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 in conjunction with the interim condensed consolidated financial statements and related notes thereto contained elsewhere in this document.

EXECUTIVE OVERVIEW

The Company's Operations

CPI Corp. is a long-standing leader, based on sittings 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 3,062 studios throughout the U.S., Canada, Puerto Rico and Mexico, principally under license agreements with Sears and lease agreements with Wal-Mart. 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 Wal-Mart stores and supercenters in the U.S., Canada, Puerto Rico and Mexico. Management has determined that the Company operates in one segment offering similar products and services in all locations.

As of the end of the third quarter in fiscal 2008 and 2007, the Company's studio counts were:

                   November   November
                   8, 2008    10, 2007
Within Sears or
Sears Grand
Stores:
    United
    States and
    Puerto Rico         891        893
    Canada              110        112

Within Wal-Mart
Stores:
    United
    States and
    Puerto Rico       1,656      1,703
    Canada              254        252
    Mexico              118        108

Locations not
within Sears or
Wal-Mart stores          33         32

Total                 3,062      3,100

As of December 17, 2008, the PMPS digital conversion is now complete in the U.S., Canada and Mexico. The PictureMe Portrait Studios acquired in 2007 were all analog film studios at the date of acquisition. The installation of a new digital lab sufficient to handle the worldwide fulfillment requirements of the PictureMe Portrait Studio business was completed in the first quarter of 2008 and has been in operation since the second quarter. The company is also testing new sales and marketing programs and studio work processes and implementing new performance management systems in the field. As of the end of the second quarter, the Company had transferred all material PMPS operations to the Company's existing support platform.

Market Challenges

The Company's results of operations for the third quarter of 2008 were adversely impacted as a result of the continuing challenging economic environment, which is affecting discretionary purchases such as portraiture. As part of the Company's continuing response to the ongoing market challenges, it has executed a number of cost reductions, which include delay or cancellation of certain discretionary expenditures, reduction in staffing and revised marketing strategies to target the more price-sensitive customer.

Market uncertainty has driven the stock price of the Company down significantly. As previously announced, the Company received notice from the New York Stock Exchange ("NYSE") on November 4, 2008, that it is out of compliance with the NYSE's listing criteria. It is possible that, depending on continuing trading factors and the outcome of discussions with the NYSE, the Company may need to seek listing on alternative markets in the near future.

As a result of decreased sales levels as discussed above, the earnings of the Company are lower than anticipated. The Company was in compliance with all debt covenants under its Credit Agreement as of November 8, 2008. In view of the continuing challenging economic environment, the Company is in discussions with its lenders to ensure continuing compliance with all its covenants. The Company has a cash balance of approximately $29.4 million at December 17, 2008, which is considered adequate, together with anticipated cash flow from operations, to fund the Company's cash requirements for the foreseeable future.

RESULTS OF OPERATIONS

A summary of consolidated results of operations and key statistics follows:

thousands, except share and per
share data                                   16 Weeks Ended                    40 Weeks Ended
                                      November 8,      November 10,     November 8,      November 10,
                                          2008             2007             2008             2007

Net sales                             $    115,849     $    135,392     $    308,923     $    261,256

Cost and expenses:
   Cost of sales (exclusive of
depreciation and amortization shown
below)                                      10,785           15,467           29,773           28,454
   Selling, general and
administrative expenses                    111,397          120,392          275,160          223,919
   Depreciation and amortization             8,668           10,079           21,764           19,669
   Other charges and impairments             1,284            2,025            2,397            3,471
                                           132,134          147,963          329,094          275,513

Loss from continuing operations            (16,285 )        (12,571 )        (20,171 )        (14,257 )

Interest expense                             3,866            3,365            6,753            5,374
Interest income                                 87              537              567            1,253
Other income, net                               56               42               59               48

Loss from continuing operations
before income tax benefit                  (20,008 )        (15,357 )        (26,298 )        (18,330 )
Income tax benefit                           6,667            5,341            9,100            6,374

Net loss from continuing operations        (13,341 )        (10,016 )        (17,198 )        (11,956 )

Net loss from discontinued
operations                                       -              (91 )              -             (197 )

NET LOSS                              $    (13,341 )   $    (10,107 )   $    (17,198 )   $    (12,153 )

NET LOSS PER COMMON SHARE

Net loss per share from continuing
operations - diluted                  $      (2.06 )   $      (1.56 )   $      (2.66 )   $      (1.87 )
Net loss per share from
discontinued operations - diluted                -            (0.01 )              -            (0.03 )
Net loss per share - diluted          $      (2.06 )   $      (1.57 )   $      (2.66 )   $      (1.90 )

Net loss per share from continuing
operations - basic                    $      (2.06 )   $      (1.56 )   $      (2.66 )   $      (1.87 )
Net loss per share from
discontinued operations - basic                  -            (0.01 )              -            (0.03 )
Net loss per share - basic            $      (2.06 )   $      (1.57 )   $      (2.66 )   $      (1.90 )

Weighted average number of common
and common equivalent
   shares outstanding - diluted          6,479,496        6,401,943        6,467,352        6,385,645

Weighted average number of common
and common equivalent
   shares outstanding - basic            6,479,496        6,401,943        6,467,352        6,385,645

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 the 40 weeks ended November 8, 2008, and resulted in lower total revenue of $8.1 million for the period June 8, 2007, through November 10, 2007, which reduced gross profit, operating income and income before taxes.

