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 interim 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 unless otherwise noted.

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 2,945 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. CPI is the sole operator of portrait studios in Walmart 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 second quarter in fiscal years 2009 and 2008, the Company's studio counts were:

                                                  July 25, 2009       July 19, 2008
  Within Sears stores:
  United States and Puerto Rico                              876                 890
  Canada                                                     110                 110

  Within Walmart stores:
  United States and Puerto Rico                            1,558               1,657
  Canada                                                     259                 254
  Mexico                                                     114                 117

  Locations not within Sears or Walmart stores                28                  33

  Total                                                    2,945               3,061

Certain under-performing PMPS studios have been closed since the second quarter of 2008 in order to improve overall financial results.

As of September 1, 2009, all of the Company's studios, with the exception of 29 Sears Portrait Studios in Canada, are digital. Effective August 19, 2009, the Company entered into a new six-year license agreement with Sears Canada, pursuant to which the Company will operate professional portrait studios in approximately 110 Sears locations in Canada. The terms of the agreement provide greater operating flexibility than the previous contract. As a result of this new agreement, the Company will convert all remaining film studios in Canada to a digital format by the end of the 2009 third quarter. The Company plans to deliver steadily increasing growth through harvesting opportunities from its digital platform to create diversified revenue streams, driving productivity and profitability gains, leveraging its manufacturing capacity and efficiency and implementing aggressive, targeted marketing campaigns.

RESULTS OF OPERATIONS

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

in thousands, except share and per share
data                                                 12 Weeks Ended                          24 Weeks Ended
                                            July 25, 2009       July 19, 2008       July 25, 2009       July 19, 2008

Net sales                                  $        81,377     $        89,562     $       174,844     $       192,930

Cost and expenses:
   Cost of sales (exclusive of
depreciation and amortization shown
below)                                               6,682               8,863              13,641              19,627
   Selling, general and administrative
expenses                                            70,358              78,118             145,512             160,706
   Depreciation and amortization                     5,552               5,565              11,591              13,058
   Other charges and impairments                     2,187               1,334               2,607               2,853
                                                    84,779              93,880             173,351             196,244

(Loss) income from operations                       (3,402 )            (4,318 )             1,493              (3,314 )

Interest expense                                     1,928               1,366               3,418               2,887
Interest income                                        118                 118                 240                 480
Other income (expense), net                              7                  (2 )                16                   3

Loss before income tax benefit                      (5,205 )            (5,568 )            (1,669 )            (5,718 )
Income tax benefit                                  (1,776 )            (2,156 )              (570 )            (2,218 )

Net loss from continuing operations                 (3,429 )            (3,412 )            (1,099 )            (3,500 )
Net loss from discontinued operations                    -                (189 )                 -                (357 )

NET LOSS                                   $        (3,429 )   $        (3,601 )   $        (1,099 )   $        (3,857 )

NET LOSS PER COMMON SHARE

Net loss per share from continuing
operations - diluted                       $         (0.49 )   $         (0.53 )   $         (0.16 )   $         (0.54 )
Net loss per share from discontinued
operations - diluted                                     -               (0.03 )                 -               (0.06 )
Net loss per share - diluted               $         (0.49 )   $         (0.56 )   $         (0.16 )   $         (0.60 )

Net loss per share from continuing
operations - basic                         $         (0.49 )   $         (0.53 )   $         (0.16 )   $         (0.54 )
Net loss per share from discontinued
operations - basic                                       -               (0.03 )                 -               (0.06 )
Net loss per share - basic                 $         (0.49 )   $         (0.56 )   $         (0.16 )   $         (0.60 )

Weighted-average number of common and
common equivalent
   shares outstanding - diluted                  7,005,244           6,468,062           6,977,021           6,459,256

Weighted-average number of common and
common equivalent
   shares outstanding - basic                    7,005,244           6,468,062           6,977,021           6,459,256

12 weeks ended July 25, 2009 compared to 12 weeks ended July 19, 2008

The Company reported a net loss of $3.4 million, or ($0.49) per diluted share, for the fiscal 2009 second quarter ended July 25, 2009, versus a net loss of $3.6 million, or ($0.56) per diluted share, in the comparable quarter of fiscal 2008. The Company believes its second quarter fiscal year 2009 results reflect the successful integration and upgrade of the PictureMe Portrait Studio® studios as well as the impact of cost reductions and productivity improvements implemented throughout the organization.

