As filed with the Securities and Exchange Commission on September 8, 2010

Registration No. 333-167865

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Amendment No. 2

TO

Form S-1

 

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 

PORTRAIT INNOVATIONS HOLDING COMPANY

(Exact name of registrant as specified in its charter)

 

 

2016 Ayrsley Town Boulevard, Suite 200

Charlotte, North Carolina 28273

(704) 499-9300

 

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

 

 

 

 

John Grosso

President and Chief Executive Officer

Portrait Innovations Holding Company

2016 Ayrsley Town Boulevard, Suite 200

Charlotte, North Carolina 28273

(704) 499-9300

(704) 499-9301 (facsimile)

 

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 

 

 

 

Copies to:

 

 

 

 

 

Approximate date of commencement of proposed sale to the public:  As soon as practicable after the effective date of this registration statement.

 

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.  o

 

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

 

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

 

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  o

 

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

 

(Do not check if a smaller reporting company)

 

CALCULATION OF REGISTRATION FEE

 

 

 

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.

 

 

SUBJECT TO COMPLETION, DATED SEPTEMBER 8, 2010

 

PROSPECTUS

            Shares

 

 

 

PORTRAIT INNOVATIONS HOLDING COMPANY

 

Common Stock

 

 

This is an initial public offering of           shares of common stock of Portrait Innovations Holding Company.

 

 

Portrait Innovations Holding Company is offering           shares of common stock and the selling stockholders identified in this prospectus are offering           shares of common stock. We will not receive any proceeds from the sale of the shares by the selling stockholders. The estimated initial public offering price is between $      and $      per share.

 

 

Prior to this offering, there has been no public market for our common stock. We have applied for listing of our common stock on the NASDAQ Global Market under the symbol PTRT.

 

 

 

 

Certain of the selling stockholders have granted the underwriters an option for a period of 30 days to purchase up to           additional shares of common stock on the same terms and conditions set forth above to cover over-allotments, if any.

 

 

  Investing in our common stock involves a high degree of risk. See “Risk Factors” beginning on page 8.

 

 

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed on the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense.

 

 

 

The underwriters expect to deliver the shares of common stock to purchasers on          , 2010.

 

 

          , 2010

 

TABLE OF CONTENTS

 

 

We have not authorized anyone to provide any information other than that contained in this prospectus or in any free writing prospectus prepared by or on behalf of us or to which we have referred you. We take no responsibility for, and can provide no assurance as to the reliability of, any other information that others may give you. The company, the selling stockholders and the underwriters are offering to sell, and seeking offers to buy, shares of common stock only in jurisdictions where offers and sales are permitted. You should assume that the information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of common stock. Our business, results of operations, financial condition and prospects may have changed since that date.

 

The name “Portrait Innovations” is a registered trademark of our operating subsidiary, Portrait Innovations, Inc. This prospectus also includes other registered and unregistered trademarks and service marks of Portrait Innovations, Inc. Solely for convenience, our trademarks and tradenames referred to in this prospectus are without the^® or ^tm symbol, as applicable, but such references are not intended to indicate, in any way, that we will not assert, to the fullest extent under applicable law, our rights to these trademarks and tradenames. Other brand names or trademarks appearing in this prospectus are the property of their respective owners.

 

Certain market and industry data and forecasts used throughout this prospectus were obtained from market research, consultant surveys, publicly available information and industry publications and surveys. These sources generally state that the information they contain has been obtained from sources believed to be reliable, but that the accuracy and completeness of such information is not guaranteed. Although we believe that each source is reliable as of its respective date, we have not independently verified any of the data from third-party sources, nor have we ascertained the assumptions relied upon therein. As a result, neither we nor the underwriters can assure you of the accuracy or completeness of the data.

 

PROSPECTUS SUMMARY

	•	Convenient, attractive locations.  We locate our free-standing studios in high-visibility, high-traffic, open-air lifestyle and power centers with easy parking and access. Our studios are designed to be warm and inviting, and feature large camera rooms, portrait viewing stations and dressing rooms, as well as spacious reception areas with comfortable couches and children’s play areas.
	•	Interactive, professional photography session.  Our highly trained studio managers and associates use professional handheld digital cameras and interact with our customers to capture candid expressions and emotions, creating high-quality and artistically appealing portraits. Our sophisticated camera rooms feature auto-adjusting, computerized lighting and background systems, which enhance the variety, quality and consistency of our images and enable us to complete photography sessions quickly and efficiently.
	•	Efficient, proprietary portrait selection process.  Immediately following the photography session, we utilize our proprietary software and processes to allow our customers to quickly and easily review their image choices, select their favorite poses and create personal, one-of-a-kind portraits using a variety of special effects. With guidance from our well-trained studio associates, our customers can customize a portrait collection tailored to their tastes and budgets. Our average customer purchase has been more than $100 in each fiscal year since our inception.
	•	High-quality, in-studio portrait production.  Each of our studios features a Fujifilm Frontiertm printer system and uses professional-quality, silver halide Crystal Archivetm portrait paper, which together

		produce vivid colors and image stability. Ordered portraits are printed on-site and typically are ready within 15 minutes after a customer selects a portrait collection.

	•	Compelling customer experience and value proposition.  We provide our customers high-quality portraits, typically within an hour and a half of entering our studio, in a pleasant and convenient studio environment. We believe that our proprietary systems and software and on-site, state-of-the-art digital imaging and printing technology allow us to offer a wide variety of portrait collections at compelling price points to a high volume of customers.
	•	Customer-focused real estate strategy.  We locate our free-standing portrait studios in high-visibility, high-traffic, open-air lifestyle and power centers that we believe have become the preferred shopping destinations for U.S. consumers due to their accessibility and convenience. In contrast, our primary competitors typically locate their studios within enclosed malls or other host retailers.
	•	Disciplined operating philosophy with scalable processes.  We have developed and documented detailed and standardized systems, procedures and processes that we believe have allowed us to rapidly grow our studio base while maintaining consistently high-quality customer service and in-studio execution.
	•	Performance-based culture with emphasis on training.  We believe our customer-focused and performance-based culture allows us to attract and retain motivated, high-achieving employees who share our vision for success. The majority of our associates are college-educated and start their employment at our central training facility, where they attend a comprehensive two-week training program that focuses on developing professional portrait techniques and personalizing the customer experience while maximizing sales productivity. Our associates also receive ongoing evaluation and training to enhance their skills.
	•	Attractive and consistent studio economics.  Our studio model has consistently delivered strong unit economics across a variety of geographic locations. Our studios require minimal inventory investment and typically generate positive cash flow within one year of opening. For new studios, we target a pre-tax, cumulative cash payback on our net investment within three years.
	•	Experienced management team with a proven track record.  We have assembled a management team that has over 100 combined years of experience in the retail photography industry. Our co-founders, John Grosso, President and Chief Executive Officer, and John Davis, Executive Vice President and Chief Development Officer, have each spent more than 30 years in the photography industry.

	•	Accelerating the expansion of our studio base.  We intend to accelerate the expansion of our studio base in new and existing markets. Based on our operating experience, we believe the U.S. market can

		support over 850 Portrait Innovations studios. We intend to open approximately 30 new studios in fiscal 2010 and increase our studio base by approximately 20% annually thereafter.

	•	Increasing sales productivity.  We seek to maximize our comparable studio sales by maintaining consistent studio-level execution and generating increased customer traffic. We plan to continue to implement a variety of initiatives to enhance sales productivity in our studios, which we believe already generate the highest average studio sales volume of any major chain in the portrait industry.
	•	Growing our national brand awareness.  We believe our Portrait Innovations brand will continue to gain awareness as we accelerate our studio openings and expand our geographic footprint. We plan to continue to support the brand through a broad mix of media, and we also believe we will continue to benefit from word-of-mouth and grass roots marketing.
	•	Investing in and developing technology.  We intend to remain at the forefront of digital image capture and printing technology, which we believe will further differentiate us from our competitors. We also plan to continue to develop business systems and methodologies intended to improve business processes, create and deliver innovative product offerings, and capture and analyze information to better manage our business.
	•	Improving our operating margins.  We believe that our initiatives to improve sales productivity will result in increased studio-level contribution margins. In addition, we believe we will achieve higher levels of profitability by leveraging corporate and other overhead costs against a growing revenue base as our studio location footprint expands.

Common stock offered by us		shares
Common stock offered by the selling stockholders		shares
Total common stock offered		shares
Common stock to be outstanding after the offering		shares
Over-allotment shares		shares from certain selling stockholders.

Use of proceeds		We intend to use the net proceeds from this offering to repay debt under our revolving credit facility and to pay accrued and unpaid dividends on our outstanding preferred stock, which were approximately $10.0 million and $3.6 million, respectively, as of August 1, 2010, and the remainder to fund studio expansion and for other general corporate purposes.

		We will not receive any proceeds from the sale of shares by the selling stockholders, including upon exercise, if any, of the underwriters’ over-allotment option. We estimate that our net proceeds from this offering will be approximately $      million, based on an assumed initial public offering price of $     per share (the mid-point of the price range set forth on the cover page of this prospectus) and after deducting the underwriting discounts and commissions and our estimated offering costs of $     million. See “Use of Proceeds.”
Dividend policy		We do not anticipate declaring or paying cash dividends on our common stock for the foreseeable future. See “Dividend Policy.”
Proposed NASDAQ Global Market symbol		PTRT
Risk factors		See “Risk Factors” and other information included in this prospectus for a discussion of factors you should carefully consider before deciding to invest in shares of our common stock.
Conflicts of interest		An affiliate of Wells Fargo Securities, LLC, one of the underwriters, is the lender under our revolving credit facility and may receive more than five percent of the net proceeds of this offering. Thus, Wells Fargo Securities, LLC has a “conflict of interest” as defined in Rule 2720 of the Conduct Rules of the Financial Industry Regulatory Authority, Inc. and, accordingly, J.P. Morgan Securities Inc. is acting as the “qualified independent underwriter.” See “Conflicts of Interest.”

	•	shares of common stock issuable upon the exercise of outstanding stock options with a weighted average exercise price of $      per share; and
	•	an aggregate of           additional shares of common stock reserved for future issuance under our stock option plans as of          , 2010.

	•	assumes an initial public offering price of $      per share of common stock, the mid-point of the range set forth on the cover page of this prospectus; and
	•	gives effect to the conversion of all outstanding shares of our convertible preferred stock into shares of our common stock subject to and upon the completion of this offering.

