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Datalink Corporation (NASDAQ:DTLK)

Q4 2012 Results Earnings Call

February 14, 2013 5:00 p.m. ET

Executives

Paul Lidsky - CEO, President

Gregory Barnum - CFO

Analysts

Mark Kelleher - Dougherty Inc.

Eric Martinuzzi - Lake Street Capital Markets

Chad Bennett - Craig-Hallum

[unintelligible] - Canaccord Genuity

Operator

Good day ladies and gentlemen, and welcome to the fourth quarter 2012 Datalink Corp earnings conference call. [Operator instructions.] I would now like to turn the conference over to your host for today, Mr. Paul Lidsky, president and CEO. Please proceed.

Paul Lidsky

Thank you, operator, and good afternoon, everyone. I'd like to welcome all of you to this afternoon's conference call and thank you for joining us. With me today is Greg Barnum, our vice president of finance and chief financial officer.

I'll now turn the call over to Greg to discuss our fourth and year end quarter results, and then I will provide some additional perspectives on the quarter and our outlook for the first quarter of 2013.

Gregory T. Barnum

Thanks, Paul. Before we begin with the quarter's results, let me first remind everyone that in today's conference call, we will be discussing our views regarding future events and financial performance.

These forward-looking statements are subject to certain risks and uncertainties. Actual future results and trends may differ materially from historical results or those anticipated, depending upon a variety of factors.

We undertake no obligation to publicly update any forward-looking statement, whether written or oral, that may be made from time to time, whether as a result of new information, future developments, or otherwise. Please refer to our filings with the Securities and Exchange Commission for a full discussion of our risk factors.

For the quarter, then, revenues for the fourth quarter ended December 31 increased 28% to a record $147.3 million, which compares to $114.7 million for the prior year’s fourth quarter. Sequentially, revenues from Q3 to Q4 increased 41%.

Revenues from the first quarter of 2012 include approximately $13.4 million related to the acquisition of StraTech, which closed at the beginning of the fourth quarter. Without the acquisition, year over year revenues would have increased to approximately 17%, and sequential revenues would have increased approximately 28%.

Revenues for the year ended December 31, 2012 increased 29% to a record $491.2 million compared to $380 million in 2011. Without the StraTech acquisition, revenues would have increased approximately 26%.

On a GAAP basis, we reported net earnings of $3.2 million, or $0.18 per share, from the first quarter of 2012, which compares to net earnings of $2.6 million, or $0.15 per share, in the comparable quarter of 2011 and $1.9 million, or $0.11 per share, in the previous quarter. For the year ended December 31, we recorded net earnings of $10.5 million, or $0.60 per share, compared to net earnings of $9.8 million, or $0.61 per share in 2011.

For the rest of my comments on the income statement, I will be referring to non-GAAP amounts and percentages as reported in today’s press release. A detailed reconciliation between GAAP and non-GAAP information is contained in the tables included in today’s press release.

The primary adjustments to GAAP results relate to acquisition accounting adjustments to deferred revenue, stock based compensation charges, the amortization of intangibles, and integration and acquisition costs, all net of income taxes.

In the fourth quarter of 2012, our product revenues increased 25% to $97.5 million, and our service revenues increased 37% to $50.5 million, compared to the fourth quarter of last year. Within the service component of revenues, we saw customer support revenues increase 39% to $41.2 million, and professional service revenues increase 29% to $9.3 million. Without the StraTech acquisition, product revenues would have increased approximately 16%, customer support revenues 22%, and professional service revenues 8%.

For the year, then, we saw product revenues increase 30%, 27% without StraTech, and service revenues increase 29% or 24% without StraTech. Our revenue mix for the quarter was 38% storage, 18% networking and servers, 9% software, 1% tape, and 34% service.

Looking at gross margins then, our overall gross margins in the fourth quarter of 2012 was 22.6%, which was down from 23.5% in the fourth quarter of last year and down from 22.9% in the third quarter of 2012. For the year, we saw gross margins decrease to 23% from 23.9% in 2011.

These decreases are primarily due to the increase in our networking and server businesses, which historically have carried lower gross margins than storage. For the year, we saw our networking and server business increase to 17% of our total revenue compared to only 13% for 2011.

In addition, near the end of the fourth quarter of 2012, we booked approximately $3.5 million of large orders for VMware licenses, which carry single digit gross margins. Without these orders, our gross margin from the first quarter of 2012 would have been 23%, which would have been in line with our expectations.

While these orders had a negative effect on our gross margin and operating margin percentages, we felt that it was necessary to take the orders in order to keep other resellers out of these key accounts.

Operating income from the first quarter of 2012 was $9.4 million, or 6.4% of revenue, compared to $6.9 million, or 6% of revenue, in the comparable quarter in 2011, and $4.7 million, or 4.5% of revenues, in the third quarter of 2012.

For the quarter, then, StraTech contributed approximately $1 million of operating income, or approximately 7.8% of their revenues. The fourth quarter operating margin shows both the leverage that we have been talking about in the model as we grow our top line and also the incremental impact that acquisitions can have on the model.

For 2012, our operating income was $25.7 million, or 5.2% of revenues, compared to $22.2 million, or 5.8% last year. Again, this decrease was expected as we made significant investments in human resources, services management, and field engineering in 2012.