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 PCA 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 agreements with Wal-Mart ($43.7 million) and the customer lists ($3.1 million). The host agreements with Wal-Mart and the customer lists 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.

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 results in higher interest expense when compared to the Company's historical financial statements prior to the acquisition.

16 weeks ended November 8, 2008 compared to 16 weeks ended November 10, 2007

The Company reported a net loss per diluted share of ($2.06) for the 16-week third quarter ended November 8, 2008, compared to ($1.57) in the comparable quarter of fiscal 2007. Net loss for the third quarter of 2008 was $13.3 million versus $10.1 million in the corresponding prior year period. The Company believes that both its Sears Portrait Studio ("SPS") and PictureMe Portrait Studio ("PMPS") brands' third quarter results reflect a challenging economic environment which is affecting discretionary purchases such as portraiture.

Net sales totaled $115.8 million and $135.4 million in the third quarter of fiscal 2008 and 2007, respectively.

· Net sales for the third quarter of 2008 decreased $19.6 million, or 14.5%, to $115.8 million from the $135.4 million reported in the third quarter of 2007.

SPS net sales for the third quarter of 2008 decreased $12.0 million, or 16.6%, to $60.4 million from the $72.4 million reported in the third quarter of 2007. The 2008 third quarter SPS net sales performance was the result of a 10.9% decline in sittings and a 6.1% decline in average sale per customer sitting. The sittings results reflect continued declines in visit frequency among existing customers mitigated in part by relatively strong trends in new customer acquisition and increasing loyalty plan conversion. The average sale decline reflects a shift toward more price sensitive customers enticed by the low price package offer, as well as the increasing difficulty selling higher priced collections and specialty products in the current environment.

Net sales related to the Company's PMPS brand for the third quarter of 2008 decreased $7.6 million, or 12.1%, to $55.4 million from the $63.0 million reported in the third quarter of 2007. This sales performance resulted from an approximate 17.4% decline in sittings, offset significantly by an 8.1% increase in average sale per customer sitting. The Company attributes the sittings decline to the difficult economic environment, which has especially pressured discretionary spending among consumers in lower income categories. The Company believes its increase in average sale per customer sitting is principally attributable to customers' positive response to the new offerings made possible by the digital conversion and the implementation of new sales and performance management processes.

Costs and expenses were $132.1 million in the third quarter of 2008, compared with $148.0 million in the comparable prior year period.

· Cost of sales, excluding depreciation and amortization expense, was $10.8 million in the third quarter of 2008 compared with $15.5 million in the comparable prior year period. The decrease in cost of sales is attributable to 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 have been further streamlined in connection with the PMPS acquisition and digital conversion.

· Selling, general and administrative ("SG&A") expenses were $111.3 million and $120.4 million for the third quarter of 2008 and 2007, respectively. The decrease in third quarter 2008 SG&A costs is primarily related to 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 marketing expense primarily due to the timing of promotional programs for the busy season, as well as reduced host sales commissions due to lower sales. These decreases were partially offset by a $1.6 million increase in digital training and travel costs related to the conversion of PMPS studios incurred during the quarter, the recording of contingent commissions due to Sears as a result of the PMPS acquisition and a nonrecurring 2007 reduction of $1.3 million attributable to a change in the Company's vacation and sick pay policy.

? Depreciation and amortization declined to $8.7 million in the third quarter of 2008 from $10.1 million in the comparable quarter of 2007 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.

? In the third quarter of 2008 and 2007, the Company recognized $1.3 million and $2.0 million, respectively, in other charges and impairments associated with the PMPS Acquisition, which include severance costs, severance accruals, cure costs related to contracts assumed and other integration-related costs in connection with the PMPS Acquisition.

Interest expense was $3.9 million in the third quarter of 2008, compared to $3.4 million in the comparable period of the prior year. The increase in interest expense is primarily the result of a $1.2 million adjustment to the fair value of an interest rate swap agreement, offset by lower average borrowings and interest rates in relation to the Credit Agreement.

Interest income was $87,000 in the third quarter of 2008 compared to $537,000 in the third quarter of 2007. This decrease is primarily attributable to lower invested balances in 2008 as compared to 2007, the result of higher capital spending in 2008 related to the digital conversion of the PictureMe Portrait Studios.