		Fiscal Year Ended(1)												Twenty-six Weeks Ended
		February 3,				February 1,				January 31,				August 2,				August 1,
		2008				2009				2010				2009				2010
		(Dollars in thousands, except per share, per studio and per square foot data)
														(Unaudited)
Statement of income data:
Net sales		$	73,203			$	97,402			$	111,009			$	48,568			$	54,428
Cost of goods sold (exclusive of depreciation and amortization shown below)			18,433				24,422				28,663				13,030				14,573
Selling, general and administrative expenses			44,409				58,559				65,863				29,192				33,025
Depreciation and amortization expense			7,247				10,643				12,208				5,895				6,215
Income from operations			3,114				3,778				4,275				451				615
Interest expense, net			1,459				1,257				497				270				139
Income before income taxes			1,655				2,521				3,778				181				476
Provision (benefit) for income taxes			(1,454	)			1,234				1,244				88				183
Net income		$	3,109			$	1,287			$	2,534			$	93			$	293
Weighted average common shares outstanding
Basic			2,944,759				3,879,927				4,164,487				4,161,527				4,296,215
Diluted			7,092,963				3,879,927				8,544,890				4,161,527				4,296,215
Net income (loss) per common share(2)
Basic		$	0.12			$	(0.29	)		$	0.02			$	(0.27	)		$	(0.21	)
Diluted		$	0.12			$	(0.29	)		$	0.02			$	(0.27	)		$	(0.21	)
Other operating data (unaudited):
Comparable studio sales increase(3)			21.6%				11.3%				6.9%				7.3%				4.7%
Number of studios (at period end)			120				150				170				160				188
Total square footage (at period end)			261,568				334,547				387,172				361,417				432,293
Average square footage per studio (at period end)(4)			2,180				2,230				2,277				2,259				2,299
Net sales per average number of studios(5)		$	732,000			$	695,000			$	692,000			$	314,153			$	301,540
Net sales per average square foot(6)		$	339			$	315			$	307			$	140.24			$	131.69
Capital expenditures		$	26,514			$	15,292			$	11,709			$	4,448			$	7,129
EBITDA(7)		$	10,361			$	14,421			$	16,483			$	6,346			$	6,830
Balance sheet data (at period end):
Cash and cash equivalents		$	5,060			$	5,951			$	1,987			$	2,662			$	752
Working capital			(3,797	)			(4,130	)			(12,333	)			(5,570	)			(8,544	)
Total assets			56,845				61,062				57,761				59,091				61,111
Total debt			13,950				13,950				4,950				13,950				9,950
Redeemable preferred stock(8)			28,414				26,393				26,433				25,237				27,630
Total stockholders’ equity (deficit)			(3,978	)			(401	)			198				(1,280	)			(155	)

(1)		Our fiscal year is the 52- or 53-week period ending on the Sunday nearest January 31. Fiscal years ended February 1, 2009 and January 31, 2010 were 52-week years. The fiscal year ended February 3, 2008 was a 53-week year, and the 53rd week accounted for approximately $1,045,000 in net sales.
(2)		Net income (loss) per common share reflects dividends accrued on, and net income allocated to, our preferred stock. See Note 15 of notes to our consolidated financial statements and Note 12 of notes to our unaudited condensed consolidated financial statements included elsewhere in this prospectus.
(3)		Comparable studio sales increase reflects sales for studios beginning on the first day of the 53rd week after opening. Comparable studio sales increase for the fiscal year ended February 3, 2008 was adjusted by excluding the 53rd week.
(4)		Average square footage per studio is calculated by dividing total square footage at period end by the number of studios at period end.
(5)		Net sales per average number of studios was calculated by dividing net sales for the trailing 12-month period by the average number of studios open during such trailing 12-month period. Net sales per average number of studios for the fiscal year ended February 3, 2008 was adjusted to exclude the net sales effects of the 53rd week.
(6)		Net sales per average square foot was calculated by dividing net sales for the trailing 12-month period by the average square footage for those studios open during such trailing 12-month period. Net sales per average total square foot for the fiscal year ended February 3, 2008 was adjusted to exclude the net sales effects of the 53rd week.
(7)		“EBITDA” is defined as net income (loss) before interest expense (net of interest income), provision for income taxes and depreciation and amortization expense. EBITDA does not represent, and should not be considered as, an alternative to net income or cash flows from operating activities, each as determined in accordance with generally accepted accounting principles in the United States (“GAAP”). We have presented EBITDA because we consider it an important supplemental measure of our performance and believe it is frequently used by analysts, investors and other interested parties in the evaluation of retail companies. Management uses EBITDA as a measurement tool for evaluating our actual operating performance compared to budget and prior periods and in evaluating performance for incentive compensation purposes. Other companies may calculate EBITDA differently than we do. EBITDA is not a measure of performance under GAAP and should not be considered as a substitute for net income prepared in accordance with GAAP. EBITDA has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for analysis of our results as reported under GAAP.

		Fiscal Year Ended												Twenty-six Weeks Ended
		February 3,				February 1,				January 31,				August 2,				August 1,
		2008				2009				2010				2009				2010
		(In thousands)
		(Unaudited)
Net income		$	3,109			$	1,287			$	2,534			$	93			$	293
Provision (benefit) for income taxes			(1,454	)			1,234				1,244				88				183
Income before income taxes			1,655				2,521				3,778				181				476
Depreciation and amortization expense			7,247				10,643				12,208				5,895				6,215
Interest expense, net			1,459				1,257				497				270				139
EBITDA		$	10,361			$	14,421			$	16,483			$	6,346			$	6,830

(8)		The holders of all of the outstanding shares of preferred stock have agreed to convert such preferred stock into common stock subject to, and upon the completion of, this offering.

 

An investment in our common stock involves a number of risks. You should carefully consider the following risk factors in addition to the other information contained in this prospectus before investing in our common stock. If any of the following risks or uncertainties occurs, our business, results of operations and financial condition could be materially and adversely affected. As a result, the trading price of our common stock could decline and you may lose all or a part of your investment in our common stock.

 

Risks related to our business and industry

 

Our business is highly dependent on our ability to anticipate and appropriately respond to the trends and preferences that drive our customers’ behavior and purchasing habits.

 

Our business is subject to changing consumer trends and preferences. The professional portrait market has been and continues to be affected by shifts in consumer preferences and expectations regarding convenience, speed, quality, value and preferred shopping venue, and our failure to accurately predict or respond to evolving consumer trends could negatively affect consumers’ opinions of us as a choice for portraits. The success of our business model depends upon a number of factors, including our ability to continue to refine and innovate our portrait experience and product offerings, price our products competitively and differentiate our product offerings and portrait experience from those of our competitors. If we are unsuccessful on any of these fronts, our business, results of operations, financial condition and prospects could be adversely affected.

 

In addition, changing customer preferences in favor of preserving and sharing photographic images in electronic, rather than printed, form could erode our market share and overall demand for our products. If such changes reduce consumer demand for our product offerings, we could be forced to significantly adapt or abandon our business model. We also believe the proliferation of amateur digital photography is making customers more discerning, demanding and self-reliant, particularly given the abundance of high-quality and easy-to-use technology now available at accessible price points, which may adversely affect overall activity in the professional portrait market.

 

Our business, sales and growth prospects depend upon our ability to continue to provide our customers a high-quality, differentiated portrait experience.

 

A critical component of our strategy is providing a high-quality, differentiated portrait experience to our customers. Accordingly, our ability to consistently and effectively deliver this experience for new and repeat customers across our existing and expanding studio base is important to our reputation and our ability to attract and retain customers. As a result, we need to continue to invest substantial capital resources in technology, studio development and employee recruiting and training. If we do not make such investments or fail to provide a high-quality, differentiated portrait experience to our customers, we may lose studio traffic, revenues, market share and suffer harm to our reputation and brand, which could have a material adverse effect on our business, results of operations and financial condition.

 

Since our business is highly dependent on customer satisfaction and providing a differentiated portrait experience, any significant increase in average waiting time will directly impact customer satisfaction. Average waiting times may increase for a variety of reasons, including the failure to adhere to scheduled appointment times, overbooking, the longer-than-expected duration of any particular portrait session and the higher customer volume we experience during busy holiday periods. Furthermore, if our studio associates and managers fail to provide a satisfactory experience to our customers, those customers may not return and our reputation and brand may be harmed. If we are unable to address customer service issues adequately, our business and results of operations could be materially adversely affected.

 

We may not be able to sustain comparable studio sales growth.

 

We may not be able to sustain or improve upon the levels of comparable studio sales that we have experienced in the recent past. A variety of factors, many of which are beyond our control, affect our comparable studio sales and could cause our quarterly and annual operating results to fluctuate significantly.

For example, our comparable studio sales increase for the fiscal quarter ending August 1, 2010 was 0.4%, compared to 8.7% for the prior fiscal quarter. We define comparable studio sales to include sales for each of our studios beginning in its 53rd week of operations. Comparable studio sales may be affected by a number of factors, including but not limited to:

 

 

Accordingly, our comparable studio sales results for any one fiscal period are not necessarily indicative of the comparable studio sales results to be expected for any other period, and our comparable studio sales for any particular future period may decrease. In addition, many retail operators have been unable to sustain high levels of comparable store sales growth during and after periods of substantial expansion. These factors may cause our comparable studio sales results to be materially lower than in recent periods and materially lower than our expectations, which could reduce our sales and profitability and limit our ability to finance our growth strategy. If our future comparable studio sales decline or fail to meet market expectations, the price of our common stock could also decline.

 

Our growth strategy depends upon our ability to successfully manage our business on a substantially larger scale by opening and operating a significant number of new studios each year in a timely and cost-effective manner without diminishing the sales and negatively affecting the performance of our existing studio base. We may not be able to open new studios as planned and any new studios we do open may not achieve our targeted profitability.

 

We intend to pursue an aggressive growth strategy of opening new studios for the foreseeable future. As a result, our future operating results will depend largely upon our ability to successfully open and operate a significant number of new studios each year in a timely and cost-effective manner and to profitably and effectively manage a significantly larger business.

 

Our ability to successfully execute our growth strategy depends on many factors including, among others, our ability to:

 

 

 

In addition, as the number of our studios increases, we may face risks associated with market saturation of our product offerings. To the extent our new studio openings are in markets where we have existing studios, we may experience reduced net sales in existing studios in those markets. There is no assurance that any newly opened studios will be received as well as, or achieve net sales or profitability levels comparable to those of, our existing studios in the time periods estimated by us, or at all. If our studios fail to achieve, or are unable to sustain, acceptable net sales and profitability levels, or incur significant losses, our business and results of operations may be materially harmed and we may incur significant costs associated with closing those studios.

 

Our current expansion plans are only estimates. The actual number of new studios we open each year and our cash payback on investment period could differ significantly from our targets. For example, we significantly decreased the number of studio openings in 2009 as a result of the economic downturn. In addition, while we believe the U.S. market can support over 850 Portrait Innovations studios, this estimate is not based on an identification of specific, future locations and other factors that we consider in opening a new studio. Any failure to successfully open and operate new studios in the numbers, within the time frames and at the costs estimated by us could have a material adverse effect on our business, results of operations, financial condition and prospects and result in a decline in the price of our common stock. Furthermore, our failure to effectively address challenges such as these could also significantly divert the time and resources of our senior management.

 

If we fail to keep pace with or adapt to changes that continue to take place in digital imaging, printing and software application technologies, or if such changes reduce consumer demand for our product offerings, our business, results of operations and financial condition could be adversely affected.

 

We believe that a key to our success to date has been our ability to invest in state-of-the-art digital imaging and printing technologies and customized software applications and systems that we believe enable us to deliver a differentiated customer experience at compelling price points. If we are unable to keep pace with changes in these technologies or invest in software applications and systems that further our business objectives, our business, results of operations, financial condition and competitive position could be adversely affected. Advances in these areas have required and could continue to require us to make significant capital expenditures, which could adversely affect our profitability. In addition, evolving technology could enable customers or small operators to capture images and produce portraits that are comparable to the quality of our portraiture at a significantly lower cost, which could force us to significantly adapt or abandon our business model.

 

The loss of our key senior management, particularly Mr. John Grosso or Mr. John Davis, or the failure to attract additional senior management, could have a material adverse effect on our business.

 

Our success depends to a significant extent on the continued services of our senior management team, particularly Mr. John Grosso and Mr. John Davis, who co-founded our business and developed our overall business and operating strategy and whose experience and knowledge of our business and industry would be difficult to replace. We do not have employment agreements or non-compete agreements with Mr. Grosso or Mr. Davis, and do not have agreements that provide for employment other than on an “at will” basis with any of our other senior executive officers. We do not maintain key person life insurance for any of our senior executives other than Mr. John Grosso.

 

In addition, the performance of our stock price may also affect our ability to attract and retain our key employees. Our senior executive officers hold a significant amount of our common stock, are vested in a substantial amount of stock options and will continue to become vested in additional stock options. These

senior executive officers may be more likely to monetize their holdings and leave us if the trading price of our common stock significantly exceeds their investment in any shares they own or the exercise price of any options they hold. They also may be more likely to leave us if the trading price of our common stock drops significantly below the exercise price of the options they hold.