Net sales totaled $81.4 million and $89.6 million in the second quarter of fiscal 2009 and 2008, respectively.

· Net sales for the fiscal 2009 second quarter decreased $8.2 million, or 9.2%, to $81.4 million from the $89.6 million reported in the second quarter of 2008. Excluding impacts of net revenue recognition change of $3.0 million, foreign currency translation ($1.8 million), revenue deferral related to positive response to the Company's loyalty programs ($1.5 million), store closures ($1.7 million) and other net adjustments of $300,000, comparable same-store sales decreased $6.5 million, or 7.5%.

Net sales from the Company's PictureMe Portrait Studio® brand ("PMPS"), on a comparable same-store basis, excluding impacts of net revenue recognition change, foreign currency translation, loyalty program revenue deferral, store closures and other items, totaling ($2.3 million), increased 7.0%, in the second quarter of 2009 to $42.6 million from $39.8 million reported in the second quarter of 2008. PMPS sales performance for the second quarter was the result of an approximate 24.9% increase in average sale per customer sitting, offset in part by an approximate 14.4% decline in the number of sittings. The Company attributes its increase in average sale per customer sitting primarily to customers' positive response to the new offerings made possible by the recently completed digital conversion and the implementation of new sales and performance management processes. The Company believes the sittings decline reflects the difficult economic environment, which has especially pressured customer demand in lower income categories.

Net sales from the Company's Sears Portrait Studio brand ("SPS"), on a comparable same-store basis, excluding impacts of net revenue recognition change, foreign currency translation, loyalty program revenue deferral, store closures and other items, totaling $600,000, decreased to $37.3 million, a decrease of 20.0%, from the $46.6 million reported in the second quarter of 2008. SPS sales performance for the second quarter was the result of declines in the number of sittings and sales per sitting of approximately 19.1% and 1.0%, respectively. The Company believes the decline in SPS brand sales reflects the difficult economic environment which pressured sittings volumes (particularly in the off-season) and led to an especially pronounced reduction in walk-in business not tied to the Company's direct marketing programs. The Company believes declines have been mitigated in part by improving execution of the Company's customer outreach and loyalty programs.

Costs and expenses were $84.8 million in the second quarter of 2009, down significantly from the $93.9 million recorded in the second quarter of 2008.

· Cost of sales, excluding depreciation and amortization expense, was $6.7 million in the second quarter of 2009, compared with $8.9 million in the second quarter of 2008. The decrease is principally attributable to lower overall manufacturing production levels, improved product mix, increased manufacturing productivity, the elimination of film and related shipping costs stemming from the PMPS digital conversion, and decreased overhead costs resulting from the integration of the PMPS operations.

· Selling, general and administrative ("SG&A") expenses were $70.3 million for the second quarter of 2009, compared with $78.1 million in the second quarter of 2008. The decrease in SG&A expenses primarily relates to lower studio employment costs of $3.4 million due to scheduling improvements and selected operating hour reductions; fiscal 2008 nonrecurring costs of $2.0 million associated with the PMPS digital conversion; favorable foreign exchange rate translation of $1.3 million; the elimination of duplicative costs in connection with the PMPS integration of $912,000; and reduced workers' compensation expense of $758,000 due to improved claims management. These decreases were offset in part by increases of $2.2 million in higher average hourly studio rates and increased sales incentives in connection with new studio and field initiatives.

· Depreciation and amortization expense was $5.6 million in the second quarter of 2009, unchanged from a year ago. Depreciation expense increased as a result of the digital equipment purchased for the PMPS digital conversion throughout fiscal 2008; however, it was equally offset by a reduction in expense related to the streamlining of manufacturing facilities and closure of unprofitable studios.

