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CPI Corp. (CPY) — Portrait of Opportunity

July 13, 2011 | About:
CPI Corp. (CPY) operates over 3,000 portrait photography studios, mainly in Walmart (WMT), Sears (SHLD), and Kids R’ Us stores. The industry appears to be in secular decline and CPY has made some questionable operating decisions, but the business model is fundamentally attractive. CPY enjoys a clear market leading position and has employed admirable capital allocation in the last several years. I think it is worth a closer look.

TickerCPY
Price as of 7/13/201113.00
52 Week Range11.76-31.00
Shares Out (MMs)7.04
Market Cap (MMs)91.5
Debt (MMs)52.9
Enterprise Value (MMs)138.3
P/E (TTM)15.5
EV/EBITDA (TTM)4.5


Positives of the business model:



  • Low capital intensity enables strong free cash flow. Portrait photography can almost be looked at as a service business as the inventory requirements are extremely minimal. The fixed capital requirements are modest as well due to almost all of the studios being hosted within big box retailers.
  • There are tremendous benefits to scale with the photo processing usually being done in a central lab, which ships the finished photos to the stores for customer pick up. CPY has grown its studio count dramatically by acquiring the Walmart (PCA) and Kids R’ Us (Kiddie Kandids) businesses out of bankruptcy in 2007 and 2010, respectively.
  • The conversion to digital photography has lowered the cost structure and provides enhanced revenue opportunities.
  • CPY pays their retail hosts a percentage of their sales as rent as opposed to a fixed rental fee. This arrangement obviously caps some of the upside, but it limits downside exposure.
  • While there is obvious risk of CPY losing their relationships with one of the retail hosts, they have long term contracts in place until 2016. They have had an exclusive contract with Sears since 1986.
Despite all of these positives the business has basically tread water for the last 15 years earnings-wise. Revenues have grown, but only due to acquisitions. The decline in the legacy Sears business is remarkable. The Sears business did $319 million in revenue in 2001 and only $195 million in 2010 at about the same store count. CPY has managed to retain its earnings power only due to the increased store count through acquisition and the lowering of their expenses due to the conversion to digital photography.

It is hard to tell exactly how much of the business decline is industry-wide and how much is company-specific because none of their few remaining competitors are publicly traded. But I think it is safe to say there is a secular decline going on. Two of their major competitors, the aforementioned PCA and Kiddie Kandids, went bankrupt. A third, Picture People, recently underwent a distressed sale. The most plausible explanation for the decline seems to be that the ease of digital photography has turned more people into do-it-yourself photographers, although it is surprising that would account for all of it.

Some of the wounds are probably self-inflicted as well. Over the past decade CPY decided not to compete on price, especially in their Sears business, even as the rest of the industry did. Given their scale and financial strength they probably would been able to be more price competitive to drive higher volumes without drastically hurting margins or putting the business at risk. Additionally, CPY has been criticized for not being innovative in their service and product offerings to justify the higher price point. It also hasn’t helped that Sears hasn’t exactly been the hottest retailer around.

The economic downturn has compounded CPY’s difficulties, as photo portraits are obviously a highly discretionary purchase (for most people anyway). Revenues are done 12% over the past two years, but CPY has managed to partially compensate with large cost cuts at both the COGS and SG&A levels. CPY has planned on another $20 million annually of cost savings, which is still a material 5% cut to total expenses.

The stock is cheap, trading at about 4X EBITDA and 3x levered cash flow (the company is modestly levered with $53 million in debt). The main question regarding the stock is whether that is cheap enough given the melting same store sales (last quarter down another 9% at Walmart and 16% at Sears) that have been patched over with studio acquisitions and cost cuts. It is also hard to tell to what extent their struggles over the past two years have been macroeconomic related as opposed to being caused by the continued structural decline of the low end portrait industry.

The margin of safety may be boosted by the prudent capital allocation led by Chairmen of the Board David Meyer, who was appointed as part of an activist initiative in 2004. The company’s capital allocation stance of the past few years has been to return cash flows to shareholders and avoid reinvestment in the business unless it is on very attractive terms such as the PCA and Kiddie Kandids bankruptcies. They have paid down about $50 million in debt in the past two years, and raised the dividend, which is now yielding 7.9%.

There is some potential upside with the relaunch of the Kiddie Kandids business acquired last year and a new expansion into event photography (such as weddings) with the recent acquisition of Bella Pictures. They paid no cash for Bella (they assumed the minimal operating liabilities and gave the sellers 5% equity in the new Bella venture), so we can view it as a free option to try to lever their excess photo processing capacity. Still, both of those initiatives are currently small on an absolute basis.

Balancing the attractive business model and solid capital allocation with the melting ice cube of the industry, I think the valuation is nearing a point where the stock becomes a buy. But ice cubes can melt quickly, so I don’t think the stock is cheap enough quite yet to provide a sufficient margin of safety.

Disclosure: No position.

Elie Rosenberg runs a value investing research website at valueslant.com. Sign up here to get his free value investing ideas and analysis by email and get his free ebook — 16 Ways to Find Undervalued Stocks.

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Rating: 3.2/5 (13 votes)

Comments

teidelman
Teidelman premium member - 3 years ago
I mostly agree with your analysis and I do think shares are cheap enough. They could earn $3 in FCF which should value the stock a lot higher than $13. I sat down with CFO Dale Heins not too long ago to go over my main concern that the photography business is in secular decline due to digital cameras and cellphone cameras. Some of his weaker counterarguments were that survey data suggests demand for professional photography still exists, the low-end consumer is really hurting, and digital photography has essentially already reached 100% penetration. More convincing to me was that all the "fourth wall" stores inside of Sears and Walmarts including the barber shops, banks, and food service experienced similar declines. I don't think hair cuts are going the way of the buggywhip so this data point gave me some conviction that his other points may be valid.

If professional photography is here to stay, then CPY will do very well. They are expanding into the event business (home photos and weddings). They have a dominant market position and economies of scale. Most encouraging is that this business has been fought over in the past to go private. I think it will get bought out sometime in the future and it will be at a much higher price.

Disclosure: I am long CPY

Elie Rosenberg
Elie Rosenberg - 3 years ago
Thanks, interesting perspective. I find it hard to understand how digital photography has hurt them so much because it would seem an in studio portrait is differentiated in terms of quality, but the secular

decline here is undeniable and that theory seems to make the most sense.

SSS sales are still trending terribly, so I guess the CFO is just making the argument that it is the economy that has been weighing on them the last few quarters? A lot of discretionary retail has seen sales declines at least slow down, so not sure how much weight to give that argument.

That is a very interesting data point that the other "fourth wall" stores have seen similar declines. Is there any specific explanation for that?

The CFO on the last call said the $3 in FCF was operating FCF meaning before interest expense. That is probably only 30 cents or so a share with the tax shield so still very cheap.

I just find the stock hard to get comfortable with because I don't have any handle on what is going on with the top line. Their main expense, labor, is at some point a fixed cost- they are limited contractually in terms of how much they can cut store hours back, so there is a limit to the cost cuts they can make to maintain profitability.
teidelman
Teidelman premium member - 3 years ago
His explanation for the "fourth wall" decline was just general economic weakness at the low-end (Walmart/Sears) consumer.

As for labor expense, one element I also found interesting is that they really can cut their hours back in Sears because nearly all their business is by appointment. If you've been to the CPI stores within Sears on a weekday it is like a ghost town. Management is looking to move to 3 days a week and thinks that will not impact sales as much because they are not drop-in based anyway. I'm sure there will be some sales loss as a result, but if he is correct, it will still increase profitability.

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