumers continue to struggle with higher fuel and food costs, strains to the family budget, and causing them to often defer or reduce the amounts they spend on discretionary items.

Although our second quarter sales results declined at a slightly higher rate than our first quarter, we generated positive EBIDTA in what has historically been our lowest revenue volume quarter through continued productivity gains, effective cost controls, and steady progress on our PictureMe integration efforts.

Even as we continue to drive efficiencies throughout the organization, restoring sales growth remains our top priority and on this score we are pleased to report that our enhanced loyalty, customer service, and outreach programs, offer changes, and improved digital capabilities are beginning to drive increased acquisition and retention which should age sales comparisons in the second half of the year.

In the second quarter of 2008 we saw sales increase 32% to $89.6 million from the $68.1 million in 2007 quarter due to the inclusion of the results of the PictureMe Portrait Studio business acquired June of 2007 for the full 12 weeks of the quarter.

On a brand-specific basis, our Sears Portrait Studio sales declined 10% to $47.8 million as sittings declined 11% and only partially were offset by a 2% increase in the average sales of customer sittings.

For our PictureMe Portrait Studio brand we recorded $41.9 million in second quarter 2008 sales, which represents a same-store sales decline of approximately 5% versus the prior year period.

We recorded a loss of $3.6 million or $0.56 per share in the second quarter compared to a net loss of $4.6 million or $0.72 per share for the prior year period. As discussed in the press release, the earnings comparison is significantly affected by non-cash charges and one-time costs associated with the acquisition.

We believe that adjusted EBIDTA is the best measure of our operating performance. Second quarter adjusted EBIDTA declined to $1.6 million from $2.3 million in the 2007 quarter, including approximately $1.8 million in extraordinary labour and travel costs associated with the digital conversion, the accrual or contingent commission to Sears arising from the acquisition of the PictureMe Portrait Studio brand, unusually high fees for professional services incurred in conjunction with the litigation, and the presence of favourable vacation policy adjustments, and an unfavourable purchase economy adjustment in last year’s period.

Excluding the impact of these unusual items referenced above, adjusted EBIDTA would be approximately $4.6 million in the current quarter compared to $4.9 million in the prior year period. Despite lower than expected sales, the operating contribution of the PictureMe Portrait Studio brand improved through substantial reductions in corporate support costs and increase field and manufacturing productivity. We continue to track our initial goal of achieving at least $15 million in annualized corporate support cost savings and potentially larger savings from the digital conversion and other productivity and margin enhancing activities by the end of 2008.

As previously discussed, although we are beginning to see an earnings impact from these activities in the current year, we expect to see the biggest year-over-year comparison impact of these reductions during the course of fiscal year 2009.

We have also reported that our PictureMe digital conversion efforts is nearly complete in the United States and present and proceeding in Canada and Mexico. As of today, 1,600 PictureMe Portrait Studios are already digital and we expect to fully convert all studios by the end of November this year.

Encouragingly, ascending what has proven to be a protracted learning curve, our PictureMe Portrait Studios are now generating substantially higher sales performance than comparable film-based studios. Consistent with past practices, our press release includes our current quarter-to-date sales performance for both brands. Sales at Sears Portrait Studios declined 13% in the first four weeks while PictureMe Portrait Studios sales decreased 12% during the same period. The lower volumes of sittings were only partially offset by improved averages.

It’s important to note that these early results reflect timing differences year over year and on marketing programs and should not necessarily be viewed as an indicator of trends leading into the back-to-school and holiday periods.

Before I move to the question and answer portion of the call I wanted to briefly address one more item. There are rulers in the market regarding the company’s liquidity and the quality of its cash management investments.

First of all, the company does not have, nor does it expect to have, liquidity issues in the coming periods. As in prior year our cash will (inaudible) in the time period leading up to the start of the holiday season. Though the PictureMe digital conversion will cause cash levels to be lower this year compared to other years, the company has sufficient liquidity to meet its operating plans.

Secondly, our cash is kept in very high-quality, short-term cash management investments. As we need cash to fund a large capital expenditure purchase investments are sold without delay.

Lastly let me point out that if we were to significantly underperform our expectations for the remainder of the year we will still end the year with significant cash on the balance sheet. With the PictureMe Portrait Studio digital conversion complete by the end of the year future capital expenditure needs will be dramatically reduced to more typical maintenance levels.