· In the second quarter of 2009, the Company recognized $2.2 million in other charges and impairments, compared with $1.3 million recognized in the second quarter of 2008. The current year charges are primarily associated with the recently completed proxy contest fees of $977,000, certain PMPS integration charges, including severance and lab closure costs, of $604,000, and litigation costs of $536,000. The prior-year charges are primarily associated with litigation costs of $612,000, certain fees incurred in conection with the settlement of the previous Sears license agreement of $472,000, and certain PMPS integration charges, including severance and lab closure costs, of $114,000.

Interest expense was $1.9 million in the second quarter of 2009 compared with $1.4 million in the comparable prior year period. The increase in interest expense primarily relates to a $340,000 change in the interest rate swap value and miscellaneous other fees.

Income tax benefit from continuing operations was $1.8 million in the second quarter of 2009 compared to $2.2 million in the second quarter of 2008. The resulting effective tax rates were 34.1% in 2009 and 38.7% in 2008. The decrease in the effective tax rate in 2009 is primarily attributable to a projected decrease in anticipated profitability as a result of current economic conditions, a projected increase in the impact of job tax credits and a decrease in Canadian tax rates.

Net losses from discontinued operations were $0 and $189,000 in the second quarters of 2009 and 2008, respectively. During the fourth quarter of 2008, the Company decided to discontinue its Portrait Gallery and E-Church operations in order to eliminate the unprofitable operations.

24 weeks ended July 25, 2009 compared to 24 weeks ended July 19, 2008

The Company reported a net loss of $1.1 million, or ($0.16) per diluted share, for the first half of fiscal year 2009, ended July 25, 2009, versus a net loss of $3.9 million, or ($0.60) per diluted share, in the comparable prior year period. The Company believes its first half 2009 results reflect the successful integration and upgrade of the PictureMe Portrait Studio® studios as well as the impact of cost reductions and productivity improvements implemented throughout the organization.

Net sales totaled $174.8 million and $192.9 million in the first half of fiscal 2009 and 2008, respectively.

· Net sales for the first half of 2009 decreased $18.1 million, or 9.4%, to $174.8 million from the $192.9 million reported in the first half of 2008. Excluding impacts of foreign currency translation ($4.6 million), revenue deferral related to positive response to the Company's loyalty programs ($3.7 million), store closures ($3.3 million), net revenue recognition change ($800,000), and other net adjustments ($600,000), comparable same-store sales decreased $5.1 million, or 2.7%.

Net sales from the Company's PictureMe Portrait Studio® brand ("PMPS"), on a comparable same-store basis, excluding impacts of foreign currency translation, store closures, net revenue recognition change, loyalty program revenue deferral and other items, totaling ($9.3 million), increased 11.6%, in the first half of 2009 to $97.8 million from $87.6 million reported in the first half of 2008. PMPS sales performance for the first half was the result of an approximate 30.5% increase in average sale per customer sitting, offset in part by an approximate 14.4% decline in the number of sittings. The Company attributes its increase in average sale per customer sitting primarily to customers' positive response to the new offerings made possible by the recently completed digital conversion and the implementation of new sales and performance management processes. The Company believes the sittings decline reflects the difficult economic environment, which has especially pressured customer demand in lower income categories.

Net sales from the Company's Sears Portrait Studio brand ("SPS"), on a comparable same-store basis, excluding impacts of loyalty program revenue deferral, foreign currency translation, net revenue recognition change, store closures and other items, totaling ($3.7 million), decreased to $83.6 million, a decrease of 15.5%, from the $98.9 million reported in the first half of 2008. SPS sales performance for the first half was the result of declines in the number of sittings and sales per sitting of approximately 14.4% and 1.3%, respectively. The Company believes the decline in SPS brand sales reflects the difficult economic environment which pressured sittings volumes (particularly in the off-season) and led to an especially pronounced reduction in walk-in business not tied to the Company's direct marketing programs. The Company believes declines have been mitigated in part by improving execution of the Company's customer outreach and loyalty
programs.

