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Preferred Bank (NASDAQ:PFBC)

Q3 2008 Earnings Call Transcript

October 23, 2008, 5:00 pm ET

Executives

Lasse Glassen – IR, Financial Relations Board

Li Yu – Chairman, President and CEO

Ed Czajka – SVP and CFO

Analysts

Joe Morford – RBC Capital Markets

Andrew [ph] – Sandler O'Neill

Joe Gladue – B. Riley & Company

Don Worthington – Howe Barnes Hoefer & Arnett

Julianna Balicka – Keefe, Bruyette & Woods

John Deysher – Pinnacle

Operator

Good afternoon, ladies and gentlemen. Thank you so much for standing by. Welcome to the Preferred Bank third quarter 2008 conference call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, this conference will be open for questions. (Operator instructions) As a reminder, this conference is being recorded today on Thursday, October 23, 2008. I will now turn the conference over to Mr. Lasse Glassen, the Financial Relations Board. Please go ahead.

Lasse Glassen

Thank you. Good day, everyone, and thanks for joining us to discuss Preferred Bank's results for the third quarter ended September 30, 2008. As you are probably aware, with us today from management are Mr. Li Yu, Chairman, President and Chief Executive Officer; Bob Kosof, Chief Credit Officer; and Ed Czajka, Chief Financial Officer. Management will provide a brief summary of the quarter, and then we will open the call up to your questions.

During the course of this conference call, statements made by management may include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are based upon specific assumptions that may or may not prove correct. Forward-looking statements are also subject to known and unknown risks, uncertainties and other factors related to Preferred Bank's operations and business environment, all of which are difficult to predict, and many of which are beyond the control of Preferred Bank.

For detailed descriptions of these risks and uncertainties, please refer to the documents the company files with the Federal Deposit Insurance Corporation, or FDIC. If any of these uncertainties materializes or any of these assumptions prove incorrect, Preferred Bank’s results could differ materially from expectations as set forth in these statements. Preferred Bank assumes no obligation to update such forward-looking statements.

At this time, I’d like to now turn the call over to Mr. Li Yu. Mr. Yu?

Li Yu

For the third quarter 2008, our net loss totaled $2.4 million, or $0.35 a share, of which that after a $6 million charge for OTTI, of which $4.4 million relate to Freddie Mac. Now without these OTTI charges, the net income would be $2 million, or $0.21. Now we understand because of the government – the US government signed the TARP bill as of October the 2nd, 2008. And for that particular reason, we can only record the OTTI charges related to Freddie Mac without any tax benefit. And the tax benefit related to the charge-off of this quarter and last quarter, which totaled $2.6 million, would be recognized in the fourth quarter. Had this amount be able to recognize in the third quarter, our total loss would be right around $0.08.

I’m personally also sad about that we have to record charges related to the trust-preferred holdings, some of the trust-preferred holdings. We certainly understand the technical aspect that may be correct. And however, from a common sense point of view, when the government is going to recapitalize most of the banks and all these institutions who issue trust-preferred and form the whole trust preferred securities, the value should increase or recover in the first quarter. To have it written down in the third quarter and we’ll not be able to written back up in the fourth quarter is something that is interesting to me as a layman. But, be it as it may that this is what the current regulation is.

Now there is two bright spot in our quarter. One is that even though in a most difficult situation, we have improved our capital ratio. Our leverage ratio – leverage capital ratio, tier one leverage capital ratio now over 10% for the first time, 10.01%. And that’s improving from the quarter-end of June 30, 2008. And in the assets quality side, we are somewhat slightly relieved that there is no deterioration in our assets quality. And we also managed to reduce the exposure in housing related construction loan area.

So looking forward, although at the end of August, we were pretty optimistic about the real estate situation, but with what’s happening in September and October really that we think that the general market has taken a backward movement. And it looks like that we’re still going to be having a challenging environment going to the fourth quarter and first quarter.

Being well capitalized as we are and we probably will be seeking new capital from the government, we feel that we’re well situation to take care of any problem that we are foreseeing right now.

At this time, I’d like to answer any questions you may have.

Question-and-Answer Session

Operator

All right. Thank you, sir. (Operator instructions) Our first question is from the line of Joe Morford with RBC Capital Markets. Please go ahead.