Income tax benefit was $6.7 million in the third quarter of 2008 as compared to $5.3 million in the third quarter of 2007. The resulting effective tax rates were 33.3% in 2008 and 34.8% in 2007. The decrease in the effective tax rate in 2008 is primarily attributable to a projected decrease in anticipated profitability as a result of current economic conditions, as well as decreased tax rates in Canada.

Net loss from discontinued operations was $91,000 in the third quarter of 2007. During the third quarter of 2007, the Company exited its UK operations, which was acquired in conjunction with the PCA Acquisition.

40 weeks ended November 8, 2008 compared to 40 weeks ended November 10, 2007

The Company reported a net loss for the 40-week first three quarters of 2008 of $17.2 million, or ($2.66) per diluted share, compared to a net loss of $12.2 million, or ($1.90) per diluted share, for the comparable first three quarters of fiscal 2007. The operations of the PMPS brand are included for the full forty weeks of the first three quarters of 2008, but only for the twenty-two-week period of ownership in the first three quarters of 2007. The Company believes that both brands' initial first three quarters' results reflect a challenging economic environment which is affecting discretionary purchases such as portraiture. Results for the first three quarters were also significantly impacted by ongoing transitional expenses and extraordinary spending on digital conversion and training associated with the PMPS brand, offset in part by an improved operating contribution from the PMPS brand due to reduced overheads, increased operating efficiencies and an improved product mix and customer transaction average.

Net sales totaled $308.9 million and $261.3 million in the first three quarters of fiscal 2008 and 2007, respectively.

· Net sales for the first three quarters of 2008 increased $47.6 million, or 18.2%, to $308.9 million from the $261.3 million reported in the first three quarters of 2007.

The Company believes that both brands' initial first three quarters' results were negatively impacted by the timing of Easter, a seasonally important time for portraiture sales, which fell two weeks earlier in 2008 than in 2007. Historically, an earlier Easter translates into lower sales due to its closer proximity to the preceding Christmas holiday season during which customers are most portrait-active.

SPS net sales for the first three quarters of 2008 decreased $22.1 million, or 12.1%, to $161.3 million from the $183.4 million reported in the first three quarters of 2007. This decrease resulted from an 11.0% decline in sittings and a 1.0% decline in average sale per customer sitting. The sittings results reflect continued declines in visit frequency among existing customers mitigated in part by relatively strong trends in new customer acquisition and increasing loyalty plan conversion. The average sale decline reflects a shift toward more price sensitive customers enticed by the low package offer, as well as the increasing difficulty selling higher priced collections and specialty products in the current environment.

Net sales related to the Company's PMPS brand increased to $147.6 million in the first three quarters of 2008 from $77.9 million in the first three quarters of 2007. The first three quarters of 2008 includes forty weeks of net sales as compared to only twenty-two weeks for the first three quarters of 2007. Additionally, a purchase accounting adjustment related to the deferred revenue at the date of acquisition resulted in a one-time decrease in net sales of $8.2 million for the 2007 first three quarters. On a comparable basis, PMPS net sales for the fiscal 2008 first three quarters represent an approximate 12.2% decrease in same store sales versus the comparable period of the prior year (results from the period February 4, 2007 to June 8, 2007 not reported in the Company's historical results). This sales performance resulted from an approximate 24.0% decline in sittings, offset significantly by a 15.5% increase in average sale per customer sitting. The Company attributes the sittings decline to the difficult economic environment, which has especially pressured discretionary spending among consumers in lower income categories. The Company believes its increase in average sale per customer sitting is principally attributable to customers' positive response to the new offerings made possible by the digital conversion and the implementation of new sales and performance management processes.

Costs and expenses were $329.1 million in the first three quarters of 2008, compared with $275.5 million in the comparable prior year period.

· Cost of sales, excluding depreciation and amortization expense, was $29.8 million in the first three quarters of 2008 compared with $28.4 million in the comparable prior year period. The increase in cost of sales is attributable to the inclusion of forty weeks of PMPS cost of sales in the first three quarters of 2008, compared to only twenty-two weeks for the first three quarters of 2007, partially offset by decreased production costs resulting from lower overall manufacturing production levels, additional gains in manufacturing productivity, improved product mix and savings on film and shipping costs that resulted directly from the PMPS digital conversion, as well as decreased overhead costs as operations have been further streamlined in connection with the PMPS acquisition and digital conversion.

