Attached files

file filename
EX-23.0 - CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM - CPI CORPexh23_0.htm
EX-11.2 - COMPUTATION OF INCOME (LOSS) PER SHARE - BASIC - CPI CORPexh11_2.htm
EX-31.1 - CERTIFICATION OF PRESIDENT AND CEO - CPI CORPexh31_1.htm
EX-11.1 - COMPUTATION OF INCOME (LOSS) PER SHARE - DILUTED - CPI CORPexh11_1.htm
EX-10.28 - 1ST AMENDMENT TO 2ND AMENDED & RESTATED CREDIT AGREEMENT - CPI CORPexh1028.htm
EX-32.0 - CERTIFICATION OF CEO AND CFO - CPI CORPexh32_0.htm
EX-21.0 - SUBSIDIAREIS OF THE REGISTRANT - CPI CORPexh21_0.htm
EX-31.2 - CERTIFICATION OF CFO - CPI CORPexh31_2.htm
EX-10.40 - AMENDMENT TO CHAIRMAN'S AGREEMENT DATED SEPT. 22, 2008 - CPI CORPexh10_40.htm
EX-10.41 - EXECUTIVE CHAIRMAN AGREEMENT - DAVID MEYER - CPI CORPexh10_41.htm
EX-10.43 - KEITH LAAKKO EMPLOYMENT AGREEMENT - CPI CORPexh10_43.htm
EX-10.44 - KEITH LAAKKO CONFIDENTIALITY AGREEMENT - CPI CORPexh10_44.htm
EX-10.45 - KEITH LAAKKO 1ST AMENDMENT TO EMPLOYMENT AGREEMENT - CPI CORPexh10_45.htm
EX-10.46 - CPI CORP RETIREMENT PLAN AMENDED AND RESTATED - CPI CORPexh10_46.htm
EX-10.42 - TOYS "R" US AMENDED & RESTATED LICENSE AGREEMENT AND AMENDMENT TO SAID AGREEMENT - CPI CORPexh10_42.htm


 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K
(Mark One)
 
x     ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended February 6, 2010                                                                                or

o     TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ___________________ to ____________________

Commission file number 1-10204

CPI Corp.
(Exact name of registrant as specified in its charter)

Delaware
(State or other jurisdiction of incorporation or organization)
 
1706 Washington Ave., St. Louis, Missouri
(Address of principal executive offices)
43-1256674
(I.R.S. Employer Identification No.)
 
63103
(Zip Code)

Registrant’s telephone number, including area code: 314/231-1575

Securities registered pursuant to Section 12(b) of the Act:

Title of each class
Common Stock, par value $0.40 per share
Name of each exchange on which registered
New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  oYes  xNo

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  oYes  xNo

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  xYes   oNo

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§229.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  oYes   oNo

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer,”  “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

Large accelerated filer  Non-accelerated filer  o  Accelerated filer  Smaller reporting company  o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  oYes    xNo

As of July 25, 2009, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was approximately $93,102,000 based on the closing sales price of the common stock as reported on the New York Stock Exchange.

As of April 16, 2010, 9,671,756 shares of the registrant’s common stock were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE:
 
Part III of this Annual Report incorporates by reference certain information from the registrant’s definitive proxy statement for the 2010 annual meeting of the shareholders, which the registrant intends to file with the Securities and Exchange Commission no later than 120 days after the close of the registrant’s fiscal year ended February 6, 2010.



 
 
 
 
 
  TABLE OF CONTENTS
PART I
 
 
Business
 
3
 
Risk Factors
 
8
 
Unresolved Staff Comments
 
11
 
Properties
 
12
 
Legal Proceedings
 
12
     
PART II
   
     
 
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
          13
 
Selected Financial Data
 
14
 
Management's Discussion and Analysis of Financial Condition and Results of Operations
             16
 
Quantitative and Qualitative Disclosures About Market Risk
    28
 
Financial Statements and Supplementary Data
 
29
 
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
    65
 
Controls and Procedures
 
65
 
Other Information
 
68
     
PART III
   
     
 
Directors, Executive Officers and Corporate Governance
 
69
 
Executive Compensation
 
69
 
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
    69
 
Certain Relationships and Related Transactions, and Director Independence
    70
 
Principal Accounting Fees and Services
 
70
     
PART IV
   
     
 
Exhibits and Financial Statement Schedules
 
70
     
76
 


 
2
 
 

Forward-Looking Statements

The statements contained in this report, and in particular in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section, that are not historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, and involve risks and uncertainties.  The Company identifies forward-looking statements by using words such as "preliminary," "plan," "expect," "looking ahead," "anticipate," "estimate," "believe," "should," "intend," and other similar expressions.  Management wishes to caution the reader that these forward-looking statements, such as the Company’s outlook for portrait studios, net income, future cash requirements, cost savings, compliance with debt covenants, valuation allowances, reserves for charges and impairments and capital expenditures, are only predictions or expectations; actual events or results may differ materially as a result of risks facing the Company.  A detailed discussion of these and other risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section entitled “Risk Factors” beginning on page 8 of this report.  The Company undertakes no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

PART I
 
Business

An Overview of the Company

CPI Corp. (“CPI”, the “Company” or “we”), a Delaware corporation formed in 1982, is a long-standing leader, based on sittings, number of locations and related revenues, in the professional portrait photography of young children, individuals and families.  From a single studio opened by our predecessor company in 1942, we have grown to 2,935 studios, as of February 6, 2010, throughout the U.S., Canada, Mexico and Puerto Rico, principally under license agreements with Sears, Roebuck and Co. (“Sears”) and lease and license agreements with Walmart Stores, Inc. (“Walmart”).

The Company has provided professional portrait photography for Sears’ customers since 1959 and has been the only Sears portrait studio operator since 1986.  On June 8, 2007, the Company completed its acquisition of substantially all of the assets (the “Assets”) of Portrait Corporation of America (“PCA”) and certain of its affiliates (collectively, the “Sellers”) and assumed certain liabilities of PCA (the “PCA Acquisition”).  For purposes of this report, the operations acquired in the PCA Acquisition are operating within CPI Corp. under the trade names PictureMe Portrait Studio® in the U.S., Walmart Portrait Studios in Canada and Estudios Fotografia de Walmart in Mexico, collectively “PMPS” or the “PMPS brand”.   As a result of the PCA Acquisition, CPI is the sole operator of portrait studios in Walmart Stores and Supercenters in all fifty states in the U.S., Canada, Mexico and Puerto Rico.
 
CPI entered into an Amendment (the “Amendment”) dated as of February 22, 2010, effective as of April 20, 2010, with Toys “R” Us – Delaware, Inc. (the “Licensor”, “Toys “R” Us” or “TRU”) to the Amended and Restated License Agreement  (the “License Agreement”) made and entered into as of December 23, 2005, between TRU and Kiddie Kandids, LLC.  Kiddie Kandids, LLC is a Chapter 7 debtor under Case No. 10-20334 brought before the United States Bankruptcy Court for the District of Utah (the “Bankruptcy Court”).  The Company acquired the License Agreement in its acquisition of certain assets of Kiddie Kandids, LLC in an auction conducted by the Bankruptcy Court.  Under the Amendment, TRU grants CPI an exclusive license to operate photo studios (the “Studios”) in certain Babies “R” Us stores under the Kiddie Kandids name.  The term of the License Agreement, as amended by the Amendment, expires on January 31, 2016.  The Amendment allows CPI significant operating flexibility and collaborative marketing opportunities and provides for the opening of additional locations over the next two years.  The Amendment and the License Agreement contain certain termination rights for both the Company and TRU.  
 
As of February 6, 2010, PMPS operates 1,923 studios worldwide, including 1,549 in the U.S. and Puerto Rico, 260 in Canada and 114 in Mexico and Sears Portrait Studios (“SPS” or the “SPS brand”) operates 1,007 studios worldwide, including 897 in the U.S. and Puerto Rico and 110 in Canada.  Approximately $96.5 million, $15.7 million and $858,000 of long-lived assets are used in our domestic, Canadian and Mexican operations, respectively, as of February 6, 2010.  The Company generated fiscal year 2009 net sales of $359.7 million, $54.8 million and $7.9 million related to its domestic, Canadian and Mexican operations, respectively, which accounted for 85%, 13% and 2% of total revenues in fiscal year 2009, respectively.

 
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We operate websites which support and complement our Sears and Walmart studio operations.  These websites serve as vehicles to archive, share portraits via email (after a portrait session) and order additional portraits and products.  In 2009, revenues from on-line sales and services were approximately $2.2 million.

The Company’s Products and Services

Each of the Company’s portrait studio brands offers customers a wide range of differentiated portrait products, portrait choices, ordering options and service offerings with digital capabilities.  CPI’s full digital process offers significant advantages compared to other portrait providers, including being the only company that employs trained digital technicians who optimize portrait quality during the manufacturing process.  A package sitting consists of a fixed number of portraits, all of the same pose, for a relatively low price. Package customers may buy additional portrait sheets for a fee.  A custom sitting consists of portraits purchased by the sheet and allows for a variety of sizes, poses and backgrounds.  A collection sitting consists of a predetermined number of portraits bundled together at significant savings.

Our PMPS brand focuses on the sales of packages and portrait collections. Our packages are offered in all studios and consist of low-priced advertised “introductory” offers that provide a high volume of portraits with less customization and more limited selections.  Our associates offer customers the opportunity to upgrade to portrait collections in which customers receive a greater variety in terms of poses, sizes and customization.  Our SPS brand focuses on customized portrait solutions that provide a wide variety of selection, customization and an enhanced studio experience.  Due to the wide variety and customization allowed within our Sears studios, the customer is charged a session fee. There are no session fees in our PMPS studios.

Each brand offers customers the opportunity to join a portrait savings club.  Each club requires a one-time membership fee for a certain enrollment period, which is currently one year.  PMPS Portrait Smiles Club and Sears’ Super Saver Program members receive savings on products and services and a free portrait sheet on each returning visit.  Additionally, Sears’ Super Saver Program members pay no session fees for the enrollment period.  Both of these plans were designed to promote customer loyalty while encouraging frequent return visits to the studio.

As of September 17, 2009, all of our studios are digital.  In Sears studios, customer orders are either printed immediately in the studio and/or high-resolution images are transmitted electronically to one of our processing centers for fulfillment.  PMPS studios do not offer on-site printing.  All studios offer same-day portraits with full copyright on a portrait CD.  Our processing centers complete the customer’s orders to their specifications and return them to the studio for pick-up.  Orders placed in studios are generally available for pick-up within 5-10 days from the time of order.

SPS and PMPS studios have the ability to upload images from any portrait session to our safe and secure websites. With a code and individualized passwords, our customers can view their images from home, share them via email with family and friends, and place orders online for portraits or gifts such as personalized t-shirts, mugs, mouse pads and more.

Financial and Other Business Information

See Item 8 – Financial Statements and Supplementary Data for information on our financial condition, including revenues and net earnings for each of the last three fiscal years.  For geographic related information, see Note 1 to the Notes to Consolidated Financial Statements – Summary of Significant Accounting Policies.

The Company’s results of operations for the fiscal year 2009 were adversely impacted as a result of the challenging economic environment, which affected discretionary purchases such as portraiture.  As part of the Company’s continuing response to the market challenges, it has executed a number of cost reductions, which include delay or cancellation of certain expenditures.  See Item 1A – Risk Factors and Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations for further information related to market challenges.

The Company’s Host Relationships

Sears

We have enjoyed a strong relationship with Sears for over 50 years under a series of license agreements, the most recent of which was entered into on December 22, 2008, pursuant to which the Company operates professional portrait studios at Sears locations in the U.S.

 
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Pursuant to the terms and subject to the conditions of the License Agreement, we operate professional portrait studios under the name “Sears Portrait Studios.” The term of the License Agreement commenced on January 1, 2009, and ends on December 31, 2014.  The Company has the right to extend the License Agreement for up to four additional years if (i) it makes over a certain amount of capital expenditures with respect to Sears U.S. studios that are approved by Sears within a 12 month period, (ii) the net sales under the contract satisfy certain sales growth targets in 2013 or (iii) the Company pays Sears the amount that we would have owed Sears if the sales growth targets were met (taking into account amounts already paid to Sears).  Under the License Agreement, the Company pays Sears a percentage commission on the net sales of the Sears U.S. studios that is higher than the commission under the previous license agreement with Sears.  The Company shares with Sears a portion of actual savings from operating productivity improvements implemented through the cooperation of the parties.  The increase in commission rates has been substantially offset by these operating productivity improvements.  Under the terms of our existing License Agreement with Sears in the United States, Sears is under no contractual obligation to invite us to open portrait studios in their new stores.  Once we do establish a portrait studio in a new Sears store, that studio is then governed by the terms of our existing License Agreement.

The License Agreement contains certain termination rights for both the Company and Sears.  These termination events include: (i) a breach of the License Agreement that is not cured (if curable) within thirty (30) days of written notice of such breach, (ii) the occurrence of a change of control of the Company without Sears’ consent, (iii) the Company’s conviction or pleading no contest to a felony or the Company engages in any conduct that is likely to materially adversely affect the Company, its Sears U.S. studios or Sears, and (iv) the Company’s failure to maintain appropriate insurance coverage or its failure to pay amounts owed to Sears under the License Agreement when due.  In addition, Sears may terminate the License Agreement solely with respect to any affected Sears U.S. studio due to the closing of a Sears store.

Upon expiration of the term of the License Agreement or upon certain termination events, Sears shall have the right to purchase certain furniture, fixtures and equipment located at the Sears U.S. studios at fair market value, as determined by three independent ASA certified equipment appraisals.

On December 22, 2008, the Company and Sears entered into a Letter Agreement (the “Letter Agreement”) to resolve all amounts owed with respect to the adjustment provision to Earned Commissions set forth under paragraph (B)(2) to Exhibit C to the previous license agreement which expired on December 31, 2008, and in settlement of certain other obligations under the previous license agreement.  Pursuant to the terms and subject to the conditions of the Letter Agreement, the Company agreed to pay Sears $6,750,000 in cash upon the execution of the Letter Agreement, $1,500,000 in cash on April 30, 2009, and $150,000 annually for six years. In addition, the Company transferred 325,000 shares of common stock to Sears.   For further details and accounting treatment, see Note 12 and Note 16 to the Notes to Consolidated Financial Statements.