With that we’ll open up the lines for comments and questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Will Hamilton – SMH Capital.

Will Hamilton – SMH Capital

Good morning, guys. Thanks. Just a couple housekeeping questions first. Dale, can you provide us with the number of studios you had at the end of the quarter?

Dale E. Heins

The total number of studios?

Will Hamilton – SMH Capital

Well, I was wondering if you could break it down between Sears and PictureMe. I know there were some planned PictureMe closures. I was wondering....

Dale E. Heins

Well, on the PictureMe closures there were 51 planned. I think only 42 have occurred. Some of them have been postponed. We’re not sure if indefinitely or not, but there’s those locations that are remaining open at least through the end of the year. But in total we have 3,061 locations, 890 US Sears Portrait Studios, 110 Canadian Sears Portrait Studios, 1,657 US PictureMe Portrait Studios, 254 Canadian Wal-Mart Studios, and 117 Mexican Wal-Mart Studios.

Will Hamilton – SMH Capital

And what was the total number of PictureMe studios converted at the end of the quarter? I’m trying to just get a progress update between....

Dale E. Heins

Do we have that? There’s 1,600 today. I don’t have the actual number at the end of the quarter. We’re doing 50 a week or so.

Will Hamilton – SMH Capital

What was the CapEx in the quarter and the cash flow from operations?

Dale E. Heins

I believe in the quarter CapEx was $11.5 million, somewhere near there. I have the year-to-date numbers. I think it was somewhere around $12 million in the quarter.

Will Hamilton – SMH Capital

And the cash flow from operations?

Dale E. Heins

It’s negative $5 million basically. That included when we assumed the Wal-Mart agreement they had some extended payment terms in terms of their commissions that allowed PCA to defer their payments for 90 days. That provision expired at the start of the fiscal year, so basically there was a catch-up payment for about $5.6 million that took place early in our fiscal year to put them on the historical 30-day payment terms. That was a large fluctuation in terms of the balance sheet.

There was also a lot of CapEx in the pipeline at the end of the year that was accrued for basically that were paid for during the first quarter. I think that was another $4 million or $4.5 million.

Will Hamilton – SMH Capital

The digital training and travel costs, I imagine those were going to start to come down in the second half. Can you give us a sense of what you kind of modelled for in the second half for that?

Dale E. Heins

I think you’ll still see quite a bit because you’ve got, I don’t have the number. I mean, probably closer to what we saw in the first quarter, which I think was $1.2 million. I think it’s probably more in that range. Second quarter was definitely the heaviest in terms of training and travel.

Will Hamilton – SMH Capital

In regards to the comparable sales and the sittings, do you think you could break down the PictureMe sittings or the decline a little bit more? How much do you think maybe were due to couponing from last year? How much you might attribute to the price increases you put in place? And then I guess certainly the economy factor, which you talked about. Then after that just talk about a little bit what is your strategy in terms of pricing going forward in the PictureMe studios given probably the more sensitive customers in those doors.

Dale E. Heins

Yes, I think about, you know, we really can’t, I can’t provide you with a detailed breakdown of the decline. What I can talk about is in the first quarter we did have some unusual comparisons with their numbers. They had extremely low offers out there, historically low offers, $0.88 cent offers. I mean, they were just kind of giving product away when they were trying to re-launch the PictureMe brand at that point in time. I would tell you that our offers today obviously aren’t $0.88, but they’re very compelling offers. They’re comparable to other historical, more normalized offers that they offered in that business.

I don’t think, from a pricing standpoint we’re probably really, you know, we haven’t raised prices that much. We’re getting lifts in our average really just from product offering. We now have product to sell that the customers love and are willing to buy more of.

Will Hamilton – SMH Capital

Are you seeing the same shift in the type of customers coming in that you saw when you converted the Sears locations to digital? I mean, are the same type of customers that dropped out after the Sears conversion because of the pricing level, is that the same as you’re seeing right now?

Dale E. Heins

Like I said, we’re still offering very low-end packages to continue to attract customers into the studios. We really, this is a different model. In the Sears model when we converted to digital we did kind of wean off some of the lower priced, weaned people off the lower priced packages. We’re not doing that at Wal-Mart. We want to get people in there, want to introduce them to all the new products, and you’re getting I think a lot of the same customers just realizing, wow, this is some great stuff. We’re willing to spend money on it.