 

Our inability to retain our key management and attract new senior management could adversely affect our ability to operate our business and execute our growth strategy, which could have a material adverse effect on our business, results of operations and financial condition.

 

Increased competition in the U.S. professional portrait market could adversely impact our business, results of operations and financial condition, as well as our future growth strategy.

 

The U.S. professional portrait market in which we operate is highly competitive. We believe the most important competitive factors in our market include service, innovation, technology, quality, convenience, value, price and package variety. Our failure to deliver on any of these measures would adversely affect our competitive position.

 

Advances in technology and changing consumer preferences may enable current or new competitors to innovate and more cheaply develop similar or new products or software platforms to compete with our business or develop a similar business model. If competitors with significantly greater resources than ours decide to replicate or develop a similar business model, they may be able to quickly gain recognition and acceptance of their products through marketing and promotion.

 

Because of the competitive pressures in our industry, it may be difficult for us to increase profitability on a sustained basis by raising our prices. Our ability to increase profitability over the longer term will largely depend on our ability to open new studios, increase customer traffic in existing studios and manage operating costs effectively. Furthermore, there can be no assurance that we will not be forced to engage in price-cutting initiatives to respond to competitive and consumer pressures.

 

Our failure to build and maintain a strong brand image and generate studio traffic through our marketing activities could harm our business, results of operations, financial condition and growth prospects.

 

We believe our success in our existing markets, as well as our prospects for growing our business in new markets, is dependent on our ability to build and maintain strong brand image and awareness. We believe a number of channels support our brand awareness, from word-of-mouth and grass roots marketing, such as our participation in local charity and public service events in markets where we operate studios, to more focused marketing efforts, such as participation in target-specific online social networking sites, an interactive website, seasonal e-mail communications, targeted customer-specific direct mail, as well as advertising through newspapers and magazines, and selective television advertising. Our success depends in part on our ability to generate positive customer feedback for dissemination through word-of-mouth and primary online channels where consumers seek and share information regarding products and services, as well as our ability to connect with customers through our marketing campaigns. If our marketing efforts and selected methods of advertising fail to keep pace with continuing changes in consumer preferences or if customers provide negative feedback on our products and services through word-of-mouth and online channels, we may be unsuccessful in our efforts to attract and retain customers, which could have a material adverse effect on our business, results of operations and financial condition.

 

Economic or other conditions that would reduce the availability or attractiveness of the locations where we operate studios or seek to open new studios, increase our leasing or construction costs or otherwise impair our real estate expansion strategy could adversely affect our business, results of operations and growth prospects.

 

We intend to grow our studio base by continuing to seek attractive locations in our target markets that are located in open-air lifestyle or power centers in high traffic areas with easy access and drive-up parking. The recent economic downturn, coupled with tightened credit markets, has slowed the pace of commercial real

estate development generally, including the types of retail centers in which we seek to locate new studios. These conditions have also led to the closure of substantial amounts of retail space nationwide. The continuation or worsening of conditions that would limit the availability of attractive retail space could adversely affect our growth plans. Conversely, as a tenant of substantial amounts of retail space, we are subject to economic risks that would increase our occupancy costs, such as rent increases due to a reduced supply of retail space, increased demand for such space, or other factors. The success of our studio locations also partly depends on our ability to establish and maintain good relationships with developers and operators of the centers where we have studios and seek to lease our studios. If our relationships with these parties become strained, it could affect our ability to renew existing leases, secure new leases or obtain lease terms or tenant allowances we deem favorable or necessary. Any reputational damage resulting from conflicts with a particular developer or operator could also impair our ability to negotiate future leases with other developers or operators.

 

Our studio sales are derived in part from the volume of traffic generated by anchor stores and other destination retailers in the centers where our studios are located. General or regional economic downturns, increases in fuel prices, increased competition or changes in demographics or consumer shopping preferences could all adversely affect actual or projected customer traffic to these centers, which in turn could affect the ability or willingness of other desirable tenants to secure leases or maintain stores in these centers. To the extent any anchor stores or other destination retailers close stores, default on pre-opening commitments or otherwise change plans in a manner that reduces customer traffic to the centers in which we have located or have committed to locate our studios, the business and revenues of our studios could be materially and adversely affected.

 

In addition, the raw materials we use to build and remodel our studios are subject to availability constraints and price volatility caused by weather, supply conditions, government regulations, general economic conditions and other unpredictable factors. Increases in the demand for, or the price of, these raw materials could increase the startup costs of building new studios and hurt our profitability. Any such changes could have a material adverse effect on our business, results of operations and financial condition.

 

Changing economic conditions, declines in consumer confidence and spending and other drivers of customer demand for our products could materially and adversely affect our business, results of operations, financial condition and future growth plans.

 

Demand for our products is driven by trends that affect consumer confidence, discretionary spending and disposable income, which have been materially and adversely affected by the recent economic downturn, including greater levels of unemployment, declining wages, volatile energy and food costs, higher levels of consumer debt, declines in home values and in the value of consumers’ investments and savings, restrictions on the availability of credit and other adverse economic conditions. To the extent any of these negative trends continue, re-emerge or worsen, demand for our products could decrease, which in turn could reduce our net sales, income from operations, operating cash flows and net income and adversely affect our future studio expansion plans. Additionally, adverse changes in economic factors that affect our operating expenses, such as increases in interest rates, prices of the commodities we purchase to operate our studios and build and equip new studios, rent and utility expenses and labor and employment costs may increase operating expenses and thereby adversely affect our operating results and growth plans.

 

In addition, our sales are highly dependent on economic conditions and discretionary spending in the local markets in which we operate. Local economic conditions that affect discretionary spending include, among other things, unemployment trends, the housing market, consumer credit availability and debt levels. A deterioration in economic conditions in any of our local markets could result in a decline in our sales and profitability.

 

Our business is highly seasonal and we typically generate a significant portion of our net sales and net income for the fiscal year during our fourth fiscal quarter, which includes the November/December holiday period. Accordingly, results for our fourth fiscal quarter are not indicative of results to be expected for the full fiscal year. Historical results for our other fiscal quarters have and are likely to continue to reflect significantly lower sales and either net losses or nominal net income. In addition, because of our significant dependence on fourth quarter performance, we are particularly vulnerable to conditions that would adversely affect customer traffic, shopping patterns and holiday spending during this period.

 

Our business is highly seasonal. Our fourth quarter, which includes the holiday season from early November through the end of December, typically accounts for and is expected to continue to account for a high percentage of our annual net sales and income from operations. Our fourth fiscal quarters in fiscal 2008 and 2009 accounted for approximately 36.5% and 37.1%, respectively, of our net sales in those fiscal years and more than 100% of our total income from operations and net income in each of those fiscal years because of offsetting losses incurred in certain other quarters, particularly the third fiscal quarter. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Quarterly results and seasonality,” for information regarding our seasonality and financial results for our previous nine fiscal quarters.

 

Our operations in general, and particularly during our important fourth quarter period, can be adversely affected by any factors that reduce consumer and holiday spending, including those listed above under “— Changing economic conditions, declines in consumer confidence and spending and other drivers of customer demand for our products could materially and adversely affect our business, results of operations, financial condition and future growth plans,” and other factors such as inclement weather conditions, which are unpredictable but to which our studios are generally more susceptible during the winter months. A decrease in net sales and income from operations during our fourth quarter would materially adversely affect our results of operations for the fiscal year.

 

The ultimate resolution of an outstanding tax matter regarding a benefit we previously provided our employees could differ materially from our expectations, which could cause us to incur and recognize cash costs that materially differ from our estimates and related accruals reflected in our consolidated financial statements. In addition, our efforts to remediate this matter could continue to increase our labor and other administrative costs and adversely affect our employee relations.

 

We previously maintained an employee benefit arrangement intended to subsidize, on a tax-free basis, the cost of health insurance purchased by our employees. We recently determined that benefits we paid under this arrangement constituted taxable wage compensation, with respect to which we were obligated to withhold income and other employment taxes, instead of tax-free payments as we had intended. We have voluntarily contacted the Internal Revenue Service (the “Service”) in an effort to discharge all federal tax liabilities related to this matter. Our audited consolidated statements of income included in this prospectus for fiscal years ending after January 28, 2007, the periods for which we believe our liability is not extinguished under the applicable statute of limitations, account for our estimate of the additional labor cost related to the withholding amounts that we did not collect, as well as related tax effects attributable to reduced pre-tax income for these periods. Our consolidated balance sheets included in this prospectus include accrued liabilities for our estimates of the amounts that may be required to satisfy this liability. See Note 14 of the notes to our audited consolidated financial statements appearing elsewhere in this prospectus.

 

Our estimates and accrued liabilities with respect to this matter are based on various assumptions, including assumed rates of withholding, our ability to deduct payments made to the Service with respect to this matter, our lack of further obligation or liability with respect to a portion of these subsidy payments that we reported to certain employees as taxable income on Form 1099 (rather than taxable wages Form W-2), the manner and extent to which the Service will require us to issue corrected wage statements and the waiver of penalties and interest in light of our voluntary reporting of this matter. If one or more of these assumptions materially differ from those relied upon by the Service in calculating our tax liability, the amount or our actual liability could differ materially from the estimates recorded in our financial statements, which in turn would materially affect our reported results of operations in the period or periods in which the change in our estimate

becomes probable and can be estimated. The ultimate amount and timing of the cash payment required to resolve this matter is uncertain. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Contingencies” for a discussion of this matter and the key assumptions on which our estimates are based.

 

In our ongoing efforts to investigate and resolve this matter, we have and may continue to incur additional expenses for legal, tax and other professional advisors. This matter also may continue to require additional management time and attention, which could divert our focus from operational and other business matters. We are unable to predict the additional time and effort that may be required to resolve this matter, and these or other uncertainties could adversely affect our expenses, business, results of operations and financial condition.

 

As a result of this matter, as well as the prospective impact of the recently enacted federal healthcare reform legislation, we are considering alternative approaches to providing some type of health-related benefit to our employees. As an interim measure, we have increased the wage rate of our current employees to permit them to continue to receive approximately the same after-tax wage rate that they received prior to our change in practice to withhold taxes on this intended benefit payment. This increase is slightly more than our average wage rate reflected in our labor costs for fiscal 2009. If we decide to address the issue on a long-term basis by offering a health benefit plan in lieu of providing the cash payments we have previously provided and the interim make-whole wage increase, our employee relations could be adversely affected, particularly with respect to those employees who elected not to use our former subsidy payment to purchase health insurance. Despite our efforts to manage the impact of this issue on our employees, our employee relations could be adversely affected to the extent that our employees may be, or perceive that they are, prejudiced by the income tax, benefits, or wage rate impact of our approach to resolving the tax issue and implementing a substitute benefit.

 

We have identified a material weakness related to our internal control in the past, and there can be no assurance that material weaknesses will not be identified in the future.

 

In connection with our discovery of the noncompliance described above with respect to the structure and administration of our intended health premium subsidy program, we identified a material weakness in our internal control over financial reporting and were required to restate previously issued financial statements. This material weakness related to the inadequacy of internal controls to monitor compliance with tax regulations regarding an employee benefit plan, as described above. In addition, our efforts to remediate this matter could continue to increase our labor and other administrative costs and adversely affect our employee relations.” Although we believe we have remediated this material weakness, we cannot assure you that other material weaknesses will not occur or be discovered in the future. As a public company, we will be required to implement more rigorous procedures and testing of our internal controls, which will increase the cost and complexity of our compliance efforts and could result in the identification of additional material weaknesses or other matters requiring remediation.

 

Maintaining and improving our financial controls and the requirements of being a public company will increase our costs and may create compliance risks, strain our resources, divert management’s attention and affect our ability to attract and retain qualified board members.