As of February 6, 2010, the Company operated 871 studios located in Sears stores and 26 freestanding studios under the Sears name in the U.S. and approximately 48% of our fiscal 2009 revenue was derived from sales within Sears.  We provide all studio furniture, equipment, fixtures, leasehold improvements and advertising and are also responsible for hiring, training and compensating our employees.  As a Sears licensee in studios located in Sears stores, we enjoy the benefits of using the Sears name, access to prime retail locations, Sears’ daily cashiering and bookkeeping systems, store security services and Sears’ assumption of certain credit card fees and credit and check authorization risks.  Our customers also have the convenience of using their Sears credit cards to purchase our products and services.  As a Sears licensee in freestanding studios under the Sears name in the U.S., we pay rent and utilities at each of these locations and benefit from the use of the Sears name.

Effective August 19, 2009, the Company entered into a new six-year license agreement with Sears Canada, Inc., a subsidiary of Sears, (“Sears Canada, Inc.”) pursuant to which the Company operates professional portrait studios in 110 Sears locations in Canada.  Prior to this date, the Company operated its Sears Canadian studios under the terms of a license agreement dated January 1, 2003, and expiring on December 31, 2006.  The terms of the new agreement provide greater operating flexibility than the previous contract.  As a result of the new agreement, the Company converted all remaining film studios in Canada to a digital format in the 2009 third quarter.  The Company pays Sears a license fee in Canadian dollars based on total annual net sales.  The Company provides all studio furniture, equipment, fixtures and advertising and is responsible for hiring, training and compensating its employees.

Throughout the period of our relationship with Sears, Sears has never terminated the operation of any of our studios, except in connection with Sears store closings.  In fiscal year 2009, the Company closed 19 related Sears studios.  While Sears has closed 2 such stores as of April 19, 2010, in fiscal 2010, and has informed us they plan to close an additional 6 locations during the year, we are not aware of any specific intentions to close a significant number of existing full-line, mall-based stores that contain our portrait studios.  There can be no assurance that some such closures may not occur in the future thus resulting in the concurrent closure of some of our existing portrait studios.  The closure of a significant number of Sears full-line, mall-based stores that result in the closing of related portrait studios, to the extent such closures are not offset by openings of portrait studios in new Sears stores or other formats or venues, could have an adverse impact on the Company’s operations.

 
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Walmart

Upon the PCA Acquisition on June 8, 2007, the Company became the sole operator of portrait studios in Walmart Stores and Supercenters in the U.S., Canada, Mexico and Puerto Rico.  The Company operates under the trade names PictureMe Portrait Studio® in the U.S., Walmart Portrait Studios in Canada and Estudios Fotografia de Walmart in Mexico.  As of February 6, 2010, the Company operated 1,923 studios in Walmart locations worldwide and approximately 52% of our fiscal 2009 revenue was derived from sales within Walmart.  In fiscal year 2009, the Company closed 95 Walmart studios due to underperformance.  As of April 19, 2010, the Company has closed 15 such locations in fiscal year 2010.    We are not aware of any specific intentions Walmart has to close a significant number of existing stores that contain our portrait studios.  There can be no assurance that some such closures may not occur in the future thus resulting in the concurrent closure of some of our existing portrait studios.  The closure of a significant number of Walmart stores that result in the closing of related portrait studios, to the extent such closures are not offset by openings of portrait studios in new Walmart stores, could have an adverse impact on the Company’s operations. As part of the PCA Acquisition, we assumed certain preexisting lease and license agreements between PCA and Walmart.  These agreements are summarized below.

Effective June 8, 2007, the Company entered into the U.S. Lease Agreement, negotiated by PCA and Walmart during PCA’s bankruptcy proceedings, which requires us to pay a rental fee to Walmart based upon a percentage of sales of our studios operating in Walmart’s U.S. stores.  The agreement has an initial term of three years but automatically extends for an additional two years for each studio from which Walmart receives rental fees for the period July 1, 2008, through June 30, 2009, at a minimum specified rate per square foot.  For each studio in which Walmart receives less than the specified rate per square foot, the Company and Walmart may mutually agree to extend the individual studio agreement for an additional two years by written agreement.  The majority of studios are located in prominent locations at the front of the Store or Supercenter, affording easy access to Walmart’s significant foot traffic.
 
Our relationship with Walmart Canada Corp. is governed by an amended and restated license agreement effective January 1, 2006.  We are required to pay Walmart Canada a license fee based on a percentage of the sales of our portrait studios operated in Walmart’s Canadian stores.  The agreement has a five-year term, and Walmart Canada has an option to renew for two renewal periods of two years each.  Studios that were in operation on the effective date of this agreement are subject to a license schedule, which specifies expiration dates for those specific studios.  Based on this license schedule, our Canadian studios’ licenses expire as follows: 105 in 2010, 135 in 2011, 10 in 2012, 4 in 2013, and 6 in 2014.  Although we anticipate that these agreements will renew, there is no assurance of such.  As of February 6, 2010, we operated 260 studios under the agreement with Walmart Canada.

Within Mexico, our relationship with Nueva Walmart De Mexico, S de R.L. de C.V. ("Nueva Walmart De Mexico") is governed by an agreement dated as of June 1, 2002, for the first 44 studios. New agreements, with the same terms, are entered into as additional studios are added in Mexico. The agreements run for an undefined period of time. Neither party may terminate an agreement for a studio during the studio's first year of operation; thereafter, either party may terminate the agreement with respect to a studio by giving the other party written notice 30 days prior to the termination date.  Under these agreements, Nueva Walmart De Mexico is compensated based upon a percentage of our total sales in all Walmart studios in Mexico.  As of February 6, 2010, we operated in 114 Nueva Walmart De Mexico studios.

Toys “R” Us

CPI entered into an Amendment (the “Amendment”) dated as of February 22, 2010, effective as of April 20, 2010, with Toys “R” Us – Delaware, Inc. (the “Licensor”, “Toys “R” Us” or “TRU”) to the Amended and Restated License Agreement  (the “License Agreement”) made and entered into as of December 23, 2005, between TRU and Kiddie Kandids, LLC.  Kiddie Kandids, LLC is a Chapter 7 debtor under Case No. 10-20334 brought before the United States Bankruptcy Court for the District of Utah (the “Bankruptcy Court”).  The Company acquired the License Agreement in its acquisition of certain assets of Kiddie Kandids, LLC in an auction conducted by the Bankruptcy Court.

 
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Under the Amendment, TRU grants CPI an exclusive license to operate photo studios (the “Studios”) in certain Babies “R” Us stores under the Kiddie Kandids name.  The term of the License Agreement, as amended by the Amendment, expires on January 31, 2016.  The Amendment allows CPI significant operating flexibility and collaborative marketing opportunities and provides for the opening of additional locations over the next two years.  The Amendment and the License Agreement contain certain termination rights for both the Company and TRU.  The fees paid to TRU under the Amendment are based upon the Gross Sales of the Studios operated under the Amendment.

Industry Background and Competition

We compete in a highly fragmented domestic professional portrait photography industry, estimated to be over $6.5 billion. The primary customer categories within the industry are babies, preschoolers, school-age children (including youth sports and graduation portraits), adults, families/groups, weddings, passports and churches.  Other categories include: cruise ships, conventions/events, glamour and business portraits.  Our competitors include large studio chains operating in national retailers, other national free-standing portrait studio companies, national school and church photographers and a large number of independent portrait photography providers. The majority of the industry is comprised of small, independent photography companies and individual photographers.

Like CPI, other portrait photography companies provide services in retail hosts. These companies and their retail hosts include LifeTouch (JC Penney and Target) and Olan Mills (K-Mart, Belk’s, Meijer’s and Macy’s). We believe that we are the largest of these competitors based on revenues generated in the respective retail hosts.

A number of other companies in the professional portrait photography industry operate free-standing studios on a national, regional or local basis.  Among the more sizeable of these companies are Picture People and Portrait Innovations, which operate independent mall-based or strip mall locations.

Our competitors generally compete on the basis of the following: price, service, quality, location, product mix and convenience, including the immediate fulfillment of finished portraits at the time of the portrait session.  Many competitors focus heavily on price and commonly feature large portrait packages at aggressively low prices in mass marketing promotions.  Some of these same competitors have eliminated all sitting or session fees.

Our PMPS brand focuses on the sales of packages and portrait collections.  While our products and services are some of the lowest priced in the industry, we do not feel that we are offering lesser value.  In fact, it is our lower price that enables the PMPS customer to attain some of the same products, services and professionalism that higher priced studios offer. It is an added benefit to the PMPS customer that session fees do not apply.  The SPS brand focuses on customized portrait solutions that provide a wide variety of selection and customization.  Except for promotions during the year, the SPS brand has not followed the “no session fee ever” practice because we believe a session fee is justified by the professionalism of our photographers, the quality of our equipment, our commitment to service and overall studio experience.  Furthermore, while our products and services are competitively priced, they are not generally the lowest priced in the industry as we focus on offering a better value proposition. Other competitors, notably Picture People, have emphasized convenience and experience over low price and also the immediate fulfillment of orders in the studio as opposed to longer lead times of central lab fulfillment.

The industry remains in constant transformation brought about by significant advances in digital photographic technology. These technologies have made it possible to capture, manipulate, store and print high-resolution digital images in a decentralized environment. It is this digital evolution that has required industry incumbents to review and adjust their business models while fostering a number of new digital start-ups.  The digital evolution has generated photographic experimentation with the consumer and a “do-it-yourself” mentality that did not exist in years past. This has impacted overall portrait studio activity and frequency.

Seasonality and Inflation

Our business is highly seasonal, with the largest volume occurring in the fourth fiscal quarter, between Thanksgiving and Christmas.  For both fiscal years 2009 and 2008, fourth quarter net sales accounted for 33% of total net sales for the year. Historically, most, if not all, of the net earnings for the year are generated in the fourth fiscal quarter.  The timing of Easter, another seasonally important time for portraiture sales, can have a significant impact on the timing of recognition of sales revenues between the Company’s first and second fiscal quarters.  Historically, earlier Easters translate into lower sales due to the closer proximity of the earlier Easter date to the preceding Christmas holiday season during which customers are most portrait-active.  Most of the Company’s Easter-related sales in fiscal year 2009, a year with an early Easter, were recognized as revenues, in accordance with the Company’s revenue recognition policies reflected in Note 1 in the accompanying Notes to Consolidated Financial Statements, in the first fiscal quarter.  The moderate rate of inflation over the past three years has not had a significant effect on the Company’s revenues and profitability.

 
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Suppliers

We purchase photographic paper and processing chemistry from four major manufacturers.  Eastman Kodak provides photographic paper for all central lab fulfillment pursuant to an agreement in effect through July 31, 2011.  Dye sublimation paper used for proof sheets, portrait collages and portrait orders delivered at the end of a sitting in digital studios is provided primarily by Sony and Kanematsu.  Fujifilm North America Corp. provides photographic chemistry for central lab fulfillment.  We purchase digital camera and lens components, monitors, computers, printers and other equipment and materials from a number of leading suppliers.
 
Typically, we do not encounter difficulty in obtaining equipment and materials in the quantity and quality we require and we do not anticipate any problems in obtaining our requirements in the future.  

CPI operates most of its U.S. studios in full digital platform utilizing the software of a single vendor for our studio photography digital system.  Our contract with our software vendor allows CPI to scale the use of the software as necessary to support all of our current and prospective studios.  The Company is testing internally developed software for its U.S. studios, now functional in a number of studios, that is expected to replace the software currently in use at most studios.  It is anticipated the new software will be implemented in all U.S. studios within the next two years.  Once fully implemented, this software will eliminate our reliance on the single outside vendor we currently use for our U.S. studio photography digital system.  CPI also utilizes a single software vendor for its manufacturing fulfillment digital system.

Intellectual Property

We own certain registered service marks and trademarks, including Portrait Creations®, Smile Savers Plan®, PictureMe Portrait Studio®, BigShots® and The Portrait Gallery®, which have been registered with the United States Patent and Trademark Office.  Our rights to these trademarks will continue as long as we comply with the usage, filing and other legal requirements relating to the renewal of trademarks.

The Company’s Employees

As of February 6, 2010, the Company employed approximately 11,000 employees, including approximately 6,000 part-time and temporary employees.

The Company Website and Periodic Reports

The Company’s website address is www.cpicorp.com.  We make available on the Investor Relations page of the website, free of charge, press releases, annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC.  References to the Company’s website address do not constitute incorporation by reference of the information contained on the website, and the information contained on the website is not part of this document.

Environmental Regulation

Our operations are subject to commonly applicable environmental protection statutes and regulations. We do not expect that compliance with federal, state and local provisions regulating the discharge of materials into the environment or otherwise relating to the protection of the environment will have a material effect on our capital expenditures, earnings or competitive position.  At present, we have not been identified as a potentially responsible party under the Comprehensive Environmental Responses, Compensation and Liability Act and have not established any reserves or liabilities relating to environmental matters under this Act.
 
Risk Factors
 
We wish to caution readers that in addition to the important factors described elsewhere in this Annual Report on Form 10-K, the following important factors, among others, sometimes have affected, or in the future could affect, our actual results and could cause our actual consolidated results during fiscal 2010, and beyond, to differ materially from those expressed in any forward-looking statements made by us or on our behalf.  The risks and uncertainties described below are not the only ones facing us and do not include other events that we do not currently anticipate or that we currently deem immaterial that may also affect our results of operations and financial condition.

 
8
 
 

We are materially dependent upon Sears, Walmart and Toys “R” Us.

Substantially all of our sales are derived from sales in Sears and Walmart stores.  Additionally, commencing in fiscal year 2010, sales will also be derived from Toys "R" Us stores.  Therefore, we are materially dependent upon our relationship with Sears, Walmart and Toys “R” Us, the continued goodwill of Sears, Walmart and Toys “R” Us and the integrity of their brand names in the retail marketplace.  Any deterioration in our host relationships could have a material adverse effect on us.

Because we represent only a small fraction of Sears, Walmart and Toys “R” Us revenues, any deterioration of any host relationship would have a far greater effect on us than on our hosts.