Will Hamilton – SMH Capital

I was wondering if you could talk a little bit about what percentage of your costs are variable given the trends we’re seeing on the top line so that we have a sense as to how the model can adjust to the changes at the top line to help keep the margins where you like them to be.

Dale E. Heins

Well, you know, the one part of our business that obviously is different than a lot of speciality retail/service providers is that our rent is basically variable. So that’s clearly an advantage we have in terms of it adjusts with the volumes that are going on.

From a labour standpoint, you know, the Wal-Mart business, there’s still some flexibility in your labourer modelling. A little less so than Sears because you have a lot of, you know, these are single camera locations during the week. Particularly Monday through Thursday. They’re single covers. So you really can’t do a whole lot. Obviously Wal-Mart has given us some ability to adjust hours, but there’s not nearly as much flexibility there. On the Sears side we dial it back as much as possible if the sittings aren’t there or increase labour when the sittings are. So there’s some labour flexibility. Those are your main components. COGS is very much a variable cost with the level of sittings.

Will Hamilton – SMH Capital

And then just a final question on the Sears contract. I know you’re sensitive about providing more information on this, but I was wondering if you could give us a little bit more detail or colour as to what’s the hold up with the contract. It was my understanding that there might have been some progress earlier this spring, but it now appears to be sort of a waiting game. Can you add more colour on that? Where’s the hold up?

Dale E. Heins

Well, I wouldn’t say it’s a waiting game. It’s a negotiation. An ongoing negotiation. Obviously we’d all like to put it behind us and focus on the holiday season, but the negotiations are continuing. There’s really not much more to say. As we’ve indicated before, this is a long-standing, very solid relationship benefiting both parties very much. Up until this latest contract which expires at the end of the year, CPI operated for decades in Sears with a contract that basically had an out clause on a day’s notice. So I don’t think, the contract is important, I understand the investment community and banks and everyone else really want to see that concrete term to the relationship, but this relationship has gone on for a long time and hopefully we’ll get this done soon and it will continue on for a long time.

Operator

Your next question comes from the line of John Shrever – Granite Point Capital.

John Shrever – Granite Point Capital

Just a quick clarification on the EBIDTA numbers you mentioned, the adjusted EBIDTA of $1.6 million in the quarter down from $2.3 million. Then you mentioned a couple more numbers. I think you said $4.6 million and $4.9 million. Could you just take me through again the difference between those two sets of EBIDTA figures?

Dale E. Heins

Yes, the first set is really kind of historically how we always present EBIDTA. There’s some add backs related to kind of very specific things, costs directly related to the acquisition that is truly one-time unusual items. The second numbers I quoted were just some kind of unusual operating activities that were going on during the quarter that were providing some distortion of the numbers. The digital and labour and travel costs associated with the digital conversion, which was $1.8 million; the contingent Sears commission; and then just some very unusual litigation costs that were going on in the quarter. Then the prior year numbers just had this unusual purchase accounting adjustment that made those numbers look unusually low. And then also this favourable vacation policy adjustment last year that also improved the numbers a little bit in the quarter.

John Shrever – Granite Point Capital

And then could you talk a little bit about the CapEx trajectory going forward now that the conversions are mostly behind you. Should we be getting down back towards a more historical $2 million to $3 million a quarter type number or could it even be lower than that?

Dale E. Heins

One thing we don’t have a lot of history on is kind of what the maintenance count will be with Wal-Mart in terms of remodelling and just keeping the locations up to date. So it’s not 100% clear exactly how much we’ll have to spend annually just to maintain those locations. I would believe that you’ll see CapEx probably far closer to $10 million. It could be a little less, it could be slightly more, but that will probably be more the maintenance levels that will be happening going forward.

John Shrever – Granite Point Capital

Would it also make sense that with Q2 your lowest volume quarter now behind you this could well be the last negative free cash flow quarter that we’ll see out of the company given that volumes pick up from here as CapEx falls? I’m just wondering, seasonally when we get into this quarter next year, you know, will you still generate positive free cash in this low seasonal quarter.

Dale E. Heins

I can’t predict what our performance will be next year, but if you can achieve even the performance levels that we’re achieving this year then yeah, I think that would be the case.