 

We have never operated as a public company. As a public company, we will be subject to the reporting requirements of the Securities Exchange Act of 1934, or the Exchange Act, the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, and The NASDAQ Stock Market rules. The requirements of these rules and regulations will significantly increase our legal and financial compliance costs, including costs associated with the hiring of additional personnel, making some activities more difficult, time-consuming or costly, and may also place undue strain on our personnel, systems and resources. Other than Mr. Bailey, our Chief Financial Officer, Vice President of Finance and Investor Relations, none of our senior accounting or finance staff has had prior experience with or responsibility for such compliance matters for a public company. If we fail to assemble appropriate compliance policies or personnel or otherwise fail to satisfy these requirements in a

timely matter, such failure could result in regulatory sanctions, penalties, stockholder lawsuits and could adversely affect our reputation, stock price or financial condition.

 

The Exchange Act requires, among other things, that we file annual, quarterly and current reports with respect to our business, results of operations and financial condition, in addition to certain other events and circumstances. The Sarbanes-Oxley Act requires, among other things, that we maintain effective disclosure controls and procedures and internal control over financial reporting. As discussed above, we have previously identified a material weakness in our internal control over financial reporting relating to the tax treatment of a benefit we previously provided to our employees and have had to restate previously issued financial statements. Ensuring that we have adequate internal financial and accounting controls and procedures in place is a costly and time-consuming effort that must be re-evaluated frequently. Section 404 of the Sarbanes-Oxley Act will require annual assessments of the effectiveness of our internal control over financial reporting by our management and a report by our independent registered public accounting firm auditing our effectiveness of internal control over financial reporting beginning with fiscal year 2011 under current rules of the Securities and Exchange Commission, or SEC. Both we and our independent registered public accounting firm will be testing our internal controls in connection with the Section 404 requirements and, as part of that documentation and testing, we could identify material weaknesses, significant deficiencies or other areas for further attention or improvement. Implementing any appropriate changes to our internal controls may require specific compliance training for our directors, officers and employees, require the hiring of additional finance, accounting, legal and other personnel, entail substantial costs to modify our existing accounting systems, and take a significant period of time to complete. Such changes may not, however, be effective in maintaining the adequacy of our internal controls, and any failure to maintain that adequacy, or consequent inability to produce accurate financial statements on a timely basis, could increase our operating costs and materially impair our ability to operate our business. Moreover, effective internal controls are necessary for us to produce reliable financial reports and are important to help prevent fraud. As a result, our failure to satisfy the requirements of Section 404 on a timely basis could result in the loss of investor confidence in the reliability of our financial statements, which in turn could cause the market value of our common stock to decline.

 

Various rules and regulations applicable to public companies make it more difficult and more expensive for us to maintain directors’ and officers’ liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to maintain coverage. If we are unable to maintain adequate directors’ and officers’ insurance, our ability to recruit and retain qualified officers and directors, especially those directors who may be deemed independent for purposes of The NASDAQ Stock Market rules and the Exchange Act rules, will be significantly curtailed. Although we expect that our appointment of two new directors effective upon consummation of this offering will enable us to satisfy the initial listing rules of The NASDAQ Stock Market regarding the composition of our Board of Directors and its key committees, under applicable phase-in rules we will need to appoint at least one other independent director within one year of the commencement of the listing of our common stock on NASDAQ in order to be fully compliant with these requirements. If we should fail to recruit and retain such an additional director on a timely basis or otherwise fail to maintain a Board of Directors composed of persons who enable us to meet these requirements, our common stock could be delisted from The NASDAQ Stock Market, which would likely have a material adverse effect on the liquidity and trading price of our common stock.

 

Our failure to attract and retain an increasing number of qualified studio managers, associates and part-time employees, especially in light of our growth strategy, could adversely affect our business and growth prospects.

 

Our business model and future growth are highly dependent on our ability to attract, promote, retain and motivate qualified, well-educated studio associates and managers who understand, appreciate and effectively represent our corporate culture and are able to establish credibility with our customers. If we are unable to hire and retain such studio personnel, our ability to open new studios may be impaired, the performance of our existing and new studios could be materially adversely affected and our brand image may be negatively impacted. We are also dependent upon part-time personnel to adequately staff our studios, particularly during peak periods such as the November/December holiday season. There is no assurance that sufficient sources of

qualified full-time and part-time personnel will be available if and when needed to meet our demands. Any such failure to meet our staffing needs or any material increases in our employee turnover rates could have a material adverse effect on our business, results of operations and financial condition.

 

Failures or interruptions of, or a breach in security relating to, our information systems could adversely affect us.

 

We rely heavily on communications and information systems to conduct our business operations and support our process-driven approach. All of our studios are connected to our corporate headquarters through our virtual private network. We also rely on numerous internet-based systems to operate and manage our business. Any failure, interruption or breach in security of these systems, including any failure of our back-up systems, could harm or disrupt our ability to operate and centrally manage our business. In addition, any occurrence of or perception that we have made an unauthorized disclosure of confidential customer information, such as personally identifiable information, payment information or portraits, could adversely affect our standing with customers and expose us to the risk of litigation and liability. Any such occurrences could result in reputational damage or loss of business or goodwill and could adversely affect our business, results of operations and financial condition.

 

We depend on key vendors and suppliers to provide us with the equipment, materials and services we need to operate our business. Any events that would impair these relationships or hinder our ability to continue sourcing these items at competitive prices could increase our operating costs, decrease our operating efficiencies and otherwise adversely affect our business, results of operations and financial condition.

 

We rely on key vendors and suppliers to provide the equipment, materials and services necessary for our business operations, including our photographic and printing supplies and equipment and other technical equipment for our studios, as well as construction and studio installation services for the development and outfit of our new studios. In particular, we purchase all of our photographic paper, processing chemistry and photographic printers from Fujifilm North America Corporation (“Fuji”) and have related supply and maintenance contracts with Fuji that govern the terms of our purchases from Fuji and the support, service, maintenance and repair on the equipment we purchase. Our supply contract with Fuji expires in January 2011. In addition, we use a single firm to coordinate the installation of furniture, fixtures and equipment in our new studios. The occurrence of any events that would disrupt or impair our ability to continue obtaining these needed goods or services from our vendors on a timely basis, or any material increase in the cost of these goods and services, could disrupt our operations, increase our operating costs and harm our competitive position. Numerous contingencies beyond our control, including deterioration in any of our key vendors’ financial condition, their failure to perform as we expect, their failure to follow our vendor guidelines or comply with applicable laws and regulations in performing on our behalf, could expose us to operational, competitive and legal risks that may harm our business.

 

We are required to make substantial lease payments under our operating leases and any failure to make these lease payments when due would likely have a material adverse effect on our business and growth plans.

 

We do not own any of our studios or our corporate facilities but instead we lease all of these facilities under operating leases. Payments under these operating leases have historically been one of our largest expenses. For example, our total rent expense in fiscal 2009 was $11.7 million, or 10.6% of our net sales. As of January 31, 2010, we were a party to operating leases requiring future minimum lease payments aggregating approximately $58.6 million through fiscal 2014. We expect that we will also lease our new studio locations, which will further increase our operating lease expenses and commitments.

 

We depend on cash flow from operations to pay our lease expenses. If our business does not generate sufficient cash flow from operations, and sufficient funds are not otherwise available to us from borrowings under bank loans or from other sources, we may not be able to service our operating leases, grow our

business, respond to competitive challenges or fund our other liquidity and capital needs, which would have a material adverse effect on our business, results of operations and financial condition.

 

We currently have indebtedness and may also incur additional indebtedness in the future, and such indebtedness could adversely affect our financial health and harm our ability to react to changes to our business and opportunities. Any future indebtedness may contain covenants that further limit our business activities.

 

As of August 1, 2010, we had approximately $10.0 million of indebtedness outstanding under our revolving credit facility. We may also incur additional indebtedness in the future for any number of reasons, including, among others, to finance our operations and growth strategy, upgrade our business systems or technology, respond to competitive conditions in our industry, pursue strategic business ventures, to settle contingent tax liabilities or other reasons. Any increase in the amount of our indebtedness could require us to divert funds identified for other purposes to debt servicing and impair our liquidity position. If we cannot generate sufficient cash flow from operations to service such debt, we may need to refinance such debt, dispose of assets or issue equity to obtain necessary funds. We do not know whether we would be able to take any of such actions on a timely basis, on terms satisfactory to us or at all.

 

In addition, any indebtedness that we incur in the future may limit our flexibility and ability to execute our business strategy by imposing conditions that, among other things:

 

 

We cannot assure you that our business will generate sufficient cash flow from operations or that future borrowings will be available to us in amounts sufficient to enable us to make payments on our indebtedness or to fund our operations, which could have a material adverse effect on our business, results of operations and financial condition.

 

We may be unable to adequately protect our intellectual property rights or avoid infringing the intellectual property rights of third parties, and the intellectual property rights we have may not be a meaningful barrier to competition.

 

We rely primarily on trademark, copyright and trade secret laws, confidentiality procedures and contractual provisions to protect our proprietary interests in our business and software. Despite our efforts, we can give no assurance that our intellectual property rights are adequate to prevent others from developing software platforms or using brands that are substantially similar to our own and upon which we rely to provide a differentiated and recognized portrait experience. Competitors may adopt brand names similar to our trademark “PORTRAIT INNOVATIONS,” and owners of similar registered trademarks may bring trade name or trademark infringement claims against us. Further, policing our proprietary rights is difficult and may not always be effective, and most of our efforts to protect our intellectual property rights, including the registration of our trademark, have been limited to the U.S. Thus, we can provide no assurance that others do

not have superior rights to use our intellectual property in other countries. Others may assert claims that our trademarks or copyrights in our proprietary software or materials are invalid or infringe upon their intellectual property rights. If such disputes were to occur, we may not be able to resolve them to our satisfaction. In addition, the laws of certain countries may not protect proprietary rights to the same extent as do the laws of the U.S. Our inability to protect or maintain exclusive use of our intellectual property could adversely affect our business operations.

 

Unauthorized parties may copy aspects of our software or obtain and use information that we hold as trade secrets and regard as proprietary. In addition, in the course of seeking patent protection, we were required to publicly disclose information related to our software sufficient to enable others with “ordinary skill” in the relevant technology area to practice our invention. Third parties may be able to legally circumvent our proprietary rights by independently developing software that is substantially similar to our own, and our disclosure could assist such development.

 

We have issued patents and pending patent applications related to certain aspects of our proprietary software. Valid patents may not issue from our pending applications, and our issued patents, along with any claims in our pending applications that are allowed, may be challenged, invalidated or circumvented, or may not be sufficiently broad to foreclose potential competitors from developing similar new technologies. Additionally, our issued foreign patents would not provide us any protection in the U.S. and vice versa. Furthermore, costly and time consuming litigation could be necessary to enforce and determine the scope of our patents.

 

In addition, in its recent decision in Bilski v. Kappos, the Supreme Court of the United States reemphasized that abstract ideas are not patentable as business methods, but that business methods may be patentable processes if they otherwise satisfy the requirements of the U.S. Patent Act — such methods are novel, nonobvious and fully and particularly described. The continued emphasis on the unpatentability of abstract ideas could result in at least some of our existing patents being rendered invalid and unenforceable or could result in the denial of one or more of our pending patent applications.

 

Changes in laws and regulations that currently or prospectively apply to our business, as well as changes in our employee benefits practices, could adversely affect our cost of operations, employee relations and profitability.