In addition, our competitive posture could be weakened by negative changes in Sears, Walmart or Toys “R” Us.

Our portrait studios in Walmart and Toys "R" Us are substantially dependent on customer traffic generated by our host retail stores, and if the customer traffic through these host stores decreases due to the economy or for any other reason, our sales could be materially and adversely affected.

Our business practices and operations need to be acceptable to our hosts.

Our business practices and procedures must at all times be acceptable to Sears, Walmart and Toys "R" Us.  In addition, under our agreements there are substantial contractual rights, the most significant of which are described more fully in “Item 1. Business,” which the host can exercise in a manner that can have a material adverse effect on us.  Consequently, in the future, we may be required to make changes to our business practices and procedures, including with regard to advertising and promotions, product offerings, studio facilities and technology in response to host requests that would not be in our best interests and could materially and adversely affect our sales, costs, margins, business development or other aspects of our business.

Our hosts may terminate, breach, otherwise limit or increase our expenses under our agreements.

Our Sears, Walmart and Toys “R” Us studios in the U.S., Canada and Mexico are operated pursuant to certain license and lease agreements.  Our agreements have the following expiration dates: for our U.S. Sears studios, December 2014; for our Canada Sears studios, August 2015; for our Puerto Rico Sears studios, December 2014; for our U.S. and Puerto Rico Walmart studios, June 2010; for our Canada Walmart Studios, 105 in 2010, 135 in 2011, 10 in 2012, 4 in 2013 and 6 in 2014; for our Mexico Walmart studios, with 30-day notice after one year of operation; and for our U.S. Toys “R” Us studios, January 31, 2016.  These agreements are more fully described in “Item 1. The Company’s Host Relationships.”

Sears and Walmart are under no obligation to renew these agreements.  The agreement with Toys “R” Us provides the Company and Toys “R” Us terms to renew the agreement under certain conditions.  Our hosts may also seek to increase the fees we pay under our agreements upon renewal of the agreements.  We do not have the contractual right to close any poorly performing locations without Sears’ or Walmart’s consent.  Under our agreement with Toys “R” Us, the Company and Toys “R” Us may close certain underperforming locations under specified conditions.  In addition, our agreements do not prohibit Sears, Walmart or Toys “R” Us from selling many of the tangible goods we sell, or from processing digital photos in other departments within their stores.  Furthermore, there is always the risk that Sears, Walmart or Toys “R” Us might breach our agreements. The loss or breach of the agreements could have a material adverse effect on us. An adverse change in any other aspects of our business relationship with Sears, Walmart or Toys “R” Us, including the reduction of the number of studios operated pursuant to such arrangements or a decision by Sears, Walmart or Toys “R” Us to license or lease studios to other persons could have a material adverse effect on us.

The economic recession has materially impacted consumer spending and may adversely affect our financial position.
 
Consumer discretionary spending has been materially and adversely impacted by the current recession, job losses, volatile energy and food costs, greater levels of unemployment, higher levels of consumer debt, declines in home values and in the value of consumers' investments and savings, restrictions on the availability of credit and other negative economic conditions which have affected consumer confidence and disposable income.  If consumer discretionary spending further declines, demand for our products could decrease and we may be forced to discount our merchandise, which in turn could reduce our revenues, gross margins, operating cash flows and earnings.  In addition, higher transportation costs, higher costs of labor, insurance and healthcare, and other negative economic factors may increase our cost of sales and operating expenses.  Additionally, our business is highly seasonal, with the largest volume occurring in the fourth fiscal quarter, between Thanksgiving and Christmas. The fourth quarters in both fiscal 2009 and 2008 accounted for approximately 33% of total net sales for the year.  As a result, any adverse impact on our fourth quarter operating results would significantly impact annual operating results.  Our fourth quarter operating results may fluctuate significantly based on many factors, including holiday spending patterns, prevailing economic conditions and weather conditions.

 
9
 
 
We have a high level of indebtedness, which may impair our ability to operate effectively and impair future performances.

As of February 6, 2010, we had $77.5 million of indebtedness under the term loan portion of our existing Credit Agreement.  This level of debt and the limitations imposed by the Company’s debt agreements could adversely affect operating flexibility and put the Company at a competitive disadvantage. The Company’s debt level may adversely affect future performance.  The ability to make scheduled payments of principal, to pay interest on, or to refinance indebtedness and to satisfy other debt and lease obligations will depend upon future operating performance, which may be affected by factors beyond the Company’s control. In addition, there can be no assurance that future borrowings or equity financing will be available to the Company on favorable terms or at all for the payment or refinancing of indebtedness. If the Company is unable to service indebtedness, the business, financial condition and results of operations would be materially adversely affected.

The agreements governing our debt impose restrictions on our business.

Our Credit Agreement contains covenants and requires financial ratios and tests, which impose restrictions on our business.  Our ability to comply with these restrictions may be affected by events beyond our control, including, but not limited to, prevailing economic, financial and industry conditions. The breach of any of these covenants or restrictions, as well as any failure to make a payment of interest or principal when due, could result in a default under the credit agreement.  If our lenders were unwilling to enter into an amendment or provide a waiver, such defaults would permit our lenders to declare all amounts borrowed from them to be due and payable, together with accrued and unpaid interest, and the ability to borrow under this agreement could be terminated.  If we are unable to repay debt to our lenders, these lenders could proceed against the collateral securing that debt.

A substantial or prolonged material adverse impact on our results of operations and financial condition could affect our ability to satisfy the financial covenants in our senior secured Credit Agreement, which could result in our having to seek amendments or waivers from our lenders to avoid the termination of commitments and/or the acceleration of the maturity of amounts that are outstanding under our term loan and revolving credit facility.  Effective April 16, 2009, the Company amended its Credit Agreement to allow more flexibility should the economy worsen, see further details on the amendment in the “Liquidity and Capital Resources” section.  This amendment significantly reduced this risk of a breach of our financial covenants.  However, if the economic conditions worsen to a degree that would not be covered by the amendment, the cost of obtaining an additional amendment or waiver could be significant, and could substantially increase our cost of borrowing over the remaining term of our senior secured credit agreement.

Our inability to remain competitive could have a detrimental impact on our results of operations.
 
The professional portrait photography industry is highly competitive. Evolving technology and business relationships may make it easier and cheaper for our competitors and potential competitors to develop products or services similar to ours or to sell competing products or services in our markets.  Likewise, the proliferation of amateur digital photography is making customers more discerning and demanding and has adversely affected overall portrait activity/frequency.

The companies in our industry compete on the basis of price, service, quality, location, product mix and convenience of retail distribution channel.  If the Company cannot continue to provide perceived value for our customers, this could have a material adverse impact on sales and profitability.  To compete successfully, we must continue to remain competitive in areas of price, service, quality, location, product mix and convenience of distribution.

If our key suppliers become unable to continue to provide us supplies under our current contracts, we will need to obtain an alternative source of supplies. If we enter into an agreement to obtain such supplies at less desirable terms, our financial condition and results of operations could be materially adversely affected.

As described in “Item 1. Suppliers,” the Company purchases photographic paper, dye sublimation paper and processing chemistry from several suppliers.  The Company operates most of its U.S. studios in full digital platform utilizing the software of a single vendor for our studio photography digital system.  The Company also utilizes a single software vendor for its manufacturing fulfillment digital system.   If these companies become unable to continue to provide us supplies or services under our current arrangements or if prices are increased dramatically, we will need to obtain alternative sources of supplies or services.

Although management believes that the available alternative sources of supplies are adequate, there can be no assurance we would be able to obtain such supplies at the same or similar terms to those we currently have in place. If we enter into an agreement to obtain such supplies at less desirable terms, our financial condition and results of operations could be materially adversely affected.

Should the Company be forced to replace its digital software vendor, related costs could increase and production could be disrupted for a period of time, which could have a material adverse impact on the results of operations.

 
10
 
 
If we lose our key personnel, our business may be adversely affected.

Our continued success depends upon, to a large extent, the efforts and abilities of our key employees, particularly our executive management team. We cannot assure you of the continued employment of any members of management. Competition for qualified management personnel is strong.  The loss of the services of our key employees or the failure to retain qualified employees when needed could materially adversely affect us.

A significant increase in piracy of our photographs could materially adversely affect our business, financial condition or results of operations.

We rely on copyright laws to protect our proprietary rights in our photographs. However, our ability to prevent piracy and enforce our proprietary rights in our photographs is limited. We are aware that unauthorized copying of photographs occurs within our industry. A significant increase in the frequency of unauthorized copying of our photographs could materially adversely affect our business, financial condition and results of operations by reducing revenues from photograph sales.

Any disruption in our manufacturing process could have a material adverse impact on our business.

Although the Company is moving to internally developed software, it currently operates most of its U.S. studios in full digital platform utilizing the software of a single vendor for our studio photography digital system.  The Company also utilizes a single software vendor for its manufacturing fulfillment digital system.   Any material delay in the vendor’s networking environment, coupled with a failure to identify and implement alternative solutions, could have an adverse effect upon the operations of the business.  Additionally, should this vendor no longer operate, the Company may be forced to find another source of this support, which could be more costly and could delay digital production for a period of time.  Although on-site printing is an available alternative to central printing in the Sears’ digital environment, it currently would be difficult and costly for on-site printing to replace central fulfillment during the holiday busy season.  On-site printing is not available for our PMPS brand.  Any disruption of our processing systems for any reason could adversely impact our business, financial condition and results of operations.

We are subject to litigation and other claims that could have an adverse effect on our business.

We are a defendant in a pending legal proceeding related to allegations that the Company failed to pay certain employees for “off the clock” work and provide meal and rest breaks as required by law.  While we believe the claim is without merit and continue our vigorous defense, the outcome of this proceeding is difficult to assess and quantify and therefore we cannot determine whether the financial impact, if any, will be material to our financial position or results of operations.  The defense of this action may be both time consuming and expensive.  If this legal proceeding were to result in an unfavorable outcome, it could have a material adverse effect on our business, financial position and results of operations.

The impact of declines in global equity markets on asset values and interest rates used to value the liabilities in our pension plan and changes in rules and regulations may result in higher pension costs and the need to fund the pension plan in future years in material amounts.

The impact of declines in the global equity and bond markets on asset values may result in higher pension costs and may increase and accelerate the need to fund the pension in future years.  The determination of pension expense and pension funding are based on a variety of rules and regulations.  Changes in these rules and regulations could impact the calculation of pension plan liabilities and the valuation of pension plan assets.  They may also result in higher pension costs and accelerate and increase the need to fully fund the pension plan.

We are subject to currency fluctuations from our operations within non-U.S. markets.

For our operations conducted in Canada and Mexico, transactions are typically denominated in local currencies.  Accordingly, certain costs of our operations in these foreign locations are also denominated in those local currencies.  Because our financial statements are stated in U.S. dollars, changes in currency exchange rates between the U.S. dollar and other currencies, have had, and will continue to have, an impact on our reported financial results.
 
Unresolved Staff Comments
 
None.

 
11
 
 
 
Properties
 
The following table sets forth certain information concerning the Company’s principal facilities as of February 6, 2010:
 
             
APPROXIMATE
               
             
AREA IN
           
OWNERSHIP
 
LOCATION
   
SQUARE FEET
 
PRIMARY USES
     
OR LEASE
 
Matthews, North Carolina
 
                 860,000
 
Unoccupied Administration and Portrait processing facility (includes 696,000 square feet in land)
 
Owned
(1)
Charlotte, North Carolina
 
                 372,000
 
Administration, Warehousing and Portrait processing (includes 315,000 square feet in land)
 
Owned
 
Charlotte, North Carolina
 
                 348,000
 
Undeveloped, industrial land
   
Owned
(1)
St. Louis, Missouri
 
                 341,000
 
Headquarters, Administration and Portrait processing (includes 31,000 square feet in land)
 
Owned
 
St. Louis, Missouri
 
                 159,000
 
Parking Lots
     
Owned
 
Brampton, Ontario
 
                 156,000
 
Unoccupied Administration, Warehousing and Portrait processing facility (includes 116,000 square feet in land)
Owned
(1)
St. Louis, Missouri
 
                   53,000
 
Warehousing
     
Leased
(2)
Charlotte, North Carolina
 
                   51,000
 
Parking Lots
     
Owned
 

(1)
 
Properties are held for sale.  See Note 7 to the Notes to Consolidated Financial Statements for further discussion.
(2)
 
Lease term expires on July 31, 2018.

Studio license/lease agreements

As of February 6, 2010, the Company operates portrait studios in host stores under license and lease agreements as shown below:

 
NUMBER
         
OF STUDIOS
   
COUNTRY
 
LICENSOR/LESSOR
 
                   871
   
United States and Puerto Rico
 
Sears
                1,549
   
United States and Puerto Rico
 
Walmart
                   110
   
Canada
 
Sears Canada, Inc.
                   260
   
Canada
 
Walmart Canada Corp.
                   114
   
Mexico
 
Nueva Walmart de Mexico, S, de R.L. de C.V.
                     31
   
United States studios not
 
Third parties - generally leased for at least 3 years
       
in Sears or Walmart
   
with some having renewal options

The Company pays Sears and Walmart a fee based on annual sales within the respective host stores.  This fee covers the Company’s use of space in the host stores, the use of Sears’ name and the use of the Walmart name in Canada and Mexico. No separate amounts are paid to hosts expressly for the use of space.

The Company believes that the facilities used in its operations are adequate for its present and anticipated future operations.
 
