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 3,046 studios throughout the U. S., Canada, Mexico and Puerto Rico principally under license agreements with Sears and lease and license 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, 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:

                                                      2008        2007        2006

     Within Sears stores:
     United States and Puerto Rico                       887         893         894
     Canada                                              110         112         112

     Within Wal-Mart stores:
     United States and Puerto Rico                     1,642       1,702           -
     Canada                                              259         253           -
     Mexico                                              118         115           -

     Locations not within Sears or Wal-Mart stores        30          33          35

     Total                                             3,046       3,108       1,041

As of April 10, 2009, all of the Company's studios, with the exception of 85 Sears Portrait Studios in Canada, are digital. 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. As of the end of the second quarter, the Company had transferred all material PMPS operations to the Company's existing support platform. The Company also plans 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 current economic downturn does not reverse in the foreseeable future.

Market Challenges

NYSE Listing

Market uncertainty drove the Company's stock price down significantly in fiscal 2008. As previously announced, the Company received notice from the New York Stock Exchange (NYSE) on November 4, 2008, that it was out of compliance with certain of the NYSE's listing criteria. The Company is considered below the applicable standards because its average market capitalization over a 30-day trading period is less than $75 million and its stockholders' equity is less than $75 million. On February 1, 2009, the Company received notice from the NYSE that it had accepted the Company's plan for continued listing. As a result, the Company's stock will continue to be listed on the NYSE, subject to quarterly reviews by the NYSE's Listing and Compliance Committee to ensure the Company's progress toward its plan to restore compliance with continued listing standards. In the event the Company does not complete its plan on a timely basis, the Company's common stock could be delisted from the NYSE.

Credit Agreement

As of February 7, 2009, 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., Funded Debt to EBITDA), prospectively, with effect from February 8, 2009. 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. See Liquidity and Capital Resources below for further discussion.

RESULTS OF OPERATIONS

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

in thousands, except share and per share data          2008          2007          2006

Net sales                                            $ 462,548     $ 423,429     $ 292,973

Cost and expenses:
  Cost of sales (exclusive of depreciation and
amortization shown below)                               41,218        45,284        28,582
  Selling, general and administrative expenses         379,372       328,419       219,911
  Depreciation and amortization                         29,432        27,291        16,861
  Other charges and impairments                         13,557         7,695         1,241
                                                       463,579       408,689       266,595

(Loss) income from continuing operations                (1,031 )      14,740        26,378

Interest expense                                         9,147        10,652         2,380
Interest income                                            620         1,834           565
Recovery of preferred security interest                      -             -          (887 )
Other income, net                                          190           175           144
(Loss) income from continuing operations before
income tax (benefit) expense                            (9,368 )       6,097        25,594

Income tax (benefit) expense                            (2,644 )       2,080         9,164

Net (loss) income from continuing operations            (6,724 )       4,017        16,430

Net loss from discontinued operations, net of
income tax benefit                                        (961 )        (441 )        (103 )

NET (LOSS) INCOME                                    $  (7,685 )   $   3,576     $  16,327

NET (LOSS) INCOME PER COMMON SHARE

Net (loss) income per share from continuing
operations - diluted                                 $   (1.03 )   $    0.63     $    2.58
Net loss per share from discontinued operations -
diluted                                                  (0.15 )       (0.07 )       (0.02 )
Net (loss) income per share - diluted                $   (1.18 )   $    0.56     $    2.56

Weighted average number of common and common
equivalent shares outstanding - diluted                  6,510         6,416         6,376

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.

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 Wal-Mart ($43.7 million) and the customer list ($3.1 million). The host agreement with Wal-Mart 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.

2008 versus 2007 and 2007 versus 2006

Unless otherwise noted, the fiscal year 2008 results include the 53-weeks ended February 7, 2009, compared to 52-weeks in fiscal years 2007 and 2006, which ended February 2, 2008, and February 3, 2007, respectively.