 

Our business is subject to numerous federal and state laws and regulations that govern, among things other than environmental and health and safety matters as discussed below, tax and employment matters. From time to time, changes are proposed to these laws and regulations that, if enacted, could materially increase our cost of operations. For example, the recently enacted federal healthcare reform legislation could significantly increase our employee costs by requiring us either to provide health insurance coverage to our employees or to pay certain penalties for electing not to provide such coverage. Because these new requirements are broad, complex, subject to certain phase-in rules and may be challenged by legal actions in the coming months and years, it is difficult to predict the ultimate impact that this legislation will have on our business and operating costs. We cannot assure you that this legislation or any alternative version that may ultimately be implemented will not materially increase our operating costs. This legislation could also adversely affect our employee relations and ability to compete for new employees if our response to this legislation is considered less favorable than the responses or health benefits offered by employers with whom we compete for talent. In addition, for the reasons discussed above in “— The ultimate resolution of an outstanding tax matter regarding a benefit we previously provided our employees could differ materially from our expectations, which could cause us to incur and recognize cash costs that materially differ from our estimates and related accruals reflected in our consolidated financial statements. In addition, our efforts to remediate this matter could continue to increase our labor and other administrative costs and adversely affect our employee relations,” we are currently reevaluating the type and structure of health-related benefits we provide, and our ultimate resolution of these matters could also increase our labor costs or adversely affect our employee relations. Other possible regulatory initiatives that would mandate minimum levels of employee benefits, including those regarding leaves of absence, paid time off or overtime pay, or that would increase business taxes or otherwise increase our cost of complying with applicable laws and regulations, could adversely affect our operating costs. In addition, changes in interpretations of existing laws and regulations could materially increase our costs of compliance.

Our activities, particularly those relating to the handling, storage and disposal of our photographic processing chemicals, are subject to environmental, health and safety laws and regulation by governmental authorities in the United States, and our failure to comply with those regulations or obtain or maintain necessary permits could adversely affect our business, financial condition and studio openings and operations.

 

Among other things, environmental laws and regulations address the generation, handling, storage, transportation, treatment and disposal of waste materials, and the health and safety of our employees. These laws generally require us to obtain and maintain various licenses and permits, and our failure to maintain these permits for our existing studios or timely obtain them for new studios could delay or prevent us from operating existing studios or opening new studios. We are also potentially subject to strict, joint and several liability for investigating and remediating any spills and other releases of hazardous substances at our current or former properties or third-party waste disposal sites. Most environmental laws provide for substantial fines and potential criminal sanctions for violations. In addition, the federal Occupational Safety and Health Administration, or OSHA, and similar state regulations, require that we maintain information about hazardous materials used or produced in our operations and that we provide this information to employees, state and local governmental authorities, and local residents. Environmental, health and safety laws and regulations are complex, change frequently and have tended to become stricter over time. Some of these laws and regulations are subject to varying and conflicting interpretations. We can give no assurance that violations of, or liability under, such laws, regulations, permits or licenses will not be identified or occur in the future, or that such laws and regulations will not change in a manner that could impose material costs on us.

 

As we continue to grow our business and expand our operations, we face increasing risk of involvement in litigation or regulatory proceedings that could distract management from our business activities and result in significant liability or damage to our business, results of operations, financial condition and brand image.

 

As we expand our operations, we increasingly face the risk of litigation and other claims against us. Litigation and other claims arise in the ordinary course of our business and may include, among other things, employee claims, commercial disputes, intellectual property issues, product-oriented allegations, environmental claims and compliance issues and personal injury claims. These cases frequently raise complex factual and legal issues, which are subject to risks and uncertainties and could divert significant management time. Litigation and other claims against us could result in unexpected material expenses and liability, as well as adversely affect our business, results of operations, financial condition and reputation.

 

We may be subject to unionization, work stoppages, slowdowns or increased labor costs, especially if the Employee Free Choice Act is adopted.

 

Currently, none of our employees is represented by a union. However, our employees have the right at any time under the National Labor Relations Act to form or affiliate with a union. If some or all of our workforce were to become unionized and the terms of the collective bargaining agreement were significantly different from our current compensation arrangements, it could increase our costs and adversely impact our profitability. A federal legislative initiative known as the Employee Free Choice Act, which could make it easier for workers to obtain union representation and increase the penalties employers may incur if they engage in labor practices in violation of the National Labor Relations Act, was passed by the United States House of Representatives in 2007, and revised versions of this proposed legislation were reintroduced in 2009 and are currently under consideration in both the United States House and Senate. President Obama and leaders of Congress have made public statements in support of this bill. Accordingly, this bill or a variation of it could be enacted in the future, and the enactment of this bill could have an adverse impact on our employee relations, business and financial condition.

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

 

Although we retain legal ownership of all the images we capture and print, including those we sell to our customers, we must rely on copyright laws and encryption software used in connection with our digital images to protect our proprietary rights in our photographs. Despite our efforts to prevent unauthorized reproduction of our photographs, our encryption software could be circumvented to allow high-resolution reproduction of the digital images we provide on CD with many of our portrait collections or our printed photographs could be copied. In practice, we recognize that unauthorized reproduction of photographs occurs within our industry and that our ability to prevent piracy and enforce our proprietary rights in our photographs is limited. A significant increase in the frequency of unauthorized reproduction of our photographs could materially adversely affect our business, results of operations and financial condition.

 

Risks related to this offering

 

Concentration of ownership among our existing executive officers, directors and principal stockholders may prevent new investors from influencing significant corporate decisions.

 

Upon consummation of this offering our executive officers, directors and current principal stockholders will own, in the aggregate, approximately     % of our outstanding common stock and will own options that will enable them to own, in the aggregate, approximately     % of our outstanding common stock. As a result, these stockholders will be able to exercise control over all matters requiring stockholder approval, including the election of directors, amendments of our amended and restated certificate of incorporation, amendments to our bylaws and approval of significant corporate transactions and will have significant control over our management and policies. We currently expect that, upon the consummation of this offering, two of the six members of our Board of Directors will be principals of Southeastern Private Investment Fund IV, LLC and Emergo Alpha Fund Limited. These stockholders will collectively control     % of our outstanding common stock upon consummation of this offering, and can take actions that have the effect of delaying or preventing a change in control of us or discouraging others from making tender offers for our shares, which could prevent stockholders from receiving a premium for their shares. These actions may be taken even if other stockholders oppose them. The concentration of voting power between Southeastern Private Investment Fund IV, LLC and Emergo Alpha Fund Limited may have an adverse effect on the price of our common stock. The interests of these stockholders may not be consistent with your interests as a stockholder. After the lock-up period expires, these stockholders would be able to transfer control of our company to a third-party by transferring their common stock, which would not require the approval of our Board of Directors or our other stockholders. See “— Future sales of our common stock, or the perception in the public markets that these sales may occur, may depress our stock price.”

 

In addition, our amended and restated certificate of incorporation will provide that the provisions of Section 203 of the Delaware General Corporation Law, or the DGCL, that relate to business combinations with interested stockholders will apply to us. Section 203 of the DGCL prohibits a publicly held Delaware corporation from engaging in a business combination transaction with an interested stockholder for a period of three years after the interested stockholder became such unless the transaction fits within an applicable exemption, such as board approval of the business combination or the transaction which resulted in such stockholder becoming an interested stockholder. Therefore, Southeastern Private Investment Fund IV, LLC and Emergo Alpha Fund Limited will not be deemed “interested stockholders” by virtue of these exemptions. The provisions of Section 203 of the DGCL may delay, prevent or deter a merger, acquisition, tender offer or other transaction that might otherwise result in our stockholders receiving a premium over the market price of their common stock.

 

Our stock price may be volatile and you may be unable to resell your shares at or above the offering price or at all.

 

Prior to this offering, there has been no public market for our common stock. The initial public offering price for our common stock will be determined through negotiations between us and the representatives of the

underwriters and market conditions, and may not be indicative of the market price of our common stock after this offering. If you purchase shares of our common stock, you may not be able to resell those shares at or above the initial public offering price. We cannot predict the extent to which investor interest in our company will lead to the development of an active trading market on The NASDAQ Global Market or how liquid that market might become. An active public market for our common stock may not develop or be sustained after the offering. If an active public market does not develop or is not sustained, it may be difficult for you to sell your shares of common stock at a price that is attractive to you, or at all.

 

After this offering, the market price for our common stock is likely to be volatile, in part because our shares have not been traded publicly. In addition, the market price of our common stock may fluctuate significantly in response to a number of factors, including our results of operations and financial performance (including changes in comparable studio sales), changes in our business and financial condition, the success of our expansion plans and certain other factors, most of which we cannot control, including:

 

 

In addition, the stock markets, and in particular The NASDAQ Global Market, have experienced extreme price and volume fluctuations that have affected and continue to affect the market prices of equity securities of many retail companies. In the past, stockholders have instituted securities class action litigation following periods of market volatility. If we were involved in securities litigation, we could incur substantial costs and our resources and the attention of management could be diverted from our business.

 

Future sales of our common stock, or the perception in the public markets that these sales may occur, may depress our stock price.

 

Sales of substantial amounts of our common stock in the public market after this offering, or the perception that these sales could occur, could adversely affect the price of our common stock and could impair our ability to raise capital through the sale of additional shares. Upon completion of this offering, we will have           shares of common stock outstanding. The shares of common stock offered in this offering will be freely tradable without restriction under the Securities Act of 1933, as amended, or the Securities Act,

except for any shares of our common stock that may be held or acquired by our directors, executive officers and other affiliates, as that term is defined in the Securities Act, which will be restricted securities under the Securities Act. Restricted securities may not be sold in the public market unless the sale is registered under the Securities Act or an exemption from registration is available.

 

We, our directors and executive officers and certain of our significant stockholders have entered into lock up agreements with the underwriters prior to the commencement of this offering pursuant to which we and each of these persons or entities for a period of 180 days after the date of this prospectus, may not, subject to limited exceptions, without the prior written consent of J.P. Morgan Securities Inc. and Wells Fargo Securities, LLC, offer, pledge, announce the intention to sell, grant any option, right or warrant to purchase, or otherwise transfer or dispose of, directly or indirectly, any shares of our common stock (including, without limitation, common stock which may be deemed to be beneficially owned by such directors, executive officers, managers and members in accordance with the rules and regulations of the SEC and securities which may be issued upon exercise of a stock option or warrant) or enter into any swap or other agreement that transfers, in whole or in part, any of the economic consequences of ownership of the common stock. J.P. Morgan Securities Inc. and Wells Fargo Securities, LLC may, in their sole discretion, waive these restrictions at any time without notice. See “Underwriting.”

 

After 180 days from the date of this prospectus, subject to certain extensions, all of our shares of common stock outstanding as of the date of this prospectus held by stockholders who have agreed to the restrictions described in the preceding paragraph may be sold in the public market, subject to applicable volume and other limitations imposed under federal securities laws. See “Shares Eligible for Future Sale” for a more detailed description of the restrictions on selling shares of our common stock after this offering.

 

After this offering, holders of approximately           shares of our common stock will have the right to require us to register the sales of their shares under the Securities Act, under the terms of an agreement between us and the holders of these securities. See “Description of Capital Stock — Registration rights” for a more detailed description of these rights.

 

In the future, we may also issue our securities in connection with investments or acquisitions. The amount of shares of our common stock issued in connection with an investment or acquisition could constitute a material portion of our then-outstanding shares of our common stock.

 

If securities or industry analysts do not publish research or publish inaccurate or unfavorable research about our business, our stock price and trading volume could decline.

 

The trading market for our common stock will depend in part on the research and reports that securities or industry analysts publish about us or our business. We do not currently have and may never obtain research coverage by securities and industry analysts. If no securities or industry analysts commence coverage of our company, the trading price for our common stock could be negatively affected. If we obtain securities or industry analyst coverage and if one or more of the analysts who covers us downgrades our common stock or publishes inaccurate or unfavorable research about our business, our stock price could decline. If one or more of these analysts ceases coverage of us or fails to publish reports on us regularly, demand for our common stock could decrease, which could cause our stock price and trading volume to decline.

 

Our management will have broad discretion over the use of the proceeds we receive in this offering and might not apply the proceeds in ways that increase the value of your investment.