Legal Proceedings
 
The Company and two of its subsidiaries are defendants in a lawsuit entitled Shannon Paige, et al. v. Consumer Programs, Inc., filed March 8, 2007, in the Superior Court of the State of California for the County of Los Angeles, Case No. BC367546.  The case was subsequently removed to the United States District Court for the Central District of California, Case No. CV 07-2498-FMC (RCx).  The Plaintiff alleges that the Company failed to pay him and other hourly associates for “off the clock” work and that the Company failed to provide meal and rest breaks as required by law.  The Plaintiff is seeking damages and injunctive relief for himself and others similarly situated.  On October 6, 2008, the Court denied the Plaintiffs’ motion for class certification but allowed Plaintiffs to attempt to certify a smaller class, thus reducing the size of the potential class to approximately 200.  Plaintiffs filed a motion seeking certification of the smaller class on November 14, 2008.  The Company filed its opposition on December 8, 2008.  In January 2009, the Court denied Plaintiffs' motion for class certification as to their claims that they worked "off the clock".  The Court also deferred ruling on Plaintiff's motion for class certification as to their missed break claims and stayed the action until the California Supreme Court rules on a pending case on the issue of whether an employer must merely provide an opportunity for employees to take a lunch break or whether an employer must actively ensure that its employees take the break.  The Company believes the claims are without merit and continues its vigorous defense on behalf of itself and its subsidiaries against these claims, however, an adverse ruling in this case could require the Company to pay damages, penalties, interest and fines.
 
The Company was a defendant in a lawsuit entitled Picture Me Press LLC v. Portrait Corporation of America, et al., Case No. 5:08cv32, which was filed in the United States District Court for the Northern District of Ohio on January 4, 2008.  The suit alleged that the Company’s use of the name PictureMe Portrait Studios® infringed Plaintiff’s trademark for its picture books and sought damages and injunctive relief.   The parties agreed to full resolution of the claims of the case on August 12, 2009. The case was dismissed with prejudice on October 2, 2009.  The matter resulted in the Company recording a $527,000 charge in other charges and impairments in fiscal year 2009, net of insurance reimbursement for expenses related to the matter.  A receivable of $114,000 is outstanding as of February 6, 2010, related to the insurance reimbursement.  Collection of this receivable occurred subsequent to the 2009 fiscal year end.

 
12
 
 
The Company is also a defendant in other routine litigation, but does not believe these lawsuits, individually or in combination with the cases described above, will have a material adverse effect on its financial condition.  The Company cannot, however, give assurances that these legal proceedings will not have a material adverse effect on its business or financial condition.
 
PART II

Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Price Range of Common Stock and Cash Dividends

Since April 17, 1989, the Company's common stock has been traded on the New York Stock Exchange under the symbol CPY.
 
The following tables set forth the high and low closing prices of the common stock reported by the New York Stock Exchange and the dividends declared for each full quarterly period during the Company's last two fiscal years.
 
FISCAL YEAR 2009
                 
(ending February 6, 2010)
 
HIGH
   
LOW
   
DIVIDEND
 
First Quarter
  $ 10.86     $ 6.00     $ 0.16  
Second Quarter
    18.80       9.90       0.16  
Third Quarter
    18.78       9.99       0.16  
Fourth Quarter
    15.00       11.60       0.16  
 
FISCAL YEAR 2008
                 
(ending February 7, 2009)
 
HIGH
   
LOW
   
DIVIDEND
 
First Quarter
  $ 20.25     $ 15.17     $ 0.16  
Second Quarter
    26.73       13.79       0.16  
Third Quarter
    16.44       5.57       0.16  
Fourth Quarter
    7.14       1.08       0.16  

Performance Graph

The following graph compares the five-year cumulative returns of $100 invested in (a) the Company (“CPY”), (b) the Standard & Poor’s 500 Index (“S&P 500”), and (c) the Russell 2000 Index (“Russell 2000”), assuming the reinvestment of all dividends.  The Russell 2000 index was selected because it encompasses similarly sized companies to the Company.  The measurement dates for the purposes of determining the stock price of the Company correspond to the fiscal year end (i.e., the first Saturday in February of each year reflected).  The corresponding measurement dates for the S&P 500 and the Russell 2000 are January 31st of each of the years reflected.

 

 
2005
2006
2007
2008
2009
2010
CPY
             100.00
              123.98
                367.18
                142.75
                 54.44
             104.84
S&P 500
             100.00
              110.26
                126.04
                123.26
                 76.35
             101.33
Russell 2000
             100.00
              118.80
                131.15
                118.48
                 75.27
             103.51


 
13
 
 


Shareholders of Record

As of April 16, 2010, the closing sales price of the Company’s common stock was $14.95 per share with 9,671,756 shares outstanding and 1,287 holders of record.

Dividends

The Company intends, from time to time, to pay cash dividends on its common stock, as its Board of Directors deems appropriate, after consideration of the Company's operating results, financial condition, cash requirements, restrictions imposed by Delaware law and credit agreements, including maximum limits of cash to be used to pay for dividends, general business conditions and such other factors as the Board of Directors deems relevant.
 
Issuer Repurchases of Equity Securities

The Company did not repurchase any equity securities during the fourth quarters of fiscal years 2009 or 2008. 

Selected Financial Data
 
The summary historical consolidated financial data as of and for each of the fiscal years in the five-year period ended February 6, 2010, set forth below have been derived from the Company’s audited consolidated financial statements. The information presented below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes included herein.  The Company acquired substantially all of the assets of PCA and certain of its affiliates and assumed certain liabilities of PCA on June 8, 2007, which affected the operating result trends as depicted in the table below.  Certain of this data has been reclassified to conform with the current year presentation.

in thousands except share and per share data
 
2009
   
2008
   
2007
   
2006
   
2005
 
                               
STATEMENT OF OPERATIONS (1)
                             
    Net sales
  $ 422,371     $ 462,548     $ 423,429     $ 292,973     $ 291,098  
               Cost of sales (exclusive of depreciation and amortization shown below)
    30,626       43,280       47,135       30,211       41,257  
               Selling, general and administrative expenses
    339,138       377,310       326,568       218,282       215,102  
            Depreciation and amortization
    22,740       29,432       27,291       16,861       19,904  
            Other charges and impairments (2)
    3,294       13,557       7,695       1,241       2,767  
                                         
Income (loss) from continuing operations
    26,573       (1,031 )     14,740       26,378       12,068  
         Interest expense, net (3)
    6,936       8,527       8,818       1,815       1,098  
            Other (expense) income, net (4)
    (44 )     190       175       1,031       (282 )
            Income tax expense (benefit)
    5,796       (2,644 )     2,080       9,164       1,889  
                                         
               Net income (loss) from continuing operations
    13,797       (6,724 )     4,017       16,430       8,799  
               Net (loss) income from discontinued operations, net of tax (1)
    -       (961 )     (441 )     (103 )     73  
                                         
 Net income (loss)
  $ 13,797     $ (7,685 )   $ 3,576     $ 16,327     $ 8,872  
                                         
SHARE AND PER SHARE DATA (1)
                                       
               Net income (loss) from continuing operations - diluted (5)
  $ 1.97     $ (1.03 )   $ 0.63     $ 2.58     $ 1.12  
               Net income (loss) from continuing operations - basic (5)
  $ 1.97     $ (1.03 )   $ 0.63     $ 2.59     $ 1.12  
            Net income (loss) - diluted
  $ 1.97     $ (1.18 )   $ 0.56     $ 2.56     $ 1.13  
            Net income (loss) - basic
  $ 1.97     $ (1.18 )   $ 0.56     $ 2.57     $ 1.13  
                                         
    Dividends
  $ 0.64     $ 0.64     $ 0.64     $ 0.64     $ 0.64  
            Average shares outstanding - diluted
    7,020       6,510       6,416       6,376       7,881  
            Average shares outstanding - basic
    6,993       6,510       6,391       6,353       7,854  
                                         
CASH FLOW DATA (continuing operations only)
                                       
               Net cash provided by operating activities
  $ 31,289     $ 12,663     $ 39,872     $ 37,993     $ 18,624  
               Net cash (used in) provided by financing activities
  $ (33,494 )   $ (13,419 )   $ 90,788     $ (43,567 )   $ (1,223 )
            Net cash used in investing activities
  $ (2,876 )   $ (33,488 )   $ (97,653 )   $ (2,358 )   $ (17,633 )
                                         
         Capital expenditures
  $ 5,234     $ 36,074     $ 14,884     $ 2,760     $ 20,235  


 
14
 
 
Item 6.
Selected Consolidated Financial Data (continued)

in thousands
 
2009
   
2008
   
2007
   
2006
   
2005
 
                               
BALANCE SHEET
                             
   Cash and cash equivalents
  $ 18,913     $ 23,665     $ 59,177     $ 26,294     $ 34,269  
   Current assets
    53,555       61,480       92,835       55,164       69,629  
   Net fixed assets
    34,169       50,887       56,280       26,693       41,282  
   Goodwill and intangible assets (6)
    60,380       61,665       62,956       512       512  
   Other assets
    18,487       18,823       27,152       11,379       15,641  
   Total assets
    166,591       192,855       239,223       93,748       127,064  
   Current liabilities
    62,643       55,010       83,051       49,407       56,065  
   Long-term debt, less current maturities
    57,855       104,578       105,728       8,333       16,667  
   Other liabilities
    35,905       32,432       33,470       23,209       25,739  
   Stockholders' equity (5)
    10,188       835       16,974       12,799       28,593  
 
(1)
 
The following business areas were classified as discontinued operations in the years indicated.  The financial statements for the periods prior to the classification were reclassified to reflect these changes:
     
   
- In 2008, Portrait Gallery and E-Church operations
   
- In 2007, UK Operations which were acquired in the PCA acquisition
 
(2)
  Other charges and impairments:
  
in thousands
 
2009
   
2008
   
2007
   
2006
   
2005
 
                               
Reserves for severance and related costs (a)
  $ 970     $ 2,046     $ 2,035     $ 878     $ 2,546  
Proxy contest fees (b)
    871       -       -       -       -  
Other transition related costs - PCA Acquisition (c)
    527       1,255       2,817       -       -  
Impairment charges (d)
    300       739       -       -       -  
Sears fees related to the settlement of the previous license agreement (e)
    -       7,527       2,500       -       -  
Other  (f)
    626       1,990       343       363       221  
    $ 3,294     $ 13,557     $ 7,695     $ 1,241     $ 2,767  

(a)
 
Consists principally of expenses and related costs for employee severance, retirements and repositioning. Specifically, in 2008 and 2007, this cost is primarily related to the PCA Acquisition.
(b)
 
Relates to certain fees incurred in connection with the proxy contest in 2009.
(c)
 
Consists of integration-related costs relative to the PCA Acquisition.
(d)
(e)
 
Consists of 2009 and 2008 write-downs of certain asset values held for sale.
Consists of certain fees and charges related to the settlement of the previous Sears license agreement.
(f)
 
Costs in 2009 primarily relate to net legal expense incurred in connection with the settlement of the Picture Me Press LLC vs. Portrait Corporation of America case.  Costs in 2008 primarily related to legal expense incurred for the settlement of the Portraits International of the Southwest vs. CPI Corp. case and in connection with the Picture Me Press LLC vs. Portrait Corporation of America case.  Costs in 2007 primarily related to the write-off of software that is no longer used in the business.  Costs in 2006 represent professional service expense in connection with a strategic alternative review and the write-off of certain legacy equipment that is no longer used in the business.  Costs in 2005 consist primarily of the write-off of certain film assets resulting from the digital conversion of SPS, offset in part by a favorable claim settlement resulting in a refund related to previously paid loan commitment fees and costs.

(3)
 
In 2009, 2008 and 2007, includes (income) expense of ($1.5 million), $617,000 and $2.9 million, respectively, in connection with marking the interest rate swap agreement to its market value.
     
(4)
 
In 2004, the Company recorded accrued lease liability obligations relating to its lease guarantees on certain of Prints Plus’ retail stores.  As the total guarantee related to these leases had decreased with the passage of time, the payment of rents by Prints Plus and the settlement by the Company of certain leases rejected in bankruptcy, the related liability was reduced by $887,000 in 2006 to reflect management’s revised estimate of remaining potential loss.
     
(5)
 
The Company recorded the repurchase of 1,658,607 shares of common stock for $32.4 million in 2006.
     
(6)
 
At the time of the PCA Acquisition, the Company acquired a host agreement and customer list with Walmart and additional goodwill.  See Note 8 to the Notes to Consolidated Financial Statements for further discussion.


 
15
 
 
Management's Discussion and Analysis of Finanical Condition and Results of Operations

Management’s Discussion and Analysis of Financial Condition and Results of Operations is designed to provide the reader of the financial statements with a narrative on the Company’s results of operations, financial position and liquidity, significant accounting policies and critical estimates, and the future impact of accounting standards that have been issued but are not yet effective.   Management’s Discussion and Analysis is presented in the following sections: Executive Overview; Results of Operations; Liquidity and Capital Resources; and Accounting Pronouncements and Policies.  The reader should read Management’s Discussion and Analysis of Financial Condition and Results of Operations in conjunction with the consolidated financial statements and related notes thereto contained elsewhere in this document.

All references to earnings per share relate to diluted earnings per common share.

EXECUTIVE OVERVIEW

The Company’s Operations

CPI Corp. is a long-standing leader, based on sittings, number of locations and related revenues, in the professional portrait photography of young children, individuals and families.  From a single studio opened by our predecessor company in 1942, we have grown to 2,935 studios throughout the U.S., Canada, Mexico and Puerto Rico, principally under license agreements with Sears and lease and license agreements with Walmart.  The Company has provided professional portrait photography for Sears’ customers since 1959 and has been the only Sears portrait studio operator since 1986.

On June 8, 2007, the Company completed the PCA Acquisition. The results of the acquired operations have been included in the consolidated financial statements since that date.  As a result of the PCA Acquisition, CPI is the sole operator of portrait studios in Walmart Stores and Supercenters in all fifty states in the U.S., Canada, Mexico and Puerto Rico.   Management has determined the Company operates as a single reporting segment offering similar products and services in all locations.

As of the end of the last three fiscal years, the Company’s studio counts were:
 
   
2009
   
2008
   
2007
 
                   
Within Sears stores:
                 
United States and Puerto Rico
    871       887       893  
Canada
    110       110       112  
                         
Within Walmart stores:
                       
United States and Puerto Rico
    1,549       1,642       1,702  
Canada
    260       259       253  
Mexico
    114       118       115  
                         
Locations not within Sears or Walmart stores
    31       30       33  
                         
Total
    2,935       3,046       3,108  
                         
 
Certain under-performing PMPS studios have been closed during 2008 and 2009 in order to improve overall financial results.  Locations not within Sears or Walmart stores include 26 free-standing SPS studio locations and 5 Shooting Star locations (located within Buy Buy Baby stores).