Joe Morford – RBC Capital Markets

Good afternoon, Li.

Li Yu

Hi, Joe.

Joe Morford – RBC Capital Markets

I guess couple of questions. First, it looks like you moved a fair bit into the OREO category and suggest there may be some continued inflows into the non-accrual loans. I was just wondering if you could give a little more color about what new deterioration you saw in the quarter in terms of a new problem loan inflows.

Li Yu

Well, actually that the net difference between the OREO and the NPL, the combined number between quarters is $1 million or $2 million differences. Okay?

Joe Morford – RBC Capital Markets

Oh, is it? Okay.

Li Yu

Yes, it’s only $1 million or $2 million there. Actually for the NPL portion, we show a more than $15 million improvement between quarters. Okay?

Joe Morford – RBC Capital Markets

Okay. I’m looking at the wrong number then, sorry.

Li Yu

And probably one of the situations that gives us some good feeling further is that the in the 30 to 89 days delinquent area, this is one area as a management that I look hopefully. And as of September 30, we’ll only have $11 million. This is even pretty good number at the glory [ph] days in 2007 or earlier. So the number just amazes me on that, but it is an improvement from last quarter and certainly a bit improvement from the first quarter, which is indicating situation as of September 30 seemed to be improving in my point of view. As I also stated in my press releases that moving to OREO is really a very welcome situation because we finally came dispose of it, as compared to let it sit there after waiting for the foreclosure processes or litigation process.

Joe Morford – RBC Capital Markets

Okay. And then I guess a separate question on the deposit side, can you just talk a little bit more about what went on this quarter in terms of kind of the restructuring, getting out of the government agency deposit? It looks like there were some outflows still in the core accounts, and just a little bit more about what will happen there?

Li Yu

Well, actually just – as you know, we have reduced our total dependence on the institution of government type of deposit, which is fully collateral supported, security supported deposits, by selling the security and reduce the government-related deposits. So, of the core deposits, our normal core customer deposit actually shows increases from the last quarter. Okay? This is partially done – is that actually because the State of California removed us from the program, the deposits, that we have to liquidate the deposit [ph] situation for about $90 million. The rest we are able to move into a different program and the belief of the collateral situation to improve our liquidity. The situation related to this is not – actually the liquidity situation has improved between quarters.

Joe Morford – RBC Capital Markets

Okay. Great. And then I guess lastly, you touched on the TARP program and looking to participate in that. Can you quantify the amount that you could raise? And would your bias be towards the upper or lower end of that range?

Li Yu

We can raise between $14 million plus to $42 million plus. However, the Board of Directors meeting two days ago has authorized management to proceed to seek up to $40 million of new preferred stock from the government. And we’re in the process of preparing application.

Joe Morford – RBC Capital Markets

Okay. Perfect. That’s all I need. Thanks so much.

Li Yu

Okay. In the meantime, we’re also interested in the government-guaranteed senior debt program. And we are talking to – because lot of detail is not out. And among constant conversation with FDIC, they don't have all the details yet. So once they have it, we’ll be submitting for a request for the approval. And the trick is that, that particular program for those guys as of September 30 had little or no debt outstanding. It would be an amount up to their approval. So we don’t know what they were approved, but we’ll be talking to them all the time.

Joe Morford – RBC Capital Markets

Okay. Right. Well, I’ll follow up on that later. Thanks, Li.

Li Yu

Okay.

Operator

All right. Thank you. Our next question is from the line of Aaron Deer with Sandler O'Neill. Please go ahead.

Andrew – Sandler O'Neill

Hi, guys. This is actually Andrew [ph] for Aaron. How are you doing today?

Li Yu

Hi, how are you?

Andrew – Sandler O'Neill

Good, thanks. A quick question, can you just tell us why you are comfortable bringing down the reserve level this quarter?

Li Yu

Actually it’s not bringing down reserve level. Part of it is getting charged off. Okay?

Andrew – Sandler O'Neill

Okay.

Li Yu

Okay? And it is just to note that we just feel this. It is not going to be – I mean, the number is not going to be collected, rather they let it sit on the book to show a fluffy negative amount to loan. It’s just to charge off just to pay the books on that. Our reserve, if you notice, everything has been marked based on the most recent appraisal.