 

Our management will have broad discretion to use the net proceeds to us from this offering, and you will be relying on the judgment of our management regarding the application of these proceeds. Our management might not apply the net proceeds from this offering in ways that increase the value of your investment. Other than the repayment of debt outstanding under our revolving credit facility and payment of all accrued and unpaid dividends on our preferred stock, we expect to use the balance of the net proceeds to us from this offering for working capital and other general corporate purposes, including our expansion strategy and the costs of operating as a public company. Until we use the remaining net proceeds to us from this offering, we plan to invest them, and these investments may not yield a favorable rate of return. If we do not invest or

apply the net proceeds from this offering in ways that enhance stockholder value, we may fail to achieve expected financial results, which could cause our stock price to decline.

 

We do not expect to pay any cash dividends for the foreseeable future.

 

The continued operation and expansion of our business will require substantial funding. Accordingly, we do not anticipate that we will pay any cash dividends on shares of our common stock for the foreseeable future. Any determination to pay dividends in the future will be at the discretion of our Board of Directors and will depend upon results of operations, financial condition, contractual restrictions, restrictions imposed by applicable law and other factors our Board of Directors deems relevant. Our ability to pay cash dividends on our common stock is limited by the covenants of our revolving credit facility and may be further restricted by the terms of any of our future indebtedness or preferred securities. Accordingly, if you purchase shares in this offering, realization of a gain on your investment will depend on the appreciation of the price of our common stock, which may never occur. Investors seeking cash dividends in the foreseeable future should not purchase our common stock.

 

Anti-takeover provisions in our charter documents and Delaware law might discourage or delay acquisition attempts for us that you might consider favorable.

 

Our amended and restated certificate of incorporation and amended and restated bylaws will contain provisions that may make the acquisition of our company more difficult without the approval of our Board of Directors. These provisions:

 

 

These anti-takeover provisions and other provisions under Delaware law could discourage, delay or prevent a transaction involving a change in control of our company, even if doing so would benefit our stockholders. These provisions could also discourage proxy contests and make it more difficult for you and other stockholders to elect directors of your choosing and to cause us to take other corporate actions you desire. See “Description of Capital Stock — Anti-takeover effects of our certificate of incorporation and bylaws and Delaware law” for more information regarding these provisions.

If you purchase shares of common stock sold in this offering, you will incur immediate and substantial dilution.

 

If you purchase shares of common stock in this offering, you will incur immediate and substantial dilution in the amount of $      per share because the initial public offering price of $      is substantially higher than the pro forma net tangible book value per share of our outstanding common stock. This dilution is due in large part to the fact that our earlier investors paid substantially less than the initial public offering price when they purchased their shares. In addition, you may also experience additional dilution upon future equity issuances or the exercise of stock options to purchase common stock granted to our employees and directors under our stock option and equity incentive plans. See “Dilution.”

 

This prospectus contains forward-looking statements that reflect our views about future events and financial performance. Forward-looking statements typically are identified by words such as “may,” “will,” “should,” “anticipate,” “estimate,” “expect,” “plan,” “believe,” “predict,” “potential,” “intend,” “continue” and similar expressions, although some forward-looking statements are expressed differently. These forward-looking statements are based on current expectations, estimates, forecasts and projections about our business and our industry, as well as management’s beliefs and assumptions. Forward-looking statements are subject to known and unknown risks, uncertainties and other factors, including those set forth in “Risk Factors,” that could cause actual results to differ materially from those projected. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this prospectus. You should consider carefully the statements under “Risk Factors” and in other sections of this prospectus, which address additional factors that could cause our actual results to differ materially from those set forth in or implied by the forward-looking statements.

 

We believe that the risks and uncertainties include, but are not limited to, the factors discussed under the heading “Risk Factors,” such as the following:

 

 

 

Although we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, level of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of any of these forward-looking statements. We are under no duty to update any of these forward-looking statements after the date of this prospectus to conform our prior statements to actual results or revised expectations. If we do update one or more forward-looking statements, no inference should be drawn that we will make additional updates with respect to those or other forward-looking statements.

 

We estimate that the net proceeds of the sale of the common stock that we are offering will be approximately $      million, assuming an initial public offering price of $      per share, which is the mid-point of the range listed on the cover page of this prospectus, and after deducting estimated underwriting discounts and commissions and estimated offering expenses payable by us.

 

We will not receive any of the proceeds from the sale of shares of common stock by the selling stockholders, including upon the exercise, if any, of the underwriters’ over-allotment option.

 

We intend to use the net proceeds of the sale of the shares we are offering:

 

 

 

 

Our revolving credit facility matures on February 1, 2012 and bears interest at a floating rate, which was 2.81% as of August 1, 2010. In the past year, we applied the borrowings under our revolving credit facility to repay and replace a prior loan facility with our lender, for working capital and for other general corporate purposes.

 

Prior to the application of the net proceeds for these purposes, we intend to invest the net proceeds in short-term, interest bearing, investment-grade instruments, bank certificates of deposit and other interest-bearing bank deposits or direct or guaranteed obligations of the United States government.

 

We do not expect to pay dividends on our common stock in the foreseeable future. We anticipate that we will retain future earnings, if any, to support our operations and to finance the growth and development of our business. In addition, because we are a holding company whose primary asset is the equity interest in our subsidiary, our ability to pay dividends to our stockholders in the future will depend upon the receipt of distributions from our subsidiary. Our ability to pay cash dividends on our common stock is limited by the covenants of our revolving credit facility and may be further restricted by the terms of any of our future debt or preferred securities.

 

The following table sets forth our cash and cash equivalents and capitalization as of August 1, 2010:

 

 

You should read this table together with “Use of Proceeds,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Description of Capital Stock” and our consolidated financial statements and related notes thereto included elsewhere in this prospectus.

 

 

 

 

The above table does not include:

 

 

 

If you invest in our common stock, your ownership interest will be diluted to the extent of the difference between the initial public offering price per share of our common stock and the net tangible book value per share of common stock upon completion of this offering. Dilution results from the fact that the per share offering price of our common stock is substantially in excess of the book value per share attributable to the shares of our common stock held by existing equity holders.

 

Our historical net tangible book value as of August 1, 2010 was $27.4 million or $6.28 per share of our common stock. Our historical net tangible book value per share represents the amount of our total tangible assets less total liabilities, divided by the number of shares of common stock outstanding.

 

Our pro forma net tangible book value as of August 1, 2010 was approximately $27.4 million, or $3.22 per share of our common stock. Pro forma net tangible book value per share represents the amount of our tangible assets less total liabilities, divided by the total number of shares of common stock outstanding after giving effect to the conversion of all outstanding shares of our convertible preferred stock into an aggregate of 4,154,258 shares of common stock upon the closing of this offering.

 

After giving effect to the issuance and sale by us of           shares of common stock in this offering at an assumed initial public offering price of $      per share, which is the mid-point of the price range listed on the cover page of this prospectus, less underwriting discounts and commissions and estimated offering expenses payable by us, our pro forma as adjusted net tangible book value as of August 1, 2010 would have been $      million, or $      per share. This represents an immediate increase in pro forma net tangible book value per share of $      to existing stockholders and immediate dilution of $           in pro forma net tangible book value per share to new investors purchasing common stock in this offering. Dilution per share to new investors is determined by subtracting pro forma as adjusted net tangible book value per share after this offering from the initial public offering price per share paid by new investors. The following table illustrates this dilution on a per share basis:

 

 

A $1.00 increase (decrease) in the assumed initial public offering price of $      per share, which is the mid-point of the price range listed on the cover page of this prospectus, would increase (decrease) our pro forma as adjusted net tangible book value per share by $      and the dilution per share to the new investors by $     , in each case assuming the number of shares offered, as set forth on the cover page of this prospectus, remains the same and after deducting underwriting discounts and commissions and estimated offering expenses payable by us.

 

If any shares are issued upon exercise of outstanding options you will experience further dilution.

 

The following table summarizes, as of August 1, 2010, the differences between the average price per share paid by our existing stockholders and by new investors purchasing shares of common stock in this offering at an assumed initial public offering price of $      per share, which is the mid-point of the range listed on the cover page of this prospectus, before deducting estimated underwriting discounts and commissions and offering costs payable by us:

 

A $1.00 increase (decrease) in the assumed initial public offering price of $      per share, which is the mid-point of the price range listed on the cover page of this prospectus, would increase (decrease) total consideration paid by new investors by $      million, total consideration paid by all stockholders by $      and the average price per share paid by all stockholders by $      , in each case assuming the number of shares offered, as set forth on the cover page of this prospectus, remains the same and after deducting underwriting discounts and commissions and estimated offering expenses payable by us.

 

The discussion and tables above are based on the number of shares of common stock outstanding as of August 1, 2010 after giving effect to the conversion of all outstanding shares of our convertible preferred stock into 4,154,258 shares of common stock upon the closing of this offering and excludes:

 

 

 

If all of our outstanding options had been exercised as of August 1, 2010, assuming the treasury stock method, our pro forma net tangible book value as of August 1, 2010 would have been approximately $      million or $      per share of our common stock, and the pro forma net tangible book value after giving effect to this offering would have been $      per share, representing dilution in our pro forma net tangible book value per share to new investors of $     .

 

The selected consolidated financial information and operating data below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited and unaudited financial statements and notes thereto included elsewhere in this prospectus. We have derived the consolidated statements of income data for the years ended February 3, 2008, February 1, 2009 and January 31, 2010 and the consolidated balance sheet data as of February 1, 2009 and January 31, 2010 from our audited consolidated financial statements included elsewhere in this prospectus. We have derived the consolidated statement of income data for the years ended January 29, 2006 and January 28, 2007 and consolidated balance sheet data as of January 29, 2006, January 28, 2007 and February 3, 2008 from our audited consolidated financial statements not included in this prospectus. We have derived the consolidated statements of income data for the twenty-six weeks ended August 2, 2009 and August 1, 2010 and the consolidated balance sheet data as of August 1, 2010 from our unaudited condensed consolidated financial statements included elsewhere in this prospectus. We have derived the consolidated balance sheet data as of August 2, 2009 from our unaudited condensed consolidated financial statements not included in this prospectus. Our historical results for any prior period are not necessarily indicative of results to be expected in any future period.

 

 

 

 

The following table sets forth the reconciliation of net income (loss) to EBITDA:

 

 

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the historical financial statements and notes thereto included elsewhere in this prospectus. The discussion in this section contains forward-looking statements that are based on our current expectations. These forward-looking statements contained herein include, without limitation, statements regarding industry outlook, our expectations and estimates concerning our future performance, cost of goods sold, selling and advertising expenses, general and administrative expenses, depreciation and amortization, income from operations, studio square footage expansion, net sales, comparable studio sales, liquidity and capital resources and other non-historical statements. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in “Risk Factors” and “Forward-looking Statements,” which we urge you to carefully review. Actual results may differ materially from those contained in or implied by any forward-looking statements.

 

We operate on a fiscal calendar used by many companies in the retail industry that results in a given fiscal year consisting of a 52- or 53-week period ending on the Sunday nearest the January month end. For example, references to “fiscal 2009” refer to the fiscal year ended January 31, 2010 and references to “fiscal 2008” refer to the fiscal year ended February 1, 2009.

 

Overview

 

We are a fast-growing retail operator of free-standing portrait studios under the Portrait Innovations brand name. We provide our customers with high-quality portraits typically within an hour and a half of entering our studio by integrating sophisticated photography techniques with state-of-the-art, on-site digital imaging and printing technologies. We locate our free-standing studios in high-visibility, high-traffic, open-air lifestyle and power centers that we believe have become the preferred shopping destination for U.S. consumers due to accessibility and convenience. As of August 1, 2010, we operated 188 studios across 41 states.