As of September 17, 2009, all of the Company’s studios are digital.  The installation of a new digital lab sufficient to handle the worldwide fulfillment requirements of the PMPS business was completed in the first quarter of 2008 and has been in operation since the second quarter of 2008.  As of the end of the second and fourth quarters of 2008, the Company had transferred all material PMPS operations to the Company’s existing support platform and completed the PMPS digital conversion, respectively.

Effective August 19, 2009, the Company entered into a new six-year license agreement with Sears Canada, Inc., pursuant to which the Company operates professional portrait studios in 110 Sears locations in Canada.  The terms of the new agreement provide greater operating flexibility than the previous contract.  As a result of the new agreement, the Company converted all remaining Sears film studios in Canada to a digital format in the 2009 third quarter.

 

 
16
 
 

CPI also entered into the Amendment, dated as of February 22, 2010, effective as of April 20, 2010, with Toys “R” Us to the License Agreement made and entered into as of December 23, 2005, between TRU and Kiddie Kandids, LLC.  The Company acquired the License Agreement in its acquisition of certain assets of Kiddie Kandids, LLC in an auction conducted by the Bankruptcy Court.  Under the Amendment, TRU grants CPI an exclusive license to operate photo studios in certain Babies “R” Us stores under the Kiddie Kandids name.  The term of the License Agreement, as amended by the Amendment, expires on January 31, 2016.  The Amendment allows CPI significant operating flexibility and collaborative marketing opportunities and provides for the opening of additional locations over the next two years.  The Amendment and the License Agreement contain certain termination rights for both the Company and TRU.  
 
The Company plans to continue to deliver steadily increasing growth through harvesting opportunities from its digital platform to create diversified revenue streams, driving productivity and profitability gains, leveraging our manufacturing capacity and efficiency and implementing aggressive, targeted marketing campaigns.  Such increases may be restrained if the economy worsens in the foreseeable future.

Market Challenges

Credit Agreement

As of February 6, 2010, the Company was in compliance with all debt covenants under its Credit Agreement.  Effective April 16, 2009, the Company entered into the third amendment (the “Amendment”) to its Credit Agreement to change the interest rate structure and the amortization schedule and to replace preexisting minimum EBITDA and interest coverage covenants with a fixed charge ratio test (i.e., EBITDA minus capital expenditures to fixed charges) and tighten the leverage ratio (i.e., Total Funded Debt to EBITDA), prospectively, with effect from February 8, 2009.  These changes were made to allow for greater flexibility in the event that a worsening economic climate has an impact on the Company’s earnings.  See Liquidity and Capital Resources below for further discussion.

 
17
 
 
RESULTS OF OPERATIONS

A summary of consolidated results of operations and key statistics follows:
 
in thousands, except per share data
 
2009
   
2008
   
2007
 
                   
Net sales
  $ 422,371     $ 462,548     $ 423,429  
                         
Cost and expenses:
                       
Cost of sales (exclusive of depreciation and amortization shown below)
    30,626       43,280       47,135  
Selling, general and administrative expenses
    339,138       377,310       326,568  
Depreciation and amortization
    22,740       29,432       27,291  
Other charges and impairments
    3,294       13,557       7,695  
      395,798       463,579       408,689  
                         
Income (loss) from continuing operations
    26,573       (1,031 )     14,740  
                         
Interest expense
    7,392       9,147       10,652  
Interest income
    456       620       1,834  
Other (expense) income, net
    (44 )     190       175  
Income (loss) from continuing operations before income tax expense (benefit)
    19,593       (9,368 )     6,097  
                         
Income tax expense (benefit)
    5,796       (2,644 )     2,080  
                         
Net income (loss) from continuing operations
    13,797       (6,724 )     4,017  
                         
Net loss from discontinued operations, net of income tax benefit
    -       (961 )     (441 )
                         
NET INCOME (LOSS)
  $ 13,797     $ (7,685 )   $ 3,576  
                         
NET INCOME (LOSS) PER COMMON SHARE
                       
                         
Net income (loss) per share from continuing operations - diluted
  $ 1.97     $ (1.03 )   $ 0.63  
Net loss per share from discontinued operations - diluted
    -       (0.15 )     (0.07 )
Net income (loss) per share - diluted
  $ 1.97     $ (1.18 )   $ 0.56  
                         
Weighted average number of common and common equivalent shares outstanding - diluted
    7,020       6,510       6,416  

Impact of the PCA Purchase Price Allocation

The purchase price of the PCA Acquisition was allocated based on fair value of the specific tangible and intangible assets acquired and liabilities assumed at the time of the acquisition pursuant to a valuation. The excess of the total purchase price over the fair value of the assets acquired and liabilities assumed at closing was recorded as goodwill, which is subject to an annual impairment review. The Company completed its assessment of the acquisition and the allocation of the purchase price in the second quarter of fiscal year 2008.  The purchase accounting adjustments that had a material impact on the Company’s financial position and results of operations included:

Deferred Revenue and Undelivered Receivables

Prior to the acquisition, the deferred revenue related to the PCA Acquisition was $10.0 million. The purchase accounting adjustment to reflect the deferred revenue balance at its fair value was $9.0 million, which resulted in a beginning deferred revenue balance related to the PCA Acquisition on June 8, 2007, of $964,000.  This adjustment had the effect of reducing revenue in periods subsequent to the acquisition. This adjustment had no impact on results for fiscal year 2008 but resulted in lower total revenue of $8.2 million for the period June 8, 2007, through February 2, 2008.  This reduction in revenue resulted in corresponding reductions to gross profit, operating income and income before taxes of $7.8 million, $3.4 million and $3.4 million, respectively.

 
18
 
 
Depreciation

As a result of the purchase accounting associated with the PCA Acquisition, fixed assets were recorded at approximately $35.0 million. The initial annual depreciation for the acquired PCA fixed assets was approximately $17.8 million.

Amortization of Acquired Intangible Assets

As a result of the purchase accounting associated with the PCA Acquisition, $46.8 million was allocated to intangible assets related to the host agreement with Walmart ($43.7 million) and the customer list ($3.1 million).   The host agreement with Walmart and the customer list are being amortized over their useful lives.  This results in higher expense in depreciation and amortization expense relative to intangible assets. The initial annual amortization was approximately $3.8 million.  Additionally, $21.2 million was allocated to goodwill, which is a non-amortizing asset.

Acquisition Related Interest Expense

To fund the PCA Acquisition, the Company entered into the Second Amended and Restated Credit Agreement, which provides for a $115.0 million term loan and a $40.0 million revolving credit facility.  Outstanding long-term debt at the date of the PCA Acquisition increased from $16.7 million to $115.0 million.  This refinancing resulted in higher interest expense when compared to the Company’s historical financial statements prior to the acquisition.

2009 versus 2008 and 2008 versus 2007
 
Unless otherwise noted, the fiscal year 2009 results include the 52-weeks ended February 6, 2010, compared to 53-weeks in fiscal year 2008, which ended February 7, 2009, and 52-weeks in fiscal year 2007, which ended February 2, 2008.

Net sales totaled $422.4 million, $462.5 million and $423.4 million in 2009, 2008 and 2007, respectively.

·  
Net sales for 2009 decreased $40.1 million, or 9%, to $422.4 million from the $462.5 million reported in 2008.  Excluding the negative impacts of store closures ($8.9 million), the 53rd week in the prior year ($7.0 million), net revenue recognition change ($4.1 million), revenue deferral related to positive response to the Company’s loyalty programs ($4.0 million), foreign currency translation ($1.9 million) and other net impacts ($1.1 million), comparable same-store sales decreased approximately 3%.

Net sales from the Company’s PMPS brand, on a comparable same-store basis, excluding impacts of store closures, net revenue recognition change, the 53rd week in the prior year, foreign currency translation and other items, totaling ($19.1 million), increased 9% in fiscal 2009 to $222.8 million from $204.1 million in fiscal 2008.  The improved PMPS sales performance for fiscal 2009 was the result of an approximate 24% increase in average sale per customer sitting, reflecting customers’ positive response to the offerings made possible by the digital conversion as well as new sales and performance management processes, offset in part by an approximate 12% decline in the number of sittings.

During fiscal 2009, net sales from the Company’s SPS brand, on a comparable same-store basis, excluding impacts of the 53rd week in the prior year, loyalty program revenue deferral, store closures and other items, totaling ($7.9 million), were $198.8 million, a decrease of 14% from $231.2 million in fiscal 2008.  SPS sales performance for fiscal 2009 was the result of a decline of approximately 15% in the number of sittings, offset slightly by an increase of 2% in average sale per customer sitting.

Net sales for 2008 increased $39.1 million, or 9%, to $462.5 million from the $423.4 million reported in 2007 as a result of the inclusion of the full 53 weeks of PMPS operations in 2008 compared with only the 34-week period of ownership in 2007.  The additional operating week in 2008 resulted in approximately $7.0 million of net sales but did not materially impact net income or net income per diluted share.  Declining foreign currency exchange rates had a significant negative impact of approximately $4.6 million on fiscal 2008 net sales; however, did not materially affect net income before tax.

 
19
 
 
Net sales from the Company’s SPS brand decreased $32.3 million, or 12%, to $242.4 million in fiscal 2008 from the $274.7 million reported in fiscal 2007.  The fiscal 2008 SPS net sales performance was the result of a 7% decline in sittings and a 5% decline in average sale per customer sitting.  The sittings results reflected continued declines in visit frequency among existing customers mitigated in part by relatively strong trends in new customer acquisition and increased loyalty plan conversion.  The average sale decline reflected a shift toward low-price package offers and lower conversion of higher priced collection and specialty product sales.  Additionally, the unfavorable foreign exchange rates in fiscal 2008 impacted net sales by approximately $1.1 million.

Net sales related to the Company’s PMPS brand increased $71.4 million, or 48%, in fiscal 2008 to $220.1 million from $148.7 million reported in fiscal 2007 due to the additional 19 weeks’ sales included in fiscal 2008 and the fact that a purchase accounting adjustment related to deferred revenue at the date of acquisition resulted in a one-time decrease in net sales of $8.2 million in fiscal 2007.  On a comparable same-store basis, PMPS net sales for fiscal 2008 represented an approximate 8% decrease in net sales versus the comparable period of the prior year (net sales from the period February 4, 2007, to June 8, 2007, are not reported in the Company’s historical results).  This sales performance resulted from an approximate 20% decrease in sittings, offset in part by an approximate 15% increase in average sale per customer sitting.  The Company believed the sittings decline reflected the difficult economic environment, which especially pressured customer demand in lower income categories.  The Company attributed the increase in average sale per customer sitting primarily to customers’ positive response to the new offerings made possible by the digital conversion and the implementation of new sales and performance management processes.  Additionally, the unfavorable foreign exchange rates in fiscal 2008 impacted net sales by approximately $3.5 million.

Costs and expenses were $395.8 million in 2009, compared with $463.6 million in 2008 and $408.7 million in 2007.  

·  
Cost of sales, excluding depreciation and amortization expense, was $30.6 million, $43.3 million and $47.1 million in 2009, 2008 and 2007, respectively.

Cost of sales, excluding depreciation and amortization expense, declined in 2009 from 2008 levels.  The decrease principally resulted from lower production levels, improved productivity due to lab consolidations, elimination of film and related shipping costs stemming from the PMPS digital conversion, savings from in-house production of greeting cards, reduced on-site printing costs and decreased overhead costs resulting from the integration of the PMPS operations.

Cost of sales, excluding depreciation and amortization expense, in 2008 declined from 2007 as a result of decreased production costs resulting from lower overall manufacturing production levels, additional gains in manufacturing productivity, savings on film and shipping costs that resulted directly from the PMPS digital conversion, as well as decreased overhead costs as operations were further streamlined in connection with the PMPS acquisition and digital conversion.

·  
Selling, general and administrative (“SG&A”) expense was $339.1 million, $377.3 million and $326.6 million for fiscal years 2009, 2008 and 2007, respectively.

SG&A expense fell to $339.1 million in fiscal 2009, compared with $377.3 million in fiscal 2008.  The decrease in SG&A expense primarily relates to lower studio employment costs due to scheduling improvements and selected operating hour reductions; the impact of the 53rd week in the prior year; fiscal 2008 nonrecurring costs associated with the PMPS digital conversion; elimination of duplicative costs in connection with the PMPS integration; reduced employee insurance costs due to plan changes and lower participation and claims levels; reduced workers’ compensation expense due to improved claims management; reduced marketing expense due to reduced direct mail expense and improvements in studio marketing and acquisition programs; and other cost reductions attributable to cost-control initiatives, operating efficiencies and lower sales levels.  These decreases were offset in part by increases in incentive pay in connection with new studio and field initiatives and corporate bonuses.

The increase in 2008 SG&A costs was a result of the inclusion of the full 53 weeks of PMPS operations in 2008 compared with only the 34-week period of ownership in 2007, a $5.4 million increase in digital training and travel costs related to the conversion of PMPS studios incurred during the year and a nonrecurring 2007 reduction of $3.9 million attributable to a change in the Company’s vacation and sick pay policy.  These increases were offset in part by reductions in expense due to the elimination of duplicate costs, streamlining of operations related to the PMPS brand; more effective cost management, particularly in the areas of employment and insurance; reduced host sales commissions due to lower sales; reduced marketing expense primarily due to the timing of promotional programs for the busy season; and a one-time gain recorded in relation to the settlement of certain supplemental employee retirement plan payments.

 
20
 
 
·  
Depreciation and amortization expense was $22.7 million in 2009 compared to $29.4 million in 2008 and $27.3 million in 2007.

Depreciation and amortization expense in 2009 decreased from 2008 due to the full depreciation of certain assets acquired in connection with both the 2005 digital conversion of SPS and the 2007 acquisition of PCA; the closure of certain facilities in fiscal 2008 and early fiscal 2009; and an adjustment made in the prior year to write-off Mexico film equipment no longer required after the digital conversion.  These decreases were offset in part by an increase as a result of the digital equipment purchased for the PMPS digital conversion throughout fiscal 2008.

The increase in 2008 is attributed to the equipment purchased for the digital rollout.  This increase was offset in part by a decline in depreciation as a result of certain assets, acquired in connection both with the 2005 digital conversion of SPS and the 2007 acquisition of PCA, becoming fully depreciated.