Costs and expenses were $173.4 million in the first half of 2009, down significantly from the $196.2 million recorded in the first half of 2008.

· Cost of sales, excluding depreciation and amortization expense, was $13.6 million in the first half of 2009, compared with $19.6 million in the first half of 2008. The decrease is principally attributable to lower overall manufacturing production levels, improved product mix, increased manufacturing productivity, the elimination of film and related shipping costs stemming from the PMPS digital conversion, and decreased overhead costs resulting from the integration of the PMPS operations.

· Selling, general and administrative ("SG&A") expenses were $145.5 million for the first half of 2009, compared with $160.7 million in the first half of 2008. The decrease in SG&A expenses primarily relates to lower studio employment costs of $8.1 million due to scheduling improvements and selected operating hour reductions; fiscal 2008 nonrecurring costs of $3.6 million associated with the PMPS digital conversion; favorable foreign exchange translation of $3.6 million; the elimination of duplicative costs in connection with the PMPS integration of $2.0 million; reduced workers' compensation expense of $1.2 million due to improved claims management; and reduced employee insurance costs of $1.0 million related to changes in plan design and lower enrollment. These decreases were offset in part by increases of $4.2 million in higher average hourly studio rates and increased sales incentives in connection with new studio and field initiatives and an increase in marketing expense of $2.0 million due to additional promotional programs for the Easter holiday.

· Depreciation and amortization decreased to $11.6 million in the first half of 2009 from $13.1 million in the first half of 2008. The decrease in depreciation and amortization is primarily attributable to certain assets, acquired in connection with the 2007 acquisition of PCA, becoming fully depreciated subsequent to the prior-year first quarter and a reduction in expense related to the streamlining of manufacturing facilities and closure of unprofitable studios. This decrease is offset in part by an increase in depreciation attributable to the equipment purchased for the PMPS digital conversion throughout fiscal year 2008.

· In the first half of 2009, the Company recognized $2.6 million in other charges and impairments, compared with $2.9 million recognized in the first half of 2008. The current year charges are primarily associated with certain PMPS integration charges, including severance and lab closure costs of $1.2 million, certain PMPS integration charges, including severance and lab closure costs of $1.2 million, proxy contest fees of $977,000, and litigation costs of $398,000. The prior-year charges are primarily associated with certain fees incurred in connection with the settlement of the previous Sears license agreement of $978,000, litigation fees of $857,000, and certain PMPS integration charges, including severance and lab closure costs of $725,000.

Interest expense was $3.4 million in the first half of 2009 compared with $2.9 million in the comparable prior year period. The increase in interest expense primarily relates to the change in the interest rate swap value.

Interest income was $240,000 in the first half of 2009 compared with $480,000 in the comparable prior year period. This decrease primarily relates to lower average invested balances in the first half of 2009 as compared to the first half of 2008, the result of higher capital spending throughout 2008 related to the digital conversion of PMPS.

Income tax benefit from continuing operations was $570,000 in the first half of 2009 compared to $2.2 million in the comparable prior year period. The resulting effective tax rates were 34.2% in 2009 and 38.8% in 2008. The decrease in the effective tax rate in 2009 is primarily attributable to a projected decrease in anticipated profitability as a result of current economic conditions, a projected increase in job tax credits and a decrease in Canadian tax rates.

Net losses from discontinued operations were $0 and $357,000 in the first half of 2009 and 2008, respectively. During the fourth quarter of 2008, the Company decided to discontinue its Portrait Gallery and E-Church operations in order to eliminate the unprofitable operations.

LIQUIDITY AND CAPITAL RESOURCES

The following table presents a summary of the Company's cash flows for the first
half of 2009 and 2008:



    in thousands                                        24 Weeks Ended
                                               July 25, 2009       July 19, 2008
    Net cash provided by (used in):
    Operating activities                      $         2,263     $        (4,950 )
    Financing activities                              (10,437 )           (10,312 )
    Investing activities                                 (832 )           (24,788 )
    Effect of exchange rate changes on cash               393                 150
    Net decrease in cash                      $        (8,613 )   $       (39,900 )

Net Cash Provided By (Used In) Operating Activities

Net cash provided by operating activities was $2.3 million during the first half of 2009 compared to net cash used of $5.0 million in the comparable period of 2008. Cash flows in the first half of 2009 increased from first half 2008 levels primarily due to net operating income and the timing of payments related to changes in the various balance sheet accounts totaling approximately $9.6 million. These increases were offset in part by additional cash used related to advertising of approximately $1.2 million, primarily for the Easter holiday, and $1.2 million in bonus and incentives related to new studio and field initiatives.