Andrew – Sandler O'Neill

Right, right. Okay. And I guess we have heard something maybe D.R. Horton out near Beaumont just sold a bunch of residential land I think for – I think it’s maybe $0.10 on the dollar. So, would you mind just explaining why you are comfortable holding that freeway, just adjacent residential land in Beaumont, at 42% of appraised value?

Li Yu

We can't – on this situation, we are in partnership with another bank on this particular deal. And they are the one agent bank on the matter. And they are – that is their appraisal value that they have received. We have it reappraised right now. We should be receiving new appraisal by November to see what the new number is. As soon as the number is out, if it represents a deterioration, we’re certain we’ll write it down. And that’s actually different type of property. So we don’t know whether it’s going down that much or not, because the last appraisal is 2008. I think the springtime of 2008 appraisal. It is not that different. And the biggest drop of the land value really happened in the fourth quarter and first quarter of 2008. So, probably that – let me just afford to be a little bit more optimistic. We hope the new appraisal coming out fairly close to our carrying value, or hopefully better.

Andrew – Sandler O'Neill

Great. Thank you for taking our questions.

Operator

All right. Thank you. Our next question is from the line of Joe Gladue with B. Riley & Company. Please go ahead.

Joe Gladue – B. Riley & Company

Yes, just a couple of questions. I guess first off, I guess about $15.5 million reduction in the exposure to Inland Empire loans noted in the press release. I guess I’m assuming that those things were either charged off or went into OREO, or just wondered if you could explain what happened to them.

Li Yu

There is about – $6 million is the paydown of the loan. Paydown, pay off the loan. The rest is a charge-off that went to OREO.

Joe Gladue – B. Riley & Company

All right. I guess I’d like to see if you could just talk a little bit about your expectations for the net interest margin, given the Fed rate cuts and I guess possibility of further ones coming?

Li Yu

Oh boy! Joe, this probably is one of the most troublesome things as far as I can see in our landscape, because what we see all over the place is people still offering right around 4% for the time certificate deposits and price their MMAs really high. In other words, right after the 50 basis points reduction in Fed rate, the deposit rate did not come down. Everybody is still frenzy in getting the deposits. And because inter-bank lending has been slowed down, everybody is holding these deposits and putting stuff on the – losing 2% net or 3% net. Okay? And so the situation sitting right now is when this deposit cost will reduce to sort of like along with the lending rate reduce, we do not know. I hope right after the recapitalization of banks by the TARP program, we will see the gradual easement of that, especially the two things that affect that in terms of increasing insurance on DDA and also the guaranteed senior debt inter-bank lending. These kind of situations would definitely work to move the deposits cost down and move the liquidity between banks better. But as it stands right now, there is still seas ahead. And therefore, as it stands right now, it’s not only us, I think every bank will see their margin compressed in the fourth quarter.

Joe Gladue – B. Riley & Company

Okay. Can you give me an idea of I guess what the net interest margin was for the average for the quarter? Do you have an idea of sort of where that ended up at the end of the quarter?

Li Yu

Ed, can you answer the question?

Ed Czajka

You’re talking about the last month of the quarter, Joe?

Joe Gladue – B. Riley & Company

Yes.

Ed Czajka

Well, I would say, excluding the effect of non-accruals, it’s probably somewhere right around 350 [ph]. It was a bit of a downward trend.

Joe Gladue – B. Riley & Company

All right. And lastly, I’ll ask about expectations for loan growth. Do you still expect to do more – just letting some things roll off and just improve liquidity? Or – I think you’ll have the capacity to grow loans a little bit going forward.

Li Yu

Well, I think that if the proper loan today – please understand, loan demand is not as strong. And the quality that’s available to us is not, how should I say, fitting in today’s environment. So we are much more prudent in doing the loan. Having said that, we do have a decent pipeline of loans waiting to be funded. Okay? And I think that the ones we have the situation clear with FDIC with the liquidity, senior debt, and such as these kind of situations, all these loans will be booked in no time. And we already see deposits start to flow back into us. Especially on the DDA side, we see some drop in the third quarter, and in fourth quarter after the Fed announcement, DDA has been increasing. So we foresee that the booking more loans in the next – this quarter. Having said that, we’d like to see some of our loans, especially housing related construction loan and land loan being paid down. But at this point in time, you know as well as I know what the market situation is. The speed of these reductions of these loans will be relatively slow.