· Selling, general and administrative ("SG&A") expenses were $275.2 million and $223.9 million for the first three quarters of 2008 and 2007, respectively. The increase in the first three quarters 2008 SG&A costs is primarily attributable to the inclusion of forty weeks of PMPS costs, compared to only twenty-two weeks in the first three quarters of 2007. The comparison is also affected by $4.6 million of digital training and travel costs related to the conversion of PMPS studios incurred during the first three quarters, the recording of contingent commissions due to Sears as a result of the PMPS acquisition, as well as nonrecurring reductions in SG&A in the prior year period of approximately $4.4 million from the deferred revenue purchase accounting adjustment and $3.0 million attributable to a change in the Company's vacation and sick pay policy. These increases were partially offset by 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 marketing expense primarily due to the timing of promotional programs for the busy season, as well as reduced host sales commissions due to lower sales.

· Depreciation and amortization was $21.7 million in the first three quarters of 2008, compared to $19.7 million in the comparable first three quarters of 2007. This increase is attributable to the inclusion of forty weeks of PMPS costs, compared to only twenty-two weeks in the first three quarters of 2007, as well as increased depreciation in relation to equipment purchased for the digital rollout. These increases were partially offset 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.

· In the first three quarters of 2008 and 2007, the Company recognized $2.4 million and $3.5 million, respectively, in other charges and impairments associated with the PMPS Acquisition, which include severance costs, severance accruals, cure costs related to contracts assumed and other integration-related costs in connection with the PMPS Acquisition.

Interest expense was $6.8 million in the first three quarters of 2008 compared to $5.4 million in the comparable first three quarters of the prior year. The increase in interest expense is primarily the result of higher average borrowings in relation to the Credit Agreement, partially offset by lower interest rates.

Interest income was $567,000 in the first three quarters of 2008 compared to $1.3 million in the first three quarters of 2007. This decrease is primarily attributable to lower invested balances in 2008 as compared to 2007, the result of higher capital spending in 2008 related to the digital conversion of the PictureMe Portrait Studios.

Income tax benefit was $9.1 million for the first three quarters of 2008 compared to $6.4 million in the first three quarters of 2007. The resulting effective tax rates were 34.6% in 2008 and 34.8 % in 2007.

Net loss from discontinued operations was $197,000 in the twenty-two weeks from the date of the PCA Acquisition to the end of the third quarter of 2007. In connection with the PCA Acquisition, the Company decided to sell the UK operations for one British Pound in the third quarter of 2007. The decision was made in order to eliminate unprofitable brands and allow a more concentrated operational focus on the PMPS brand.

LIQUIDITY AND CAPITAL RESOURCES

The following table presents a summary of the Company's cash flows for first
three quarters of 2008 and 2007:

thousands                                              40 Weeks Ended
                                          November 8, 2008       November 10, 2007
Net cash (used in) provided by:
Operating activities                      $         (13,653 )   $            11,275
Financing activities                                 (6,137 )                93,812
Investing activities                                (31,101 )               (95,654 )
Effect of exchange rate changes on cash                (163 )                   303

Net (decrease) increase in cash           $         (51,054 )   $             9,736

Net Cash (Used In) Provided By Operating Activities

Net cash used in operating activities was $13.7 million during the first three quarters of 2008 compared to net cash provided of $11.3 million in the comparable period of 2007. Cash flows in the first three quarters of 2008 decreased from the first three quarters of 2007 primarily due to net operating losses and the timing of payments related to changes in various balance sheet accounts totaling $25.5 million, $3.5 million related to a change in the payment schedule for Wal-Mart commissions per the related contract, $4.4 million for digital training and travel related to the ongoing conversion and increased spending for interest cost ($2.0 million). These were offset in part by delays in spending for advertising ($8.2 million) and decreased payments for severance and integration-related costs associated with the acquisition of PCA ($2.3 million).

Net Cash (Used In) Provided By Financing Activities

The increase in cash used in financing activities in the first three quarters of 2008 is primarily attributable to nonrecurring events from 2007. These include long-term borrowings of $116.1 million related to the PCA Acquisition and the release of $1.0 million of restricted cash, offset by the payment of debt issuance costs of $2.7 million. Additionally, the company experienced a decrease in repayment of long-term borrowings of $8.5 million and received proceeds of $5.5 million in relation to the Company's revolving credit facility, which was used for working capital and general business purposes.

At November 8, 2008, the Company had $111.5 million outstanding under its existing Credit Agreement. The Company was in compliance with all the covenants under its Credit Agreement as of November 8, 2008.

Net Cash Used In Investing Activities

Net cash used in investing activities was $31.1 million during the first three quarters of 2008 as compared to $95.7 million during the first three quarters of 2007. This decrease was primarily attributable to the PCA Acquisition and related costs in 2007 totaling $83.3 million, offset in part by an increase in capital expenditures of $18.0 million in the first three quarters of 2008 as compared to the first three quarters of 2007 due to the ongoing digital conversion of the PictureMe Portrait Studios.

Off-Balance Sheet Arrangements

Other than standby letters of credit to support various self-insurance programs . . .