Net sales totaled $462.5 million, $423.4 million and $293.0 million in 2008, 2007 and 2006, respectively.

· 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 appriximately $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.

Net sales from the Company's Sears Portrait Studio brand ("SPS") 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 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 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 PictureMe Portrait Studio® ("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 represent 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 believes the sittings decline reflects the difficult economic environment, which has especially pressured customer demand in lower income categories. The Company attributes the increase in average sale per customer sitting primarily to customers' positive response to the new offerings made possible by the recently instituted digital conversion and the implementation of new sales and performance management processes. Additoinally, the unfavorable foreign exchange rates in fiscal 2008 impacted net sales by approximately $3.5 million.

· Net sales for 2007 increased $130.4 million, or 45%, to $423.4 million from the $293.0 million reported in 2006 as a result of the inclusion of net sales of $148.8 million attributable to the Company's PMPS brand. In accordance with purchase accounting guidelines, PMPS's deferred revenue balance at the June 8, 2007, date of acquisition was reduced by a purchase accounting adjustment to record deferred revenue at its fair value in the PictureMe Portrait Studio® beginning, post-acquisition balance sheet. This purchase accounting adjustment had the effect of reducing revenue in periods subsequent to the acquisition for one year. The deferred revenue adjustment resulted in a reduction in net sales of $8.2 million and an increased pre-tax loss from operations of $3.4 million for fiscal 2007.

SPS net sales for fiscal 2007 decreased $18.4 million or 6% to $274.6 million from the $293.0 million reported in fiscal 2006. The SPS sales performance was the result of a 14% decline in sittings partially offset by a 9% increase in average sale per customer sitting. The Sears Portrait Studio brand is experiencing lower customer response to its direct marketing programs and significantly reduced same-day business. PMPS reported $148.8 million in sales for fiscal 2007 (for the period June 8, 2007 through February 2, 2008).

Costs and expenses were $463.6 million in 2008, compared with $408.7 million in 2007 and $266.6 million in 2006.

· Cost of sales, excluding depreciation and amortization expense, was $41.2 million, $45.3 million and $28.6 million in 2008, 2007 and 2006, respectively.

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 have been further streamlined in connection with the PMPS acquisition and digital conversion.

The increase in cost of sales, excluding depreciation and amortization expense, in 2007 as compared to 2006 is attributable to the inclusion of the PMPS brand cost of sales from the June 8, 2007 date of acquisition. This increase was partially offset by decreased production costs resulting from lower overall manufacturing production levels, additional gains in manufacturing productivity and an improved product mix.

· Selling, general and administrative ("SG&A") expenses were $379.4 million, $328.4 million and $219.9 million for fiscal years 2008, 2007 and 2006, respectively.

The increase in 2008 SG&A costs is 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 are 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.

The increase in 2007 SG&A costs is attributable to the inclusion of the PMPS brand costs from the June 8, 2007 date of acquisition. This increase was partially offset by the net effect of lower studio and corporate employment costs, reduced host sales commissions, reductions in various other operating expense categories resulting from ongoing cost reduction efforts, increased professional service costs, increased advertising spending and increased restricted stock amortization expense associated with past performance awards. The reduction in studio and employment costs included approximately $3.9 million resulting from a change in the Company's vacation and sick pay policy announced in the first quarter of 2007.

· Depreciation and amortization was $29.4 million in 2008, compared to $27.3 million in 2007 and $16.9 million in 2006.

The increase in 2008 is attributable to the equipment purchased for the digital rollout. This increase is 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.

The increase in 2007 is attributable to the inclusion of PMPS depreciation and amortization from the June 8, 2007 acquisition date and includes $2.8 million of amortization resulting from the allocation of the purchase price to certain amortizable intangible assets. The increase from the inclusion of the PMPS depreciation and amortization was partially offset by a decline in depreciation and amortization related to the Company's non-PMPS assets.