Joe Gladue – B. Riley & Company

Okay. All right. That’s all I had. Thank you.

Operator

All right. Thank you. And our next question is from the line of Don Worthington with Howe Barnes Hoefer & Arnett. Please go ahead.

Don Worthington – Howe Barnes Hoefer & Arnett

Good afternoon.

Li Yu

Hi.

Don Worthington – Howe Barnes Hoefer & Arnett

Couple of things. One is more housekeeping. In looking at the expense categories, there is just a line that’s labeled Other. It was about $2.1 million in the quarter about double from the last quarter. What specifically was in there driving the increase?

Li Yu

Ed, do you want to take that?

Ed Czajka

Yes. Well, primarily – and I think it is in the text of the press release. I know you guys didn't get all a chance to read that. But OREO expenses are in that Other category, Don, and that was about $777,000 of that increase. So it really accounted for a majority of that. In addition, FDIC insurance premiums have increased as well. So that’s really primarily the major difference between the two quarters.

Don Worthington – Howe Barnes Hoefer & Arnett

Okay, great. And then in terms of the other OTTI charge, what type of securities were those – the non-government agency?

Ed Czajka

About $1.1 million of that $1.6 million was a trust-preferred CDO by community banks, I believe, in the early 2000s. And the other one was a Ford corporate note that’s about $480,000.

Don Worthington – Howe Barnes Hoefer & Arnett

Great. Thank you very much.

Operator

Thank you. Our next question is from the line of Julianna Balicka with Keefe, Bruyette & Woods. Please go ahead.

Julianna Balicka – Keefe, Bruyette & Woods

Good afternoon.

Li Yu

Hi.

Julianna Balicka – Keefe, Bruyette & Woods

Hi, how are you? I have a few questions. On the OTTI charge for the TruPS CDO, of the markdown, how much of it is credit-related and how much of it is liquidity discount?

Ed Czajka

Julianna, if I had that answer, I probably wouldn't be doing this. It’s really – what we really have to do is, it’s a two-pronged process. First off, we got the market valuation from our pricing service on a monthly and a quarterly basis. That’s the mark we have to use relative to the balance sheet. And that’s what you see on the face of the balance sheet where we show the market value. The second prong is that with the security such as a CDO where we own a beneficial interest in a pool of issuers who have issued securities, we have to use EITF 99-20 as our primary accounting guide. Under that EITF, we have to go through and simulate what are the estimated future cash flows that a market participant would expect to receive in the current environment as of September 30, given what’s going on in the market. So based on that, which the numbers actually come out a little different than our pricing service comes up with, if there is any impairment in the future estimated cash flows compared to the previous estimated cash flows or when the instrument was purchased, then we have record a charge for other-than-temporary impairment. That charge has to go back to and has to be based on the original pricing services market value, not the estimated cash flows we ran under EITF 99-20. If I would go back and to look at what our pricing service did in terms of what the default they use, the estimated default rates they would use in the future cash flows versus the discount rates used, I would have to go back and find those cash flows and then determine – put the discount rate back at the note rate and then I could determine what the impairment was based on credit and what it was based on discount. So, unfortunately it’s a longer answer, but it’s not even an answer, but it explains a little bit of what we have to do there.

Julianna Balicka – Keefe, Bruyette & Woods

I think that’s what I was getting at with that. So, that works. And then in terms of your construction portfolio, which decreased in balances, which was very welcome to see, what are your outstanding commitments still?

Li Yu

I don’t have the number. Okay? But I can dig that number out, but it’s reducing. We’re trying – I mean, Ed is trying to find the number right now (inaudible) the construction commitment on the housing related.

Julianna Balicka – Keefe, Bruyette & Woods

Okay. And then I have a third question and I’ll step back.

Li Yu

Okay.

Julianna Balicka – Keefe, Bruyette & Woods

On the $13.2 million NPL in the Inland Empire, recent appraised value, what’s the recent appraised value in that?

Li Yu

$13.2 million – one of the appraised value is 55%. And related to that $7.5 million loan – I mean, I don’t remember exactly what’s the appraisal. I think it’s about $17 million, $18 million on the $7.5 million piece. It’s two banks together. You know the other bank, right?

Julianna Balicka – Keefe, Bruyette & Woods

That’s right.