·  
Other charges and impairments reflect costs incurred from strategic actions implemented by the Company to restructure its operations, costs that are unpredictable and atypical of the Company’s operations and additional charges due to asset impairments.  Actions taken during 2009, 2008 and 2007 are as follows:
 
in thousands
 
2009
   
2008
   
2007
 
                   
Recorded as a component of income (loss) from operations:
                 
   Reserves for severance and related costs (1)
  $ 970     $ 2,046     $ 2,035  
   Proxy contest fees (2)
    871       -       -  
   Other transition related costs - PCA Acquisition (3)
    527       1,255       2,817  
   Impairment charges (4)
    300       739       -  
   Sears fees related to the settlement of the previous license agreement (5)
    -       7,527       2,500  
   Other (6)
    626       1,990       343  
                         
   Total Other Charges and Impairments
  $ 3,294     $ 13,557     $ 7,695  
                         

(1)  
Charges in 2009 primarily relate to severance costs resulting from the termination of employees in connection with the closure of the film lab facility in Canada due to the digital conversion of the SPS Canada studios.
 
Charges in 2008 and 2007 were principally related to severance costs resulting from the termination of employees in connection with the integration of operations of the PCA Acquisition into CPI.
 
(2)  
Charges relate to certain fees incurred in connection with the proxy contest in 2009.
 
(3)  
During 2009, expense primarily relates to lab closure-related costs of $1.1 million.  This expense is offset in part by a $546,000 net gain recognized on the sale of certain properties previously held for sale.
 
During 2008, expense primarily related to lab closure-related costs of $902,000.  The remainder of expense related to professional service and consultant costs associated with the transition.
 
During 2007, in connection with the PCA Acquisition, the Company incurred transition-related costs associated with combining the operations of PCA into the CPI organization ($2.0 million) and cure costs associated with contractual obligations transferred from PCA to CPI ($523,000).
 
(4)  
During 2009 and 2008, the Company incurred $300,000 and $739,000, respectively, related to the write-down of certain asset values held for sale.

(5)  
In 2008 and 2007, the Company incurred certain fees and charges in relation to the settlement of the previous Sears license agreement.  These fees and charges are discussed further in Item 1, “Business” and in Note 16 to the Notes to Consolidated Financial Statements.

(6)  
Costs in 2009 primarily relate to net legal expense of $527,000 incurred in connection with the settlement of the Picture Me Press LLC vs. Portrait Corporation of America case as well as the write-off of certain Canada film inventory due to the digital conversion of the SPS Canada studios.  These expenses are offset in part by a reduction in certain lease obligation reserves of $288,000. 
 
Costs in 2008 primarily related to legal expense of $913,000 incurred for the settlement of the Portraits International of the Southwest vs. CPI Corp. case and $866,000 incurred in connection with the Picture Me Press LLC vs. Portrait Corporation of America case.  The remainder of expense related to executive recruitment expense and a contract negotiation with a director.
 
Costs in 2007 primarily related to charges incurred related to software that is no longer used in the business, one-time strategic studies and legal charges.
 
 
 
21
 
 
 
Interest expense was $7.4 million in 2009 compared to $9.1 million in 2008 and $10.7 million in 2007.  The decreases in interest expense in 2009 and 2008 are primarily the result of adjustments to the fair value of the interest rate swap agreement that decreased interest expense by $2.1 million and $2.3 million in 2009 and 2008, respectively.  The decrease in 2008 was offset in part by an increase in higher average borrowings after the refinancing of the Credit Agreement to fund the PCA Acquisition as discussed in Note 10 to the Notes to Consolidated Financial Statements.

Interest income was $456,000 in 2009 compared to $620,000 in 2008 and $1.8 million in 2007.  The decrease in interest income in 2008 is primarily attributable to lower invested balances in 2008 compared to 2007, the result of higher capital spending in 2008 related to the digital conversion of PMPS.

The income tax expense (benefit) on income (loss) from continuing operations totaled $5.8 million, ($2.6 million) and $2.1 million in 2009, 2008 and 2007, respectively.  These provisions resulted in effective tax rates of 30% in 2009, (28%) in 2008 and 34% in 2007.  The change in the effective tax rate in 2009 is primarily attributable to the recognition of a $2.1 million, net, foreign tax credit benefit.  The change in the effective tax rate in 2008 was primarily attributed to the tax effect of WOTC credits as a percent of pre-tax income and the exclusion of certain tax benefits due to the fiscal year loss.

Net losses from discontinued operations were $961,000 and $441,000 in 2008 and 2007, respectively.  In 2008, the Company decided to discontinue its Portrait Gallery and E-Church operations.  In 2007, in connection with the PCA Acquisition, the Company decided to sell the 5-portrait studio operation in the United Kingdom (the “UK Operations”).  These decisions were made in order to eliminate the unprofitable operations.

LIQUIDITY AND CAPITAL RESOURCES

The following table presents a summary of the Company’s cash flows for each of the last three fiscal years:
 
in thousands
 
2009
   
2008
   
2007
 
                   
Net cash (used in) provided by:
                 
Operating activities (1)
  $ 31,289     $ 11,847     $ 39,466  
Financing activities
    (33,494 )     (13,419 )     90,788  
Investing activities
    (2,876 )     (33,488 )     (97,653 )
Effect of exchange rate changes on cash and cash equivalents
    329       (452 )     282  
Net (decrease) increase in cash and cash equivalents
  $ (4,752 )   $ (35,512 )   $ 32,883  
                         
 
(1)  
Includes cash flows used in discontinued operations of $816,000 and $406,000 in 2008 and 2007, respectively.

Net Cash Provided By Operating Activities

Net cash provided by operating activities was $31.3 million in 2009 compared to $11.8 million and $39.5 million in 2008 and 2007, respectively.  Cash flows in 2009 increased from 2008 primarily due to payment reductions over the prior year related to digital training and travel of $5.8 million, fees in connection with the settlement of the previous Sears license agreement of $5.4 million, employee insurance of $3.9 million, severance and integration-related payments of $2.5 million, interest of $1.9 million, pension of $1.6 million and worker’s compensation of $1.1 million.  These were offset in part by the timing of payments related to changes in the various balance sheet accounts totaling $2.7 million.

Cash flows in 2008 decreased from 2007 levels primarily due to net operating losses and the timing of payments related to changes in the various balance sheet accounts totaling $26.7 million, $5.4 million for training and travel related to the PMPS digital conversion, $4.3 million for fees incurred in connection with the settlement of the previous Sears license agreement and $2.6 million related to additional worker’s compensation premiums and claims paid primarily due to the acquisition of PCA.  These were offset in part by delays in spending for advertising ($4.1 million), reductions in tax payments ($2.8 million), decreased payments for severance and integration-related costs associated with the acquisition of PCA ($2.6 million) and a decrease in pension payments ($1.9 million).

Net Cash (Used In) Provided By Financing Activities

Net cash (used in) provided by financing activities was ($33.5 million), ($13.4 million) and $90.8 million in 2009, 2008 and 2007, respectively.  The increase in cash used in 2009 compared to 2008 is primarily attributed to an increase in repayment of long-term debt.  In addition to the mandatory payments made pursuant to the mandatory payment schedule in the Credit Agreement, the Company made voluntary prepayments of $17.0 million of outstanding principal of the debt during 2009.  Additionally, the Company applied proceeds of $982,000 and $917,000 in the second and fourth quarters of 2009, respectively, from the sale of the Charlotte, North Carolina warehouse and the Thomaston, Connecticut facility, respectively, to the outstanding principal of the debt in connection with certain mandatory prepayment requirements under the Credit Agreement.

 
22
 
 
The increase in cash used in 2008 was primarily attributable to events from 2007.  These include higher net long-term borrowings of $106.5 million related to the PCA Acquisition and the release of $1.0 million of restricted cash, offset in part by the payment of debt issuance costs of $2.7 million.

In connection with the PCA Acquisition on June 8, 2007, the Company amended and restated its Credit Agreement to a five-year term and revolving credit facility in an amount up to $155 million, consisting of a $115 million term loan and a $40 million revolving loan with a sub-facility for letters of credit in an amount not to exceed $25 million.  The obligations of the Company under the Credit Agreement are secured by (i) a guaranty from certain material direct and indirect domestic subsidiaries of the Company, and (ii) a lien on substantially all of the assets of the Company and such subsidiaries.

The Company incurred $2.7 million in issuance costs associated with this second amended and restated agreement.  The term loan portion of issuance costs is being amortized using the effective interest method over the life of the related debt.  Fees associated with the revolving portion are being amortized on a straight-line basis over the life of the revolving commitment since there are no borrowings or repayments scheduled.

As part of this Credit Agreement, the Company entered into an interest rate swap agreement to manage the interest rate risk on $57.5 million of the term loan.  This swap agreement has not been designated as a hedge as it has not been determined that it qualifies for cash flow hedge accounting.  As discussed above, payments under the term loan are based on an applicable London Interbank Offered Rate ("LIBOR") period plus 2.75%.  To economically hedge the risk of increasing interest rates, the Company entered into an interest rate swap that effectively converted three-month floating rate LIBOR-based payments to a fixed rate of 4.97% plus the LIBOR-rate spread of 2.75%, resulting in a 7.72% interest rate.  The contract expires in September 2010.  The fixed rate gain (loss) related to this agreement was $1.5 million, ($617,000) and ($2.9 million) at February 6, 2010, February 7, 2009 and February 2, 2008, respectively, which is included in interest expense.

The proceeds of the term loan were used for working capital and general business purposes, for acquisitions permitted under the Credit Agreement (including the acquisition of PCA (as defined in the Credit Agreement)), for capital expenditures (including retail store expansions and conversion to digital photography), to pay dividends and distributions on the Company’s capital securities to the extent permitted thereunder, and to make purchases or redemptions of the Company’s capital securities to the extent permitted thereunder.

Effective April 16, 2009, the Company entered into the third amendment (the “Amendment”) to its Credit Agreement to change the interest rate structure and amortization schedule and to replace preexisting minimum EBITDA and interest coverage covenants with a fixed charge ratio test (as defined, EBITDA minus capital expenditures to fixed charges) and tighten the leverage ratio test (as defined, Total Funded Debt to EBITDA).  These changes were made to allow for greater flexibility in the event that the economic climate worsens and has an impact on the Company’s earnings.  As of February 6, 2010, the Company had $77.5 million outstanding under the term loan portion of its existing Credit Agreement.  The Company was in compliance with its financial covenants under its Credit Agreement as of February 6, 2010.

Pursuant to the Amendment, the term loan bears interest at the Company’s option, at either a period-based LIBOR plus a spread ranging from 3.75% to 4.25%, or the Base Rate plus a spread ranging from 2.25% to 2.75%.  The Base Rate is determined from the greater of the prime rate, the Federal Funds rate plus 0.50% or the LIBOR Rate plus 1.00% (the “Base Rate”).  Revolving loans are priced at the Base Rate or LIBOR.  The Company is also required to pay a non-use fee of 0.50% per annum on the unused portion of the revolving commitment and letter of credit fees of 3.25% to 4.00% per annum.  The interest rate spread in the case of LIBOR and Base Rate loans and the payment of the non-use fees and the letter of credit fees is dependent on the Company’s Ratio of Total Funded Debt to EBITDA (as defined in the Credit Agreement).  If the Company fails to deliver required financial statements and compliance certifications, all of the above interest rates reset to the maximums indicated until five days following the date such statements and certifications are submitted.

In addition, under the Amendment, the mandatory payment schedule requires that unless sooner repaid in whole or part pursuant to the terms of the Credit Agreement, the outstanding principal balance of the term loan is to be repaid in installments of $1.0 million on each of March 31, June 30 and September 30 and $7.0 million on December 31 for all periods after the date of the Amendment, with a final payment being made on the maturity date thereof.  The Amendment also includes mandatory prepayments based on the Company’s levels of cash flow and certain transactions.  The mandatory prepayment based upon cash flow is calculated annually at the conclusion of the fiscal year and is equal to 75% of excess cash flow (as defined in the Credit Agreement).  If the Ratio of Total Funded Debt to EBITDA is below 1.50 to 1.00 for any two consecutive fiscal years, such percentage is reduced to 25% of excess cash flow.

The Company incurred $943,000 in fees paid to creditors associated with this Amendment, which is being amortized over the remainder of the life of the loan in addition to fees that are currently being amortized, the amounts of which are included in Prepaid debt fees in the Consolidated Balance Sheet as of February 6, 2010.

We have defined benefit and defined contribution pension plans, as described in Note 14 to the Notes to Consolidated Financial Statements.  We fund these plans based on the minimum amounts required by law plus such amounts we deem appropriate.
 
 
 
23
 
 

Net Cash Used In Investing Activities

Net cash used in investing activities was $2.9 million, $33.5 million and $97.7 million in 2009, 2008 and 2007, respectively.  The decrease in cash used in 2009 from 2008 primarily relates to a decrease in capital expenditures of $30.8 million as the digital conversion was completed by the end of 2008.  This decrease is offset in part by a decrease of $2.5 million related to the proceeds received and distribution of funds in excess of related obligations from the Rabbi Trust and proceeds of $1.9 million from the sale of certain assets previously held for sale during 2009.

The decrease in cash used in 2008 from 2007 was primarily due to the PCA Acquisition and related costs in 2007 totaling $83.0 million, as well as an additional $2.3 million received related to the proceeds received and distribution of funds in excess of related obligations from the Rabbi Trust, offset in part by an increase in capital expenditures of $21.2 million primarily due to the PMPS digital conversion.

Off-Balance Sheet Arrangements

Other than standby letters of credit primarily used to support the Company’s various large deductible insurance programs and the ongoing guarantee of certain operating real estate leases of Prints Plus, both of which are more fully discussed in the “Other Commitments” table below, the Company has no additional off-balance sheet arrangements.