 

Under the leadership of our President and Chief Executive Officer, John Grosso, we have grown net sales from $43.0 million for fiscal 2006 to $111.0 million for fiscal 2009, representing a compound annual growth rate of 37.2%. Over the same period we have grown net income from $1.3 million to $2.5 million and our EBITDA from $7.0 million to $16.5 million. We have achieved positive comparable studio sales in every year since opening our first studio in 2002. We believe our business performs well through economic cycles, including the recent economic downturn, demonstrated by our comparable studio sales increases over prior periods of 11.3% in fiscal 2008 and 6.9% in fiscal 2009. Comparable studio sales increased 4.7% for the first twenty-six weeks of fiscal 2010.

 

We intend to accelerate the expansion of our studio base in new and existing markets. Based on our operating experience, we believe the U.S. market can support over 850 Portrait Innovations studios. During the past five fiscal years, we have opened an average of 30 new studio locations per year. We intend to open approximately 30 new studios in fiscal 2010 and increase our studio base by approximately 20% annually thereafter.

 

Our sales are primarily derived from photographic portraits that we produce on-site only after our customers have ordered them. Unlike typical specialty retailers, we do not purchase retail merchandise in advance of knowing specific customer demand. As a result, our inventory costs, which principally consist of photographic paper and chemicals used in the printing process, are relatively low and we are not subject to the ongoing risks of planning and purchasing inventory in advance of sales.

 

Our average investment for the studios we opened during fiscal 2009 was $365,000, which includes the cost of our digital imaging and display equipment, studio fixtures net of landlord contributions, and initial inventory investment of approximately $5,000. For new studios, we target a pre-tax cumulative cash payback on our net investment within three years. New studios typically experience rapid sales growth in their first four years of operation as they gain recognition in their markets and new and repeat customer traffic increases. Based upon historical operating performance, we expect new studios to generate on average, approximately

$473,000 in sales in their first year of operation. We expect mature studios to generate, on average, approximately $1 million in annual sales.

 

We seek to increase our net sales through increases in comparable studio sales, as well as by opening new studios. We seek to maximize our comparable studio sales by maintaining consistent studio-level execution and generating increased customer traffic. We plan to continue to implement a variety of initiatives to enhance sales productivity in our studios, which we believe already generate the highest average studio sales volume of any major chain in the portrait industry. These initiatives include: testing and, as appropriate, adding new portrait collections and products to better satisfy our customers’ varied tastes and budgets; implementing new digital imaging technologies to further differentiate the quality, speed and value of our portrait experience; and marketing to select target customers to enhance customer traffic during non-holiday periods. We plan to continue to support the Portrait Innovations brand through a broad mix of media, including participation in target-specific online social networking sites, informative and seasonal e-mail communications to our existing customer database, newspapers, magazines, targeted customer-specific direct mail and selective television advertising. As we increase our geographic footprint, we plan to move from regional to national advertising campaigns, which we anticipate will provide further cost efficiencies. In addition, we believe we will achieve higher levels of profitability by leveraging corporate and other overhead costs against a growing revenue base.

 

While we believe our growth strategy offers significant opportunities, it also presents significant risks and challenges including, among others, the risk that we may not be able to open new studios in accordance with our growth plans, keep pace with or adapt to changes in digital imaging, printing and software applications technologies, build and maintain a strong brand image and hire and train qualified associates and studio managers, any or all of which could result in lower sales volume and profitability. In addition, our growth plans will require additional funds for capital expenditures for new studios and related infrastructure investments and we may be unable to raise capital for these investments when needed. For a more complete discussion of the risks and uncertainties associated with our business, see “Risk Factors.”

 

Basis of presentation and key trends

 

Net sales

 

Net sales primarily consists of gross portrait sales net of any returns, which have historically been insignificant. Net sales also includes proceeds from the sale of silver recovered from our printing process, although this has historically been immaterial.

 

Cost of goods sold

 

Cost of goods sold includes printing costs, occupancy costs, studio supplies, credit card transaction fees and related miscellaneous costs, and does not include our studio-level payroll and benefits expense and depreciation and amortization expense. Printing costs include the cost of raw materials and equipment repair and maintenance costs. Occupancy costs include rent, common area maintenance, real and personal property taxes, insurance, utilities and studio repair and maintenance costs. Studio supply costs include seasonal props and backgrounds, photography supplies, freight and other miscellaneous supplies. The components of our cost of goods sold may not be comparable to those of other competitors and retailers.

 

Our cost of goods sold is higher in quarters in which customer volumes are higher, particularly during the holiday season, because cost of goods sold generally increases as net sales increase. However, during the higher volume quarters and particularly during the holiday season, cost of goods sold as a percentage of net sales substantially declines relative to the lower volume quarters and non-holiday seasons because substantial components of our cost of goods, including our occupancy costs, are relatively fixed. In addition, cost of goods sold as a percentage of net sales is affected by the number of new studios that we open, and the time of year in which they are opened, because we begin to incur significant expenses that are included in cost of goods sold upon the opening of new studios, such as occupancy costs, and initial net sales from new studios are lower than levels expected for mature studios.

Selling, general and administrative expenses

 

Selling, general and administrative expenses include studio and corporate payroll and benefit expenses, pre-opening expenses of new studios, share-based compensation expense, marketing and advertising costs, studio recruiting and training costs, costs of accounting and legal services, information technology expenses, travel costs and expenses related to our corporate facilities. The components of our selling, general and administrative expenses may not be comparable to those of other competitors and retailers. We expect that our selling, general and administrative expenses will increase in future periods due to our continuing studio growth and in part to additional legal, accounting, insurance and other expenses we expect to incur as a result of being a public company. Among other things, we expect that compliance with the Exchange Act and the Sarbanes-Oxley Act, and related rules and regulations, will result in significant legal and accounting costs. Over time, we anticipate that our selling, general and administrative expenses as a percentage of our net sales will begin to decline as we are able to leverage corporate and other overhead costs against a growing revenue base.

 

Depreciation and amortization

 

The primary components of our depreciation and amortization expenses are deprecation of studio leasehold improvements and deprecation of studio furniture and equipment. Historically, our depreciation expense has been higher than other specialty retailers and competitors because of the higher capital requirements of our business and the shorter lease terms used early in our operating history over which our studio leasehold improvements are depreciated. Our capital requirements are higher than other specialty retailers due to the cost of the printers, cameras and other photographic equipment in each of our studios.

 

Our studios typically generate rapidly increasing sales during their first four years of operation. As a result, our depreciation expense, which is relatively fixed, is significantly higher as a percentage of sales for newer studios compared with studios open for four years or more.

 

Based on our current studio growth expectations, we anticipate that we will have an increasing number of mature studios and an increasing percentage of studios with longer lease terms relative to the shorter lease terms used early in our operating history. As a result, we anticipate that our overall depreciation expense as a percentage of net sales will decline.

 

Interest income and interest expense

 

Interest income includes interest earned on our cash balances and certificate of deposit investments. Interest expense includes interest costs associated with our revolving credit facility and amortization of financing costs. We anticipate that interest expense will decrease and interest income will increase in the near term following the completion of the offering, reflecting our application of the net proceeds of this offering to repay outstanding indebtedness and the interim investment of a portion of net proceeds as described in “Use of Proceeds.”

 

Provision for income taxes

 

Our provision for income taxes depends on the statutory tax rates of the United States and the states where we operate our studios. Several factors have contributed to our historical effective tax rate being significantly different than our anticipated long-term effective tax rate. In fiscal 2007, our effective tax rate of (87.9)% was significantly affected by the reversal of allowances on certain deferred tax assets, including tax assets related to our net operating loss carry-forwards, as a result of our company’s continued profitability in fiscal 2007 compared to loss periods earlier in our operating history. In fiscal 2008, we established a valuation allowance against certain state deferred tax assets due to uncertainty related to the realization of state deferred tax assets, and as a result our effective tax rate was 48.9%. In fiscal 2009, we reduced this valuation allowance because management concluded certain state deferred tax assets would be realized due to our profitability in those states, and as a result our effective tax rate was 32.9% for fiscal 2009. For fiscal 2010, we estimate that our effective tax rate will be approximately 38% to 39%, which we expect would be a more typical rate going forward.

Key performance indicators and statistics

 

In evaluating the performance of our business, we consider a variety of financial and other performance measures. In addition to the financial measures described above, we also use comparable studio sales, non-comparable studio sales, sales per studio and EBITDA in evaluating how our business is performing.

 

Comparable studio sales and non-comparable studio sales

 

Net sales consists of comparable studio sales and non-comparable studio sales. Comparable studio sales measures the change in year-over-year sales for our studios that have been open for 53 weeks or more. A studio is included in comparable studio sales beginning in its 53rd week of operation. Comparable studio sales also includes sales in existing studios that have been remodeled or relocated for the period in which they are open in the current year and the comparable period in the prior year. Because there may be variations in the way in which some of our competitors and other retailers calculate comparable or “same store” sales, information in this prospectus regarding our comparable studio sales may not be comparable to similar data made available by other competitors or retailers. Measuring comparable studio sales allows us to evaluate how our core studio base is performing. Various factors that affect comparable studio sales include:

 

 

Opening new studios is an important and significant part of our growth strategy. As we continue to open new studios, we expect that our new studios will achieve rapidly increasing sales and robust comparable studio sales growth in their first four years of operation before moderating to more mature growth rates thereafter. Comparable studio sales represents only one metric we use for assessing the success of our growth strategy, as comparable studio sales do not reflect the performance of studios open less than 52 weeks.

 

Non-comparable studio sales consists of net portrait sales not included in comparable studio sales.

 

Sales per studio

 

Based upon historical operating performance, our current target annual average sales for mature studios is approximately $1 million. For any given period, our overall average sales per studio is in part impacted by the number and timing of new studio openings.

 

EBITDA

 

“EBITDA” is defined as net income (loss) before interest expense (net of interest income), provision for income taxes and depreciation and amortization expense. Although EBITDA is not a financial measure under GAAP, we use it as a measurement tool for evaluating our actual operating performance compared to our budget and prior periods.

Results of operations

 

The following tables summarize, for the periods indicated, our net sales and certain key operating data and components of our results of operations as a percentage of net sales:

 

 

 

 

 

Twenty-six weeks ended August 1, 2010 compared to the twenty-six weeks ended August 2, 2009

 

Net sales

 

Net sales increased 12.1%, or $5.8 million, to $54.4 million for the twenty-six weeks ended August 1, 2010 from $48.6 million for the twenty-six weeks ended August 2, 2009. Comparable studio sales increased by $2.3 million, or 4.7%, and non-comparable studio sales contributed $3.5 million. The increase in comparable studio sales was due primarily to an increase of approximately 3.2% in the number of customer transactions. This increase is due primarily to our studios becoming more established in their markets, resulting in increased awareness of our brand. We also experienced an increase of approximately 1.5% in the average dollar value of customer transactions. Our modest increase in average dollar volume reflects improved in-studio execution.

 

We opened 18 studios during the twenty-six weeks ended August 1, 2010, compared to 10 studios during the twenty-six weeks ended August 2, 2009. We operated 188 studios as of August 1, 2010.

 

Cost of goods sold

 

Cost of goods sold increased 11.8%, or $1.5 million, in the twenty-six weeks ended August 1, 2010 to $14.6 million from $13.0 million in the twenty-six weeks ended August 2, 2009. Cost of goods sold increased primarily due to a $1.3 million increase in occupancy costs related to the operation of 28 more studios and a $340,000 increase in printing costs related to a 9.9% increase in total customer transactions.

 

As a percentage of net sales, cost of goods sold was flat at 26.8% for both the twenty-six weeks ended August 1, 2010 and August 2, 2009. When comparing the components, occupancy costs as a percentage of net sales increased due to the opening of 18 new studios in the first half of fiscal 2010 compared to the 10 studios opened in the first half of fiscal 2009, offset by a small decrease in printing costs as a percentage of net sales due to the higher customer purchase average and a small decrease in credit card transaction fees as a percentage of net sales due to lower pricing from our credit card vendor.