Li Yu

Okay. So, together that – together the loan was $15 million, and that is equal to 42%. So we (inaudible) about $30 some million appraised value of that piece of land. And the other piece of land, the appraised value is 55%. And we each had $5.7 million.

Julianna Balicka – Keefe, Bruyette & Woods

Right. All right. Well, I’ll step back now. And if you are able to get the commitments during the call, that would be great.

Li Yu

Okay.

Ed Czajka

If not, Julianna, I’ll get it for you.

Julianna Balicka – Keefe, Bruyette & Woods

Perfect. Thank you very much.

Operator

All right. Thank you. (Operator instructions) Next question is from the line of John Deysher with Pinnacle. Please go ahead.

John Deysher – Pinnacle

Good afternoon.

Li Yu

Hello.

John Deysher – Pinnacle

Back to your comments on the TARP program, $14 million to $42 million I think you said?

Li Yu

Yes.

John Deysher – Pinnacle

Okay. Exactly how will that work? What types of assets – specifically what types of loans are putting to the government?

Li Yu

We don’t have to put – it’s a government purchase of the preferred stock. They will purchase from us a series of preferred stock. And the amount they will purchase is minimal, is equal to 1% of our risk-based capital. And the maximum is 3% of the risk-based capital – risk-weighted – risk-weighted assets. I’m sorry. So we are just using round number. Okay? Between $14 million to $42 million. And we have decided to go after $40 million.

John Deysher – Pinnacle

Okay. $40 million, okay. So the $40 million is within the range of the $14 million to $42 million.

Li Yu

Yes, sir.

John Deysher – Pinnacle

Okay. So you're basically going to sell preferred stock to the government?

Li Yu

Yes.

John Deysher – Pinnacle

Okay. What types of terms will that involve?

Li Yu

Well, there's all kinds of publications. I can send it to you. Okay?

John Deysher – Pinnacle

No. Just tell me in a nutshell what you expect to do.

Li Yu

It’s 5% of the coupon rate.

John Deysher – Pinnacle

5% coupon?

Li Yu

Yes.

John Deysher – Pinnacle

It’s a perpetual preferred?

Li Yu

It’s ten-year perpetual preferred, ten-year (inaudible) term. It can be called after three – I mean, it can be called any time, would spread three years with certain conditions. Okay?

John Deysher – Pinnacle

I’m sorry, called any time three years with certain –?

Li Yu

The first three-year has certain condition. You can call within the first three years. That has to be through a refinancing on the public market of your capital stock.

John Deysher – Pinnacle

Okay. And after three years, you can call it without restrictions?

Li Yu

Yes, at par.

Ed Czajka

After five years, John, the dividend rate goes from 5% to 9%. So, really what this is intended to do is to be a short-term capital instrument for the institution. The other component is that we will issue – we will have to issue warrants to the US government equal to 15% of the capital stock purchase.

John Deysher – Pinnacle

Equal to 15% of that $40 million, let’s say.

Ed Czajka

Yes.

John Deysher – Pinnacle

Okay.

Li Yu

If you want it, John, would you call us a little later and we’ll send you a detail of the program.

John Deysher – Pinnacle

That’s fine. It just seems to me that your capital ratio went up, but yet you are raising money from the government. That doesn’t portend a very favorable outlook in terms of what problem loans or assets you may have going forward.

Li Yu

Well, you probably can – you can draw the conclusion in the first place. But number one is that a 5% coupon rate, the thing is not going to be very much of a so-called dilutive. Okay? The second situation is that during this economic environment nobody is sure what lies ahead of us, whether it is recession, whether it is depression, when and if the other should fall on the marketplace. So with that, the Board decided to have that. And please remember that if the market quickly returns to good situation and that we can always pay it off early.

John Deysher – Pinnacle

Well, you can pay it off early subject to certain restrictions for the first five years.

Li Yu

For three years with restrictions. If – let’s say, if the market turns out to be really well and we as a bank also turn out very well, it’s conceivable we can raise some kind of capital during the – through the open market within the next three years to pay for the government’s – pay for the $40 million, that is if they allow us to have $40 million. And if not – you know, if we don’t have any use for it, at the end of three years, we certainly can pay it off.

John Deysher – Pinnacle

Okay. And this is non-voting stock?