Future Cash Flows

To facilitate an understanding of the Company’s contractual obligations and other commitments, the tables below are provided.  The Company is self-insured with stop-loss coverage for medical insurance and has a large deductible program for worker’s compensation and general liability insurance.  The Company has established reserves for claims under these plans that have been reported but not paid and incurred but not reported.  As of February 6, 2010, estimated reserves for these claims totaled $10.5 million.  These reserves have been excluded from the table below, as we are uncertain as to the timing of when cash payments may be required. The tables also do not include our deferred income tax, interest rate swap, rental and license host fee liabilities and pension plan obligations beyond 2010, as the liabilities are not currently estimable and/or it is not certain when they will become due.
 
in thousands
 
PAYMENTS DUE BY PERIOD
 
                           
2015 &
 
   
Total
   
2010
      2011-12       2013-14    
Beyond
 
Contractual obligations:
                                 
                                   
Long-term debt (1)
  $ 77,541     $ 19,686     $ 57,855     $ -     $ -  
Interest expense (2)
    8,513       3,626       4,887       -       -  
Operating leases
    3,035       616       888       568       963  
  Purchase obligations for
                                       
materials and services (3)
    6,428       4,655       1,773       -       -  
  Pension plan obligations (4)
    1,694       1,694       -       -       -  
  Sears Agreement settlement fees (5)
    750       150       300       300       -  
Other liabilities (6)
    676       566       98       12       -  
                                         
TOTAL
  $ 98,637     $ 30,993     $ 65,801     $ 880     $ 963  
                                         

in thousands
 
AMOUNT OF COMMITMENT EXPIRATION PER PERIOD
 
                           
2015 &
 
   
Total
   
2010
      2011-12       2013-14    
Beyond
 
Other commitments:
                                 
                                   
Standby letters of credit (7)
  $ 16,980     $ 16,980     $ -     $ -     $ -  
Contingent lease obligations
    210       120       90       -       -  
                                         
TOTAL
  $ 17,190     $ 17,100     $ 90     $ -     $ -  
                                         

 
24
 
 

(1)
 
The long-term debt agreement includes mandatory prepayments based on the Company’s levels of cash flow and certain transactions; these amounts for 2011 are not incorporated since they are not currently estimable.  Payments in 2010 reflect a voluntary debt prepayment of $5.0 million made on April 16, 2010.  The Company, in connection with its Credit Agreement, plans to use the cash proceeds, if any, from the sale of certain properties, as described more fully in Note 7 to the Notes to Consolidated Financial Statements, to pay down its long-term debt.
     
(2)
 
Amounts represent the expected cash payments of the Company’s interest expense on its long-term debt, calculated based on the rates included in the Credit Agreement amendment, effective April 16, 2009.
     
(3)
 
Amount represents outstanding purchase commitments at February 6, 2010.  The purchase commitments relate principally to photographic paper, manufacturing supplies, telecommunication services, database maintenance contracts and marketing initiatives.
 
(4)
 
The Company anticipates it will make a contribution of approximately $1.7 million to the pension plan in 2010.  Obligations beyond 2010 are not currently estimable.  Future contributions to the pension plan will be dependent upon legislation, future changes in discount rates and the earnings performance of the plan assets.
 
(5)
 
The Company is obligated to remit to Sears additional payments as stipulated in the settlement of the previous license agreement.  A $150,000 payment is due to Sears on December 31 of each year through 2014.
     
(6)
 
Amounts consist primarily of accruals for severance and related costs, which are recorded at the contractual amounts due.
     
(7)
 
The Company primarily uses standby letters of credit to collateralize its various large deductible insurance programs.  The letters of credit generally have a one-year maturity and have auto renewal clauses.

Liquidity

Cash flows from operations, cash and cash equivalents and the borrowing capacity under the revolving portion of the Company’s Credit Agreement, represent expected sources of funds in 2010 that will meet the Company’s obligations and commitments, including debt service, annual dividends to shareholders, planned capital expenditures, which are estimated to approximate $6.5 million for fiscal year 2010, and normal operating needs.

ACCOUNTING PRONOUNCEMENTS AND POLICIES

Adoption of New Accounting Standards

In June 2009, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 168, “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles – a replacement of FASB No. 162” (“SFAS No. 168”).  SFAS No. 168 provided for the FASB Accounting Standards Codification (“ASC” or the “Codification”) to become the single official source of authoritative, nongovernmental U.S. GAAP.  The Codification did not change U.S. GAAP but reorganized existing literature and is effective for interim and fiscal years ending after September 15, 2009.  The Company adopted the provisions of SFAS No. 168 (referenced as ASC Topic 105, “Generally Accepted Accounting Principles” (“ASC Topic 105”) under the Codification) on July 26, 2009.  The effect was not material to the Company’s financial statements; however, references to legacy U.S. GAAP, where appropriate, have been replaced with their respective ASC references.  Additionally, all authoritative U.S. GAAP issued by the FASB after July 1, 2009, has been designed to update the Codification and will now be referred to as Accounting Standards Updates (“ASU”).  ASU No. 2009-01, “Topic 105 – Generally Accepted Accounting Principles – amendments based on SFAS No. 168” issued in June 2009, created ASC Topic 105, as noted above, in the General Principles and Objective Section of the Codification and includes SFAS No. 168 in its entirety, including the accounting standards update instructions.

In February 2010, the FASB issued ASU No. 2010-09, “Amendments to Certain Recognition and Disclosure Requirements” (“ASU No. 2010-09”).  ASU No. 2010-09 amends ASC Topic 855, “Subsequent Events”, which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued, by requiring U.S. Securities and Exchange Commission (“SEC”) filers to evaluate subsequent events through the date that the financial statements are issued and by removing the requirement for SEC filers to disclose the date through which subsequent events have been evaluated.  ASU No. 2010-09 was effective upon issuance.  In accordance with ASU No. 2010-09, the Company performed an evaluation of subsequent events through the date which the financial statements were issued and determined no subsequent events had occurred which would require adjustment to or additional disclosure in its consolidated financial statements.

 
 
25
 
 
In January 2010, the FASB issued ASU No. 2010-06, “Improving Disclosures about Fair Value Measurements” (“ASU No. 2010-06”).  ASU No. 2010-06 amends existing disclosure requirements under ASC Topic 820, “Fair Value Measurements and Disclosures” (“ASC Topic 820”) by adding required disclosures about items transferring into and out of levels 1 and 2 in the fair value hierarchy; adding separate disclosures about purchases, sales, issuances, and settlements on a gross basis relative to level 3 measurements; and clarifying, among other things, the existing fair value disclosures about inputs and valuation techniques and the level of disaggregation.  The new disclosures and clarifications of existing disclosures are effective for interim and annual periods beginning after December 15, 2009, except for the requirement to provide level 3 activity of purchases, sales, issuances and settlements on a gross basis, which is effective for interim and annual periods beginning after December 15, 2010.  The Company adopted the applicable requirements of ASU No. 2010-06 on February 7, 2010, with the exception of the requirement to provide level 3 activity of purchases, sales, issuances and settlements on a gross basis, as this is not effective until the Company’s first quarter of fiscal year 2011, and the effect was not material to the Company’s financial statements.

In September 2009, the FASB issued ASU No. 2009-06, “Income Taxes” (“ASU No. 2009-06”).  ASU No. 2009-06 provides additional implementation guidance to improve current accounting by helping to achieve consistent application of accounting for uncertainty in income taxes and is effective for interim and annual periods ending after September 15, 2009.  The Company adopted the applicable requirements of ASU No. 2009-06 on July 26, 2009, and the effect was not material to the Company’s financial statements.
 
In August 2009, the FASB issued ASU No. 2009-05, “Fair Value Measurements and Disclosures” (“ASU No. 2009-05”).  ASU No. 2009-05 supplements and amends the guidance in ASC Topic 820 to clarify how an entity should measure the fair value of liabilities and outlines alternative valuation methods and a hierarchy for their use.  ASU No. 2009-05 also clarifies that restrictions preventing the transfer of a liability should not be considered as a separate input or adjustment in the measurement of its fair value.  ASU No. 2009-05 is effective for interim and annual periods beginning after issuance of the Update.  The Company adopted the applicable requirements of ASU No. 2009-05 on July 26, 2009, and the effect was not material to the Company’s financial statements.

In April 2009, the FASB issued three related Staff Positions (FSP) intended to provide additional application guidance and enhanced disclosures regarding fair value measurements and impairments of securities: (i) FSP SFAS No. 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly” (“FSP SFAS No. 157-4”) (transition included under ASC Topic 820), (ii) FSP SFAS No. 107-1 and Accounting Principles Board Opinion (“APB”) No. 28-1, “Interim Disclosures about Fair Value of Financial Instruments” (“FSP SFAS No. 107-1 and APB No. 28-1”) (transition included under ASC Topic 825, “Financial Instruments”) and (iii) FSP SFAS No. 115-2 and FSP SFAS No. 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments” (“FSP SFAS No. 115-2 and FSP SFAS No. 124-2”) (transition included under ASC Topic 320, “Investments – Debt and Equity Securities”).

FSP SFAS No. 157-4 provides guidelines for determining fair values when the volume and level of activity for an asset or liability have significantly decreased.  This position reaffirms that the objective of fair value measurement is to reflect the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (as opposed to a distressed or forced transaction) between market participants at the date of the financial statements under current market conditions.  FSP SFAS No. 107-1 and APB No. 28-1 relate to fair value disclosure for any financial instrument not currently reflected on the balance sheet at fair value and requires qualitative and quantitative disclosure about fair value estimates for such financial instruments on an interim basis.  FSP SFAS No. 115-2 and FSP SFAS No. 124-2 relate to recognition, presentation and disclosure of other-than-temporary impairments of impaired debt securities, of which the Company currently has none.  The Company adopted the applicable requirements of these positions on May 3, 2009, and has included the appropriate disclosures in the Company’s financial statements.

ASC Topic 715, “Compensation – Retirement Benefits” (“ASC Topic 715”) (which includes certain disclosure requirements issued under FSP SFAS No. 132R-1, “Employers’ Disclosure about Postretirement Benefit Plan Assets”, an amendment of SFAS No. 132 (revised 2003), “Employers’ Disclosure about Pensions and Other Postretirement Benefits”, in December 2008 and effective for fiscal years ending after December 15, 2009) requires more detailed disclosures regarding defined benefit pension plan assets including investment policies and strategies, major categories of plan assets, valuation techniques used to measure the fair value of plan assets and significant concentrations of risk within plan assets.  These enhanced disclosures are required for fiscal years ending after December 15, 2009.  Upon initial application, the enhanced disclosures are not required for earlier periods that are presented for comparative purposes.  The Company has incorporated the applicable enhanced disclosures required under ASC Topic 715 within Note 14 to the Notes to Consolidated Financial Statements.

 
 
26
 
 
Application of Critical Accounting Policies

The application of certain of the accounting policies utilized by the Company requires significant judgments or a complex estimation process that can affect the results of operations and financial position of the Company, as well as the related footnote disclosures.  The Company bases its estimates on historical experience and other assumptions that it believes are reasonable.  If actual amounts are ultimately different from previous estimates, the revisions are included in the Company’s results of operations for the period in which the actual amounts become known.  The Company’s significant accounting policies are discussed in Note 1 to the Notes to Consolidated Financial Statements; critical estimates inherent in these accounting policies are discussed in the following paragraphs.

Long-Lived Asset Recoverability

In accordance with ASC Topic 360, “Property, Plant and Equipment” (“ASC Topic 360”) long-lived assets, primarily property and equipment, are tested for recoverability whenever events or changes in circumstances indicate that their carrying amount may not be recoverable.  The impairment test is a two-step process.  If the carrying value of the asset exceeds the expected future cash flows (undiscounted and without interest) from the asset, impairment is indicated.  The impairment loss recognized is the excess of the carrying value of the asset over its fair value.  During  2009, the carrying value of a certain asset classified as held for sale exceeded its fair value less cost to sell.  As such, the Company recorded a $300,000 charge in other charges and impairments in the Consolidated Statement of Operations in 2009 to reduce the asset carrying value to its fair value less cost to sell.  See Note 7 to the Notes to Consolidated Financial Statements.

Recoverability of Goodwill and Acquired Intangible Assets

The Company accounts for goodwill under ASC Topic 350, “Intangibles-Goodwill and Other” (“ASC Topic 350”) which requires the Company to test goodwill for impairment on an annual basis, and between annual tests whenever events or changes in circumstances indicate the carrying amount may not be recoverable.  ASC Topic 350 prescribes a two-step process for impairment testing of goodwill.  The first step is a screen for impairment, which compares the reporting unit’s estimated fair value to its carrying value.  If the carrying value exceeds the estimated fair value in the first step, the second step is performed in which the Company’s goodwill is written down to its implied fair value, which the Company would determine based upon a number of factors, including operating results, business plans and anticipated future cash flows.

The Company performs its annual impairment test at the end of its second quarter, or more frequently if circumstances indicate the potential for impairment.  As of July 25, 2009, the end of the Company’s second quarter, the Company completed its annual impairment test and concluded that the estimated fair value of its reporting unit substantially exceeded its carrying value, and therefore, no impairment was indicated.  As of February 6, 2010, the Company considered possible impairment triggering events since the July 25, 2009, impairment test date, including its market capitalization relative to the carrying value of its net assets, as well as other relevant factors, and concluded that no goodwill impairment was indicated at that date.  The Company has one goodwill reporting unit, which is currently not at risk of failing the step-one impairment test.

The Company reviews its intangible assets with definite useful lives, consisting primarily of the Walmart host agreement, under ASC Topic 360, which requires the Company to review for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable.  Recoverability of intangible assets with definite useful lives is measured by a comparison of the carrying amount of the asset to the estimated future undiscounted cash flows expected to be generated by such assets.  If such assets are considered to be impaired, the impairment is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets, which is determined on the basis of discounted cash flows.

As of February 6, 2010, the Company considered possible impairment triggering events, including projected cash flow data, as well as other relevant factors, and concluded that no impairment was indicated at that date.  It is possible that changes in circumstances, assumptions or estimates, including historical and projected cash flow data, utilized by the Company in its evaluation of the recoverability of its intangible assets with definite useful lives, could require the Company to write-down its intangible assets and record a non-cash impairment charge, which could be significant, and would adversely affect the Company’s financial position and results of operations.