John Shrever – Granite Point Capital

And then finally, given that free cash should start to grow steadily from here, what are your plans for the use of that free cash? Obviously the stock is pretty attractive at these levels. There’s debt on the balance sheet that you could be paying down, but a lot of investors have been waiting a number of quarters for this moment and I’m excited to find out what you’ll do with the free cash generation.

Dale E. Heins

Yes, obviously our focus this year has been this digital conversion. We wanted to get that behind us, get it out in the locations so that they are hopefully prepared for the important holiday season. So that’s been really the focus of all of our attention this year. I think as we’re getting closer to the holidays here and seeing what’s going to happen for the year, you know, the board and management will begin discussions in terms of what the possibilities are for use of cash going forward. We’ll also have to have some discussions with our debt holders to make modifications. I think those activities will be going on in the fourth quarter. I mean, you’ve seen what this board has done in the past in terms of returning money to shareholders through some buy-backs. That option will be explored. And others as well.

Operator

Your next question comes from the line of Austin Rute – BLH Capital.

Austin Rute – BLH Capital

But I just kind of wanted to understand balancing top line degradation given the market with efforts to reduce costs. When we would see the SG&A line grow at a slower rate than sales. Or, you know, in the instance of declining year over year would it decline by more? In other words, this quarter we had sales growth by 31%, but SG&A go up by 37%. When, as you look out, will that sort of reverse and be more favourable?

Dale E. Heins

Well, again, I mean, we can’t predict what’s going to happen. It’s our top priority to get the sales line headed in the right direction. There’s lots of efforts going on. Obviously on the PictureMe Portrait Studio brand we’re hoping that once you get the digital conversion out there really begin to market all the new products and the new image and the new experience that the customers can have out there that we’ll start getting some wind behind our sales and see that business improve.

Now, obviously we have economic issues out there that are affecting performance. We can’t fix that ourselves. But we also think there could be some pent up demand that will build here hopefully for the holiday season that could be going for us. So that part of the business we think will, you know, we’re hoping will move in the right direction.

On the Sears side of the business we have lots of activities going on out there to get customers in the studios. Lots of acquisitioning going on to find new customers, get them in. New loyalty program that has sold very well that we started earlier this year. We’re just now starting to see redemptions of some of those coupons and starting to see the back end of that, and that’s why you put loyalty programs out there is to get repeat business. We’re hoping that we’re taking enough steps to begin to change that trend.

Obviously I’d like to report to you now that it has changed, but obviously it hasn’t. We’re doing everything we can to get it headed in the right direction.

Austin Rute – BLH Capital

You mentioned your rent is variable. I believe that’s true on the Wal-Mart side as well. Have you spoken about what that approximately number is as a percent of sales? Is it still about 14% and 15%?

Dale E. Heins

You know, we basically, we don’t want to disclose that information. And that’s also Wal-Mart’s desire as well.

Austin Rute – BLH Capital

Is there a component to the negotiations with Sears that revolves around the fact that it’s variable? Is there a possibility that you could make it more of a flat rate going forward?

Dale E. Heins

No. I don’t think that’s going to change.

Operator

Your next question comes from the line of Jim Pouliot – Century Management

Jim Pouliot – Century Management

Can you just clarify the CapEx remaining for the year? I think you’ve done, what, $25 million year to date?

Dale E. Heins

Yes, I think we’re talking about another $8 million to $10 million for the remainder of the year. Most of which is really happening right now or already has happened.

Jim Pouliot – Century Management

By November you’re going to be done, basically.

Dale E. Heins

Yes. There won’t be much left in the fourth quarter. And I mean, there could be some hold over just in terms of paying for things in the fourth quarter, but for the most part it will be done.

Jim Pouliot – Century Management

So just based on the quarter end, $8 million to $10 million and then now we start entering maintenance capital spending levels. Right?

Dale E. Heins

Right.

Jim Pouliot – Century Management

The other thing, relative to the PictureMe acquisition, there was some assets that were acquired, obviously, that you’re not using as you turn to digital. Non-core assets, real estate buildings. What do you have there that could be liquidated or sold?

Dale E. Heins

I think there’s, we are looking at our, I guess I would view it excess real estate. Some of it is really, you know, we still need it basically until we have completed the digital conversion. So basically we have a film lab in Charlotte, which was also their headquarter facility that frankly we have to operate until the last store has been converted. So obviously by the end of the year that will be done and that building, frankly, right now is being prepped for a potential sale. So that will be hopefully monetized some time in possibly 2009 or 2010. There’s also some other excess real estate that we acquired that will probably also be put on the market as well.