 

Selling, general and administrative expenses

 

Selling, general and administrative expenses increased 13.1%, or $3.8 million, to $33.0 million for the twenty-six weeks ended August 1, 2010 from $29.2 million for the twenty-six weeks ended August 2, 2009, primarily resulting from a $3.1 million increase in studio labor costs and advertising costs resulting from the operation of 28 more studios in the first half of fiscal 2010 compared to first half of fiscal 2009. General and administrative expenses increased $0.7 million in first half of fiscal 2010 compared to first half of fiscal 2009, primarily due to increased labor costs for additional staffing to support our growing company and increased accounting and legal costs associated with preparing to become a public company.

 

As a percentage of net sales, selling, general and administrative expenses were 60.7% in the twenty-six weeks ended August 1, 2010 compared to 60.1% in the twenty-six weeks ended August 2, 2009, primarily due to an increase in general and administrative expenses as a percentage of net sales due to increased labor costs for additional staffing to support our growing company and increased accounting and legal costs associated with preparing to become a public company.

 

EBITDA

 

EBITDA increased 7.6%, or $484,000, to $6.8 million for the twenty-six weeks ended August 1, 2010 from $6.3 million for the twenty-six weeks ended August 2, 2009. EBITDA as a percentage of net sales was 12.5% in first half of fiscal 2010 compared to 13.1% in first half of fiscal 2009.

 

Depreciation and amortization expense

 

Depreciation and amortization expense increased 5.4%, or $320,000, to $6.2 million for the twenty-six weeks ended August 1, 2010 from $5.9 million for the twenty-six weeks ended August 2, 2009. The increase in first half of fiscal 2010 was principally attributable to the incremental depreciation related to the 18 new studios

opened in the first half of fiscal 2010 as well as the full year depreciation for the 10 new studios opened in fiscal 2009 after August 2, 2009. Depreciation and amortization expense as a percentage of net sales decreased to 11.4% for the twenty-six weeks ended August 1, 2010 from 12.1% for the twenty-six weeks ended August 2, 2009 due to the increasing sales base in our mature studios and an increasing number of studios with longer lease terms relative to the shorter lease terms used early in our operating history. In addition, our older studios have lower depreciation expense as the original leasehold improvement investments continue to be depreciated.

 

Interest expense, net

 

Interest expense, net decreased by $131,000 to $139,000 in first half of fiscal 2010 due primarily to lower borrowing levels.

 

Provision for income taxes

 

Our effective tax rate was 38.4% for the twenty-six weeks ended August 1, 2010 compared to 48.6% for the twenty-six weeks ended August 2, 2009. The higher effective income tax rate for the twenty-six weeks ended August 2, 2009 was primarily the result of interest related to uncertain timing differences.

 

Net income

 

Due to the factors described above, net income increased 215.1%, or $200,000, to $293,000 for the twenty-six weeks ended August 1, 2010 from $93,000 for the twenty-six weeks ended August 2, 2009.

 

Fiscal 2009 compared to fiscal 2008

 

Net sales

 

Net sales increased 14.0%, or $13.6 million, to $111.0 million in fiscal 2009 from $97.4 million in fiscal 2008, despite a difficult economic environment in both 2008 and 2009. Comparable studio sales increased by $6.7 million, or 6.9%, and non-comparable studio sales contributed $6.9 million. The increase in comparable studio sales was due primarily to an increase of approximately 8.3% in the number of customer transactions. This increase is due primarily to our studios becoming more established in their markets, resulting in increased awareness of our brand. The increase in the number of customer transactions was partially offset by a decrease of approximately 1.3% in the average dollar value of customer transactions, due to the difficult economic environment which continued into 2009.

 

We opened 20 studios in fiscal 2009, compared to 30 studios in fiscal 2008. We operated 170 studios as of January 31, 2010.

 

Cost of goods sold

 

Cost of goods sold increased 17.4%, or $4.2 million, in fiscal 2009 to $28.7 million from $24.4 million in fiscal 2008. Cost of goods sold increased primarily due to a $2.1 million increase in occupancy costs and a $0.9 million increase in studio supplies related to the operation of 20 more studios, as well as a $1.0 million increase in printing costs and a $0.2 million increase in credit card transaction fees and miscellaneous costs related to a 15.6% increase in total customer transactions.

 

As a percentage of net sales, cost of goods sold increased to 25.8% in fiscal 2009 from 25.1% in fiscal 2008. The increase in cost of goods sold as a percentage of net sales was principally due to an increase in the cost of studio supplies as a percentage of net sales due to the purchase of several new seasonal props.

 

Selling, general and administrative expenses

 

Selling, general and administrative expenses increased 12.5%, or $7.3 million, to $65.9 million in fiscal 2009 from $58.6 million in fiscal 2008. Studio labor costs and advertising costs increased $6.8 million, primarily resulting from the operation of more studios in fiscal 2009 compared to fiscal 2008. General and

administrative expenses increased $0.5 million in 2009 compared to 2008 primarily due to an increase in corporate labor costs for additional staffing to support our growing company and an increase in corporate rent expense associated with the expansion of our corporate headquarters.

 

As a percentage of net sales, selling, general and administrative expenses were 59.3% in fiscal 2009 compared to 60.1% in fiscal 2008, primarily due to the continued benefits of leveraging corporate general and administrative expenses over an increasing sales base. As a percentage of net sales, total studio labor costs and advertising costs were relatively flat.

 

EBITDA

 

EBITDA increased 14.3%, or $2.1 million, to $16.5 million in fiscal 2009 from $14.4 million in fiscal 2008. EBITDA as a percentage of net sales was 14.8% in both fiscal 2009 and fiscal 2008.

 

Depreciation and amortization expense

 

Depreciation and amortization expense increased 14.7%, or $1.6 million, to $12.2 million in fiscal 2009 from $10.6 million in fiscal 2008. The increase in fiscal 2009 was principally attributable to the incremental depreciation related to the 20 new studios opened in fiscal 2009 as well as the full year of depreciation for the 30 new studios opened in fiscal 2008. Depreciation and amortization expense as a percentage of net sales was essentially the same in both periods.

 

Interest expense, net

 

Interest expense, net decreased by $760,000 to $497,000 in fiscal 2009 due primarily to the reduction in amortization of financing costs, lower average interest rate on borrowed funds and reduced weighted average borrowings due to fewer studio openings and increased cash flows from operations.

 

Provision for income taxes

 

Our effective tax rate decreased to 32.9% in fiscal 2009 from 48.9% in fiscal 2008 due primarily to the reversal of the deferred tax asset valuation allowance. In fiscal 2008, we established a valuation allowance against certain state deferred tax assets due to uncertainty related to the realization of state deferred tax assets, and as a result our effective tax rate was 48.9%. In fiscal 2009, we reduced this valuation allowance because management concluded certain state deferred tax assets would be realized due to our profitability in those states, and as a result our effective tax rate was 32.9% for fiscal 2009.

 

Net income

 

Due to the factors described above, net income increased 96.9%, or $1.2 million, to $2.5 million in fiscal 2009 from $1.3 million in fiscal 2008.

 

Fiscal 2008 compared to fiscal 2007

 

Net sales

 

Net sales increased 33.1%, or $24.2 million, to $97.4 million in fiscal 2008 from $73.2 million in fiscal 2007, despite a difficult economic environment in 2008. Comparable studio sales increased by $8.2 million, or 11.3%, and non-comparable studio sales contributed $16.0 million. The increase in comparable studio sales was due primarily to an increase of approximately 13.0% in the number of customer transactions. This increase is due primarily to our studios becoming more established in their markets, resulting in increased awareness of our brand. The increase in the number of customer transactions was partially offset by a 1.4% decrease in the average dollar value of customer transactions, due to the difficult economic environment in 2008.

 

We opened 30 studios in fiscal 2008, compared to 42 studios in fiscal 2007. We operated 150 studios as of February 1, 2009.

Cost of goods sold

 

Cost of goods sold increased 32.5%, or $6.0 million, in fiscal 2008 to $24.4 million from $18.4 million in fiscal 2007. Cost of goods sold increased primarily due to a $3.4 million increase in occupancy costs and a $0.2 million increase in studio supplies related to the operation of 30 more studios, as well as a $1.7 million increase in printing costs and a $0.7 million increase in credit card transaction fees and miscellaneous costs related to a 27.0% increase in total customer transactions.

 

As a percentage of net sales, cost of goods sold decreased to 25.1% in fiscal 2008 from 25.2% in fiscal 2007. When comparing the components, studio supplies as a percentage of net sales decreased due to increased efficiencies in our purchasing programs as a result of our increased size and purchasing leverage, offset by an increase in occupancy costs as a percentage of net sales due to a higher number of newer studios.

 

Selling, general and administrative expenses

 

Selling, general and administrative expenses increased 31.9%, or $14.2 million, to $58.6 million in fiscal 2008 from $44.4 million in fiscal 2007.

 

Studio labor costs increased by $10.4 million in fiscal 2008 compared to fiscal 2007, and advertising costs increased by $3.2 million, in each case primarily due to the operation of more studios in fiscal 2008 compared to fiscal 2007. General and administrative expenses increased $0.5 million in fiscal 2008 compared to fiscal 2007 primarily due to increased corporate labor costs and accounting and auditing costs to support our growth.

 

As a percentage of net sales, selling, general and administrative expenses decreased to 60.1% in fiscal 2008 from 60.6% in fiscal 2007, primarily due to the continued benefits of leveraging corporate general and administrative expenses over an increasing sales base.

 

EBITDA

 

EBITDA increased 39.2%, or $4.1 million to $14.4 million from $10.4 million in fiscal 2008. EBITDA as a percentage of net sales increased to 14.8% in fiscal 2008 compared to 14.2% in fiscal 2007.

 

Depreciation and amortization expense

 

Depreciation and amortization expense increased 46.9%, or $3.4 million, to $10.6 million in fiscal 2008 from $7.2 million in fiscal 2007. As a percentage of net sales, depreciation and amortization expense increased from 9.9% in fiscal 2007 to 10.9% in fiscal 2008. The increase in fiscal 2008 of depreciation and amortization expense, including as a percentage of net sales, was principally attributable to the incremental depreciation related to the 30 new studios opened in fiscal 2008, as well as the full year of depreciation for the 42 new studios opened in fiscal 2007.

 

Interest expense, net

 

Interest expense, net decreased by $202,000 to $1.3 million in fiscal 2008 from $1.5 million in fiscal 2007 due primarily to the lower average interest rate.

 

Provision for income taxes

 

In fiscal 2007, our effective tax rate of (87.9)% was significantly affected by the reversal of allowances on certain deferred tax assets, including tax assets related to our net operating loss carry-forwards, as a result of our company’s continued profitability in fiscal 2007 compared to loss periods earlier in our operating history. In fiscal 2008, we established a valuation allowance against certain state deferred tax assets due to uncertainty related to the realization of state deferred tax assets, and as a result our effective tax rate was 48.9%.

Net income

 

Due principally to the differences in our effective tax rate in fiscal 2008 compared to fiscal 2007, net income decreased (58.6%), or $1.8 million, to $1.3 million in fiscal 2008 from $3.1 million in fiscal 2007.

 

Quarterly results and seasonality

 

Our business is seasonal and as a result, our net sales fluctuate from quarter to quarter. Net sales are typically highest in our fourth fiscal quarter. Our most productive sales months are November and December, during the important holiday season. We also incur significant additional costs and expenses during the fourth fiscal quarter due to increased staffing levels and increased marketing efforts.

 

The following table sets forth certain unaudited statement of operations data and certain operating data for the previous nine fiscal quarters. This unaudited quarterly information has been prepared on the same basis as our annual audited consolidated financial statements appearing elsewhere in this prospectus, and includes all adjustments, consisting only of normal recurring adjustments, that we consider necessary to present fairly the financial information for the fiscal quarters presented.

 

The unaudited quarterly data should be read in conjunction with our unaudited and audited consolidated financial statements and the related notes thereto appearing elsewhere in this prospectus.