Self-insurance Reserves

The Company is self-insured with stop-loss coverage for medical insurance and has a large deductible program for worker’s compensation and general liability insurance.  The Company has established reserves for claims under these plans that have been reported but not paid and incurred but not reported.  These reserves are based upon the Company’s estimates of the aggregate liability for uninsured claims incurred using actuarial assumptions followed in the insurance industry and the Company’s historical experience. Loss estimates are adjusted based upon actual claims settlements and reported claims.
 
 
 
27
 
 

Income Taxes

The Company provides deferred income tax assets and liabilities based on the estimated future tax effects of operating losses and tax credit carryforwards, as well as the differences between the financial and tax bases of assets and liabilities based on currently enacted tax laws.  Deferred tax assets and liabilities are measured using the enacted tax rates expected to apply in the years in which those temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The tax balances and income tax expense (benefit) recognized by the Company are based on management’s interpretation of the tax laws of multiple jurisdictions.  Income tax expense (benefit) also reflects the Company’s best estimates and assumptions regarding, among other things, the level of future taxable income, interpretation of the tax laws and tax planning.  The Company assesses temporary differences that result from differing treatments of certain items for tax and accounting purposes.  These differences result in deferred tax assets and liabilities, which are shown on our consolidated balance sheet.  The Company must assess the likelihood that deferred tax assets will be realized.  To the extent the Company believes that realization is not likely, a valuation allowance is established.  When a valuation allowance is established or increased in an accounting period, a corresponding tax expense is recorded in our consolidated statement of operations.

Defined Benefit Retirement Plans

The plan obligations and related assets of defined benefit retirement plans are presented in Note 14 in the accompanying Notes to Consolidated Financial Statements. Plan assets, which consist primarily of marketable equity and debt instruments, are valued using market quotations. Plan obligations and the annual pension expense are determined by independent actuaries and through the use of a number of assumptions. Key assumptions in measuring the plan obligations include the discount rate, the rate of salary increases and the estimated future return on plan assets. In determining the discount rate, the Company utilizes the yield on high-quality, fixed-income investments currently available with maturities corresponding to the anticipated timing of the benefit payments.  Asset returns are based upon the anticipated average rate of earnings expected on the invested funds of the plans.  Actuarial assumptions used in the Company’s plans at February 6, 2010, are included in Note 14 to the Notes to Consolidated Financial Statements.  Effective February 20, 2009, the Company implemented a freeze of future benefit accruals related to its pension plan for the remaining grandfathered participants.  See further discussion in Note 14 to the Notes to Consolidated Financial Statements.

The Company has made certain other estimates that, while not involving the same degree of judgment, are important to understanding the Company’s financial statements. These estimates are in the areas of establishing reserves or accruals in connection with restructuring or other business changes.  On an ongoing basis, management evaluates its estimates and judgments in these areas based on its substantial historical experience and other relevant factors.  Management’s estimates as of the date of the financial statements reflect its best judgment giving consideration to all currently available facts and circumstances.  As such, these estimates may require adjustment in the future, as additional facts become known or as circumstances change.

The Company’s management has discussed the development and selection of these critical accounting policies with the Audit Committee of the Company’s Board of Directors and the Audit Committee has reviewed the Company’s disclosure relating to it in this Management Discussion and Analysis of Financial Condition and Results of Operations section.

 
Quantitative and Qualitative Disclosures About Market Risk

Market risks relating to the Company’s operations result primarily from changes in interest rates and foreign exchange rates.

At February 6, 2010, all of the Company’s debt obligations have floating interest rates, however, the swap agreement discussed below has effectively fixed the rate on $57.5 million of the debt.  The impact of a 1% change in interest rates affecting the Company’s variable rate debt would be minimal and would increase or decrease interest expense by approximately $200,000.

The Company’s net assets, net earnings and cash flows from its Canadian and Mexican operations are based on the U.S. dollar equivalent of such amounts measured in the respective country’s functional currency.  Assets and liabilities are translated to U.S. dollars using the applicable exchange rates as of the end of a reporting period.  Revenues, expenses and cash flows are translated using the average exchange rate during each period.  The Company’s Canadian operations constitute 14% of the Company’s total assets and 13% of the Company’s total sales as of and for the year ended February 6, 2010.  A hypothetical 10% unfavorable change in the Canadian-to-U.S. dollar exchange rate would cause an approximate $1.1 million decrease to the Company’s net asset balance and could materially adversely affect its revenues, expenses and cash flows.  The Company’s exposure to changes in foreign exchange rates relative to the Mexican operations is minimal, as Mexican operations constitute only 1% of the Company’s total assets and 2% of the Company’s total sales as of and for the year ended February 6, 2010.

 
28
 
 

The Company has an interest rate swap agreement to reduce exposure to market risk from changes in interest rates by swapping an unknown variable interest rate for a fixed rate.  This swap agreement has not been designated as a hedge as it has been determined that it does not qualify for hedge accounting treatment.  The principal objective of this contract is to minimize the risks and/or costs associated with the Company’s variable rate debt.  Gains and losses are recognized in the statement of operations as interest expense throughout the interest period.  The Company is exposed to credit-related losses in the event of nonperformance by the counterparty to this financial instrument; however, the counterparty to this agreement is a major financial institution, and the risk of loss due to nonperformance is considered by management to be minimal.  The Company does not hold or issue interest rate swaps for trading purposes.  The following is a summary of the economic terms of the agreement at February 6, 2010:

Notional amount
 
$57,500,000
Fixed rate paid
 
4.97%
Variable rate received
 
0.23%
Effective date
 
September 17, 2007
Expiration date
 
September 17, 2010
     

Financial Statements and Supplementary Data
 
(a)
FINANCIAL STATEMENTS
PAGES
           
   
-
 
Report of Independent Registered Public Accounting Firm
30
   
-
 
Consolidated Balance Sheets as of February 6, 2010 and February 7, 2009
31-32
   
-
 
Consolidated Statements of Operations for the fiscal years ended
 
         
February 6, 2010, February 7, 2009 and February 2, 2008
33
   
-
 
Consolidated Statements of Changes in Stockholders' Equity
 
         
for the fiscal years ended February 6, 2010, February 7, 2009 and February 2, 2008
34
   
-
 
Consolidated Statements of Cash Flows for the fiscal years ended February 6, 2010,
 
         
February 7, 2009 and February 2, 2008
35-37
   
-
 
Notes to Consolidated Financial Statements
38-66

The Company's fiscal year ends the first Saturday of February.  Accordingly, fiscal year 2009 ended February 6, 2010, and consisted of 52 weeks, fiscal year 2008 ended February 7, 2009, and consisted of 53 weeks, and fiscal year 2007 ended February 2, 2008, and consisted of 52 weeks. Throughout the "Financial Statements and Supplemental Data" section, references to 2009, 2008 and 2007 represent the fiscal years ended February 6, 2010, February 7, 2009, and February 2, 2008, respectively.

 
 
29
 
 



Report of Independent Registered Public Accounting Firm


The Board of Directors and Stockholders
CPI Corp.:
 
We have audited the accompanying consolidated balance sheets of CPI Corp. and subsidiaries (the Company) as of February 6, 2010, and February 7, 2009, and the related consolidated statements of operations, changes in stockholders’ equity and cash flows for each of the years in the three-year period ended February 6, 2010. These consolidated financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of CPI Corp. and subsidiaries as of February 6, 2010, and February 7, 2009, and the results of their operations and their cash flows for each of the years in the three-year period ended February 6, 2010, in conformity with U.S. generally accepted accounting principles.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), CPI Corp. and subsidiaries’ internal control over financial reporting as of February 6, 2010, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated April 20, 2010 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
 
/s/ KPMG LLP
 
_________________________________
 
KPMG LLP
 
St. Louis, Missouri
 
April 20, 2010
 





 
30
 
 


CPI CORP.
Consolidated Balance Sheets – Assets

 

in thousands
 
February 6, 2010
   
February 7, 2009
 
             
ASSETS
           
Current assets:
           
Cash and cash equivalents
  $ 18,913     $ 23,665  
Accounts receivable:
               
Trade
    5,960       6,050  
Other
    880       923  
Inventories
    7,465       8,489  
Prepaid expenses and other current assets
    5,396       5,800  
Refundable income taxes
    1,350       357  
Deferred tax assets
    7,253       9,581  
Assets held for sale
    6,338       6,615  
                 
Total current assets
    53,555       61,480  
                 
Property and equipment:
               
Land
    2,185       3,249  
  Buildings and building improvements
    25,289       32,377  
  Leasehold improvements
    4,491       4,406  
  Photographic, sales and manufacturing equipment
    168,371       178,732  
Total
    200,336       218,764  
  Less accumulated depreciation and amortization
    166,167       167,877  
    Property and equipment, net
    34,169       50,887  
Prepaid debt fees
    2,237       2,262  
Goodwill
    21,720       21,459  
Intangible assets, net
    38,660       40,206  
Deferred tax assets
    7,701       8,359  
Other assets
    8,549       8,202  
                 
TOTAL ASSETS
  $ 166,591     $ 192,855  
                 

See accompanying footnotes to the consolidated financial statements.

 

 
31
 
 


CPI CORP.
Consolidated Balance Sheets - Liabilities and Stockholders’ Equity
 
in thousands, except share and per share data
 
February 6, 2010
   
February 7, 2009
 
             
LIABILITIES
           
Current liabilities:
           
Current maturities of long-term debt
  $ 19,686     $ 1,150  
Accounts payable
    4,390       6,816  
Accrued employment costs
    9,878       10,146  
Customer deposit liability
    11,528       12,503  
Sales taxes payable
    3,929       5,284  
Accrued advertising expenses
    1,062       978  
Accrued expenses and other liabilities
    12,170       18,133  
                 
Total current liabilities
    62,643       55,010  
                 
Long-term debt, less current maturities
    57,855       104,578  
Accrued pension plan obligations
    17,724       10,591  
Other liabilities
    18,181       21,841  
                 
Total liabilities
    156,403       192,020  
                 
CONTINGENCIES (See Note 16)
               
                 
STOCKHOLDERS' EQUITY
               
Preferred stock, no par value, 1,000,000 shares authorized; no shares outstanding
    -       -  
Preferred stock, Series A, no par value, 200,000 shares authorized;
               
no shares outstanding
    -       -  
Common stock, $.40 par value, 50,000,000 shares authorized; 9,184,081 and 17,089,788
               
shares outstanding at February 6, 2010, and February 7, 2009, respectively
    3,674       6,836  
Additional paid-in capital
    29,017       55,394  
Retained earnings
    41,516       183,723  
Accumulated other comprehensive loss
    (14,887 )     (13,114 )
      59,320       232,839  
Treasury stock - at cost, 2,175,591 and  10,270,319 shares at
               
February 6, 2010, and February 7, 2009, respectively
    (49,132 )     (232,004 )
                 
Total stockholders' equity
    10,188       835  
                 
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
  $ 166,591     $ 192,855  
                 

See accompanying footnotes to the consolidated financial statements.


 
32
 
 


CPI CORP.
Consolidated Statements of Operations

Fifty-two weeks ended February 6, 2010, Fifty-three weeks ended February 7, 2009, and Fifty-two weeks ended February 2, 2008
 
in thousands, except share and per share data
 
2009
   
2008
   
2007
 
                   
Net sales
  $ 422,371     $ 462,548     $ 423,429  
                         
Cost and expenses:
                       
Cost of sales (exclusive of depreciation and amortization shown below)
    30,626       43,280       47,135  
Selling, general and administrative expenses
    339,138       377,310       326,568  
Depreciation and amortization
    22,740       29,432       27,291  
Other charges and impairments
    3,294       13,557       7,695  
      395,798       463,579       408,689  
                         
Income (loss) from operations
    26,573       (1,031 )     14,740  
                         
Interest expense
    7,392       9,147       10,652  
Interest income
    456       620       1,834  
Other (expense) income, net
    (44 )     190       175  
Income (loss) from operations before income tax expense (benefit)
    19,593       (9,368 )     6,097  
                         
Income tax expense (benefit)
    5,796       (2,644 )     2,080  
                         
Net income (loss) from continuing operations
    13,797       (6,724 )     4,017  
                         
Net loss from discontinued operations, net of income tax benefit
    -       (961 )     (441 )
                         
NET INCOME (LOSS)
  $ 13,797     $ (7,685 )   $ 3,576  
                         
NET INCOME (LOSS) PER COMMON SHARE
                       
                         
Net income (loss) per share from continuing operations - diluted
  $ 1.97     $ (1.03 )   $ 0.63  
Net loss per share from discontinued operations - diluted
    -       (0.15 )     (0.07 )
Net income (loss) per share - diluted
  $ 1.97     $ (1.18 )   $ 0.56  
                         
Net income (loss) per share from continuing operations - basic
  $ 1.97     $ (1.03 )   $ 0.63  
Net loss per share from discontinued operations - basic
    -       (0.15 )     (0.07 )
Net income (loss) per share - basic
  $ 1.97     $ (1.18 )   $ 0.56  
                         
Dividends per share
  $ 0.64     $ 0.64     $ 0.64  
                         
Weighted average number of common and common equivalent
                       
shares outstanding-diluted
    7,019,981       6,509,840       6,415,706  
Weighted average number of common and common equivalent
                       
shares outstanding-basic
    6,992,511       6,509,840       6,390,961  

See accompanying footnotes to the consolidated financial statements.


 
33
 
 
 
CPI CORP.
Consolidated Statements of Changes in Stockholders' Equity

Fifty-two weeks ended February 6, 2010, Fifty-three weeks ended February 7, 2009, and Fifty-two weeks ended February 2, 2008
 
in thousands, except share and per share data
                   
Accumulated
             
         
Additional
         
other
   
Treasury
       
   
Common
   
paid-in
   
Retained
   
comprehensive
   
stock,
       
   
stock
   
capital
   
earnings
   
(loss) income
   
at cost
   
Total
 
                                     
Balance at February 3, 2007
  $ 6,790     $ 52,421     $ 196,032     $ (9,387 )   $ (233,057 )   $ 12,799  
                                                 
Net income
    -       -       3,576       -       -       3,576  
Total other comprehensive income, net of tax effect
    -       -       -       2,662       -       2,662  
(consisting primarily of foreign exchange impact)
                                               
Total comprehensive income
    -       -       -       -       -