Net Cash Used In Financing Activities

The increase in cash used in financing activities in the first half of 2009 is primarily attributable to payments in the first half of 2009 of $943,000 in fees paid to creditors incurred in connection with the Amendment to the Credit Agreement in the first quarter of 2009, the amount of which is being amortized over the remainder of the life of the loan in addition to fees that are currently being amortized. This increase is offset in part by a decrease in repayments of long-term debt in the first half of 2009 compared to the prior year comparable period.

At July 25, 2009, the Company had $98.5 million outstanding under its existing Credit Agreement. The Company was in compliance with its covenants under its Credit Agreement as of July 25, 2009.

Net Cash Used In Investing Activities

Net cash used in investing activities was $832,000 during the first half of 2009 as compared to $24.8 million during the first half of 2008. This decrease was primarily attributable to a decrease in capital expenditures of $22.8 million in the first half of 2009 compared to the prior year comparable period since the digital conversion is now completed. Partially offsetting this decrease is an increase in proceeds from the sale of property and equipment of $1.3 million, primarily related to the sale of the Charlotte, North Carolina warehouse, in the second quarter of 2009.

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 following Commitments and Contingencies section, the Company has no additional off-balance sheet arrangements.

Commitments and Contingencies

Standby Letters of Credit

As of July 25, 2009, the Company had standby letters of credit outstanding in the principal amount of $20.3 million primarily used in conjunction with the Company's various large deductible insurance programs.

Settlement Commitment

The Company is obligated to remit Sears additional payments as stipulated in the settlement of the previous license agreement. As such, $1.5 million was due to Sears on April 30, 2009, and paid on May 7, 2009. An additional $150,000 is due on December 31st in each 6 successive years, commencing December 31, 2009; these amounts have been accrued at present value in the Interim Consolidated Balance Sheet as of July 25, 2009.

Contingent Lease Obligations

In July 2001, the Company announced the completion of the sale of its Wall Décor segment, Prints Plus, which included the ongoing guarantee of certain operating real estate leases of Prints Plus. As of July 25, 2009, the maximum future obligation to the Company under its guarantee of remaining leases is approximately $1.0 million before consideration of replacement tenant income. To recognize the risk associated with these leases based upon the Company's past experience with renegotiating lease obligations and the management's evaluation of remaining lease liabilities, the Company has recorded lease obligation reserves totaling approximately $710,000 at July 25, 2009. Based on the status of remaining leases, the Company believes that the $710,000 reserve is adequate to cover the potential losses to be realized under the Company's remaining operating lease guarantees.

Liquidity

Cash flows from operations, cash and cash equivalents and the seasonal borrowing capacity under the revolving portion of the Company's Credit Agreement, represent expected sources of funds in 2009 to meet the Company's obligations and commitments, including debt service, annual dividends to shareholders, planned capital expenditures, which are estimated not to exceed $5.0 million for fiscal 2009, 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 provides for the FASB Accounting Standards Codification (the "Codification") to become the single official source of authoritative, nongovernmental U.S. GAAP. The Codification did not change U.S. GAAP but reorganizes existing literature and is effective for interim and fiscal years ending after September 15, 2009. The Company does not expect the adoption of this statement will have a material effect on its financial statements.

In May 2009, the FASB issued SFAS No. 165, "Subsequent Events" ("SFAS No. 165"), 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. SFAS No. 165 is effective for interim and fiscal years ending after June 15, 2009. The Company performed an evaluation of subsequent events through September 3, 2009, 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 interim consolidated financial statements.

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