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 2008, 2007 and 2006 are as follows:

       in thousands                                 2008        2007        2006

       Sears fees related to settlement of the
       previous license agreement (1)             $  7,527     $ 2,500     $     -
       Other transition related costs - PCA
       Acquisition (2)                               2,121       2,817           -
       Reserves for severance and related costs
       (3)                                           2,046       2,035         878
       Impairment charges (4)                          739         256         179
       Other (5)                                     1,124          87         184
                                                    13,557       7,695       1,241
       Recorded as a component of other
       (expense) income following income from
       operations:

         Lease guarantee reserve reduction (6)           -           -         887

         Total Other Charges and Impairments      $ 13,557     $ 7,695     $   354

(1) Consists of fees related to the settlement of the previous Sears license agreement.

(2) Other transition related costs - PCA Acquisition

In 2008, costs related to the PCA Acquisition included transition-related costs associated with combining the operations of PCA into the CPI organization of $1.1 million and $866,000 related to litigation assumed with the PCA Acquisition.

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), costs associated with the closure of the Institutional business acquired from PCA ($265,000) and costs associated with the transfer of contractual obligations from PCA to CPI ($523,000).

(3) Reserves for severance and related costs

Charges in 2008 and 2007 were $2.0 million in each year and principally related to severance costs resulting from the termination of employees in connection with the integration of operations of the PCA Acquisition into CPI.

Charges in 2006 were $878,000 and related principally to the separation of employment of three executives, including the Company's former CEO.

(4) Impairment charges

During 2008, the Company incurred $739,000 primarily related to the write-down of certain asset values held for sale.

During 2007, the Company incurred $256,000 in charges related to software that is no longer used in the business.

During 2006, the Company incurred $179,000 in charges related to the write-off of certain legacy equipment that is no longer used in the business.

(5) Other

Costs in 2008 primarily include legal charges and a contract negotiation with a director.

Costs in 2007 related to one-time strategic studies and legal charges.

The Company began a process to explore strategic alternatives to enhance shareholder value in 2006. Investment banking and legal services in connection with this review totaled $184,000 in 2006.

(6) Lease guarantee reserve reduction

The lease guarantee reserve reduction recorded in 2006 represents a partial reversal of reserves initially recorded in 2004 related to operating lease guarantees associated with the Company's former Wall Décor segment, Prints Plus. As the total guarantee related to these leases 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 to reflect management's revised estimate of remaining potential loss. This reserve is more fully discussed in Note 16 in the accompanying Notes to Consolidated Financial Statements.

Interest expense was $9.1 million in 2008 compared to $10.7 million in 2007 and $2.4 million in 2006. The decrease in interest expense in 2008 compared to 2007 is primarily the result of an adjustment to the fair value of the interest rate swap agreement that decreased interest expense by $2.3 million, 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 Company's Consolidated Financial Statements included in this Annual Report on Form 10-K. The increase in interest expense in 2007 is primarily related to the higher average borrowings as discussed above, as well as the charge of $2.9 million in interest expense in 2007 in connection with the recording of the interest rate swap agreement to fair value.

Interest income was $620,000 in 2008 as compared to $1.8 million in 2007 and $565,000 in 2006. 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 PictureMe Portrait Studio®. The 2007 increase is primarily attributable to higher invested balances in 2007 as compared to 2006.

The income tax (benefit) expense on (loss) income from continuing operations totaled ($2.6 million), $2.1 million and $9.2 million in 2008, 2007 and 2006, respectively. These provisions resulted in effective tax rates of (28%) in 2008, 34% in 2007 and 36% in 2006. The decrease in the effective tax rate in 2008 is primarily attributable to the tax effect of WOTC credits as a percent of pre-tax income and the exclusion of certain tax benefits due to the current year loss. The decrease in the effective tax rate in 2007 was primarily due to employment tax credits resulting from the PCA Acquisition, as well as favorable settlements of two state tax audits and refunds in 2007 related to previously paid penalties and interest in 2006.

Net losses from discontinued operations were $961,000, $441,000 and $103,000 in 2008, 2007 and 2006, 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.