Jim Pouliot – Century Management

Care to quantify the dollar amount?

Dale E. Heins

You know, it’s all too speculative at this point. I’m not sure what the market value is. The Charlotte market has probably been a little bit better in terms of holding up in the real estate market, but I still don’t have good numbers in terms of what we think we can get on them.

Jim Pouliot – Century Management

And then as we finalize this digital conversion and there’s at least $15 million in cost benefit due to the conversion, where are we going to see that first? Is that going to be in COGS or SG&A or a combination of both?

Dale E. Heins

Both. The manager’s starting. You’re already seeing it in COGS. You can see that’s been coming down. It’s in both. You’ll see it in both areas.

Jim Pouliot – Century Management

And that should be, the beginnings of that, of greater magnitude in the fourth quarter.

Dale E. Heins

Yes. I mean, like I said, we’ve done a lot in the second quarter. A lot of locations were converted, so obviously a lot more are on the digital platform. So you’re buying less film. You’re processing through the new digital lab. So just with every location being converted you’re seeing more and more benefit.

Jim Pouliot – Century Management

And then, staying with PictureMe, what’s the potential, once all this is converted and you’re up and running with a new system inside Wal-Mart, what’s the opportunity for opening new locations at Wal-Marts you’re not in?

Dale E. Heins

I don’t know. I don’t think we’ve had that discussion with Wal-Mart yet. I mean, we’ve really been focused on trying to restore the image of brand there. I mean, really, you know, we’re showing Wal-Mart what we can do this year. Showing them that we are making substantial investments in the business. I think they’re viewing that favourably and hopefully we’ll have some discussions in the future, if it makes sense, to open locations and they’ll be agreeable.

There are locations that are presented to us now, new locations that they ask us if we’re interested in going into. I mean, to some degree that’s already happening. I guess the question is, do you go back to a lot of locations that they closed or ones that they’ve never been in. Most we’ll just have to wait and see.

Jim Pouliot – Century Management

Can you give me a little bit, give us a little more detail. You talked about some of the customer acquisition activity that you’ve done, loyalty programs, and you’re starting to see some increased traffic due to that. Can you give a little bit more detail or flavour on what it is you’re doing and the kind of response you’re getting?

Dale E. Heins

Yes, I mean, the loyalty program is really kind of two pronged. It’s a fairly low buy-in in terms of getting the program. And then what happens is they get benefits if they, there’s two different levels of benefits. If they come in during the week there are very attractive offers. Obviously trying to drive sittings into the lower volume times of, kind of the Tuesday through Thursday time frames. And then there’s also benefits on the weekends where they get no session fees and a free sheet. I mean, there’s pretty attractive offers.

Like I said, we get very good acceptance in terms of selling the program. Pretty high conversion rates. We’re starting to see some benefit.

Jim Pouliot – Century Management

Is this in both platforms?

Dale E. Heins

The programs in the PictureMe brand is a little bit different. I don’t remember exactly what the benefits are there, but it’s one we’re pushing more in the Sears side of the house at the moment.

Jim Pouliot – Century Management

And then you talked about some real low packages, the $0.88 type packages at Wal-Mart. They’ve been low pretty much across the board. I know part of the philosophy is that you need to get paid for the value you’re presenting and all, although it would be a lower price point than, say, inside Sears. How much of, you know, as you raise prices and get out of the giving away pictures business and get paid for what you do, how much of the sitting decline has been related to getting out of that give-away business and how much is, can you quantify any of that?

Dale E. Heins

No, but (inaudible) I don’t think we, in the Wal-Mart business we really are still kind of operating that package model. We’re not, I don’t think it’s our plan to kind of, you know, like we did in Sears where we basically just completely got out of it and then seated those customers through other providers. In the PictureMe side of it you need to, that consumer, you need kind of an eye-popping offer to get them into the studios and then track them in. So we’ll continue to have some fairly attractive packages out there.

Now, I think the back-end pricing is obviously a little bit different, but hopefully we’re not going to be driving off, we’re not going to be scaring people off with our pricing.

Operator

There are no further questions at this time.

Dale E. Heins

Well, thanks, everyone, for joining us today and I look forward to our call after our third quarter. That’ll be sometime in mid December. Thank you very much.

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