Ed Czajka

Correct.

Li Yu

Non-voting.

John Deysher – Pinnacle

Okay.

Ed Czajka

So – I’ll just say – you know, I have always listened to a couple of conference calls since this capital purchase program was announced. And a number of institutional shareholders have been on these calls, and there has been really just unanimous, widespread favorable response to this, especially in light of what’s going on. Of course, as Mr. Yu said, there is a lot of uncertainty going forward relative to the overall economy. And given the fact that right now our dividend yield is in excess of 5%, a 5% on preferred shares looks pretty cheap at this point

John Deysher – Pinnacle

Yes. I guess we’re scratching our heads and trying to figure out are you doing this strictly as a safety measure or as a backstop in case things really get bad? Or do you see holes in some of the loans that you know you're going to need the capital for?

Li Yu

Let me put it this way. Since you asked the question, we have just been examined by the State of California. We don't have exit interview yet, but we have loan exit already. And we’ve gone through all the loans. Our loan loss reserve is being done based on whatever their classification that they review it at. Their review covered almost 40% of our total loan portfolio. And I might say, your government has been working very hard at this time in looking at the loan that they are taking a very, very – how should I say – careful view about all the credits.

John Deysher – Pinnacle

Okay. The 40%, would that be the diciest portion of the portfolio, would you say?

Li Yu

Obviously it will be the diciest situation. They will decide on that situation. But it usually covers – the sample is big enough. We have – some of the smaller things, when you have a small apartment, $3 million cash flow sitting there, I mean, they don't all look at those things.

John Deysher – Pinnacle

I guess we take some comfort in that that you’ve been held to pretty high standards in terms of the examiner requirements.

Li Yu

Yes, we – I mean, and I have to say that all over from what I hear in the industry is that both the state and the FDIC now, and for that matter, OCC too, has been more than proactive in doing the loan reviews.

John Deysher – Pinnacle

All right. Was that a routine exam?

Li Yu

It’s a scheduled exam, but it’s early a little bit. But it takes a lot longer time, lot bigger sample.

John Deysher – Pinnacle

Okay. All right, great. I guess final question unrelated to that preferred offering. Are you seeing any – what’s the commercial real estate loan portfolio look like at this point?

Li Yu

Generally speaking, I’ve also not only – in ourselves, I’m also talking to many of my peer group people is that, it seems to me the commercial real estate at this point of time is largely pretty reasonable.

John Deysher – Pinnacle

Okay. I mean, you’re not seeing any rise in vacancy rates or anything like that in –?

Li Yu

You know, there’s some vacancy rising from what I hear in – I mean, in the selective, something like some type of office building and some type of strip centers and so on. Largely, we like to think we don’t have much situation in that. And many of the loans we did is underwritten four or five years ago, where the rent rate four or five years ago has been elevated to today's rent. Even with some vacancy, they still have enough cash flow.

John Deysher – Pinnacle

Okay. So you’ve got a buffer there if vacancy rates go up?

Li Yu

Yes. In general, yes.

John Deysher – Pinnacle

In general. Okay. Very good. Thank you.

Operator

All right. Thank you. (Operator instructions) Gentlemen, I’m not registering any further questions. Please continue with any closing comments.

Li Yu

Anyway, thank you very much for your interest in that. Obviously, this credit market is really is amazing what’s happening in late September to early October situation. And as a matter of fact, we have a couple of deals, a couple of loans, a couple of non-performing loans is ready to be sold and one OREO ready to be sold. And as of September 30, the market changes, the funding stopped, and the deal gets terminated. And we were hoping to report better assets quality at September 30. It just didn’t happen, which is very disappointment of ours because of environment. Having said that, again, you know that I’d like to think that the third quarter credit quality actually improved a bit rather than deteriorate a bit now. And with that, thank you very much. And any question you may have, please call either Ed or myself.

Operator

All right. Thank you. Ladies and gentlemen, this concludes the Preferred Bank third quarter 2008 conference call. If you would like to listen to today’s conference in its entirety, you may dial 800-405-2236 or 303-590-3000 and put the access code 11121375. Those numbers again, 1-800-405-2236 or 303-590-3000 and put the access code 11121375. AT&T would like to thank you very much for your participation. You may now disconnect. Have a very pleasant rest of your day.

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