Net earnings, then, from the first quarter of 2012 were $5.6 million, or $0.31 per share, which beat our October guidance of between $0.20 and $0.26 per share. This compares to net earnings of $4.1 million, or $0.24 per share, in the fourth quarter of 2011 and $2.8 million, or $0.16 per share, in the previous quarter.

For the year we saw net earnings increase 18% to $15.3 million, or $0.88 per share, compared to $13 million, or $0.80 per share, in 2011. With that, then, let me now turn the call over to Paul.

Paul Lidsky

Thanks, Greg. Let me start by saying that I’m very pleased with Datalink’s fourth quarter and year end performance, and with the return to a more normal sales pace, following the elongated sales cycles of the previous two quarters.

Our strong performance in the last months of the year helped us deliver record sales and earnings per share for the quarter and the year, fourth quarter revenues and earnings that were well above our guidance, and our 15th consecutive quarter of non-GAAP net earnings.

As we will discuss in this call, these gains are because of the product and service offerings we’ve been building for the past few years, which are paying off in areas such as expanded wallet share, a growing customer base, rising services revenues, and more sales relating to our entire portfolio of data center solutions.

As Greg outlined, we saw significant growth in revenue both quarter-over-quarter and year over year. To recap, we had a 28% year over year revenue increase in the fourth quarter, or 17% without StraTech, and a 29% increase in revenues in 2012, when compared to 2011, or a 26% increase without StraTech.

Equally significant is the 41% increase in sequential revenues from Q3 to Q4, or 28% if you don’t count the StraTech acquisition. This significantly exceeded our guidance and demonstrated that sales cycles began to return to a more-normal cadence after almost two quarters of very slow decision making.

We recorded $147.3 million in revenues in Q4 compared to the guidance of $125 million to $135 million that we issued on our last conference call, in large part because we had 27 customers spend over $1 million with us during the quarter. I will elaborate on that as well as some of the benefits of the StraTech acquisition in just a few minutes.

We did see an erosion in our gross margins, and operating margins, for the year, but as Greg mentioned, most of this was expected, because of our decision to take the $3.2 million of VMware orders at the end of Q4. While eroding our margins, these transactions allowed us to solidify our position as our customers’ primarily data center solutions provider while at the same time fencing out major competitors.

We also had lower margins in our networking and server business. As we have discussed in the past, these are more than offset by our ability to provide virtual data center solutions like Unified Compute that increase our wallet share with customers and make us a much stronger competition in the market. And finally, as Greg said, we have made investments in human resources, service management, and field engineering which will help us to continue to grow at a healthy pace in the years to come.

Now the expansion of our OEM relationships with Cisco and EMC, which complement our NetApp, Symantec, and HDS relationships, is one of the main drivers behind the record $97.5 million in product revenues for the fourth quarter that Greg mentioned. That marks a 25% increase over the same period in 2011, with an overall 30% growth in product revenues in 2012 when compared to 2011.

The acquisition of StraTech contributed to those numbers, but so did strong organic growth fueled largely by our strategy of selling entire data center solutions instead of only storage. In 2012, for example, our expanding product portfolio resulted in a 76% increase in our networking and server revenues.

That included a jump of nearly 198% in our Cisco revenues from $20 million to $59.8 million during the year. It also pushed our networking and server business from 13% to 17% of revenues year over year, part of an overall shift in our product mix relating to our diversification strategy.

Storage still accounts for 39% of our product revenues, the same percentage as it did in 2011. That is to be expected because of the continuing escalation in enterprise data stores. As a result, we again saw increases with all of our major disk storage partners in 2012, with aggregate storage revenues increasing 20% and EMC revenues more than doubling over 2011.

We are also seeing a strong growth pattern in services. This, again, is because we continue to expand our services portfolio as we look to increase customer wallet share, drive higher margins, and become more relevant to our customers. We had a record $50.5 million in services revenues for the fourth quarter, which was a 37% increase over the same period in 2011, and a 29% increase in services revenues in 2012 when compared to 2011.

These are promising results from the buildout of our services business that we have been talking about for several years, including the multiple new managed services we added in 2012. Those additions included managed backup, monitoring and systems management, archiving, and cloud backup. In addition, we offer unified monitoring and managed infrastructure services for the entire virtual data center stack to serve customers that purchase converged data center infrastructure from us.

Many of these new services were made possible by the expanded services portfolio that we gained as a result of the StraTech acquisition, along with their very experienced managed services team. We expect the services portfolio to continue to contribute a steady increase in our managed services business as we move throughout 2013.

We also launched a robust set of advisory services offerings in 2012 to address every phase of the IT lifecycle. Data migration, disaster recovery planning, and transitional residency services address business challenges such as risk, infrastructure complexity, operational management, and exponential storage growth.

In addition, cloud-enabled and data center transformation services help enterprise and mid-market companies analyze the impact of cloud deployments on their business as well as continue the transition to next-generation data centers.

Two other important measures of our growth in 2012 are the expansion of our customer base and the increase in multimillion dollar accounts. In both of these areas we had a strong year. We attracted 452 new customers during the year, compared to 290 in 2011. With the integration of StraTech into the operation, we added 400 additional mid-sized and enterprise accounts, with three out of four of them already using our services.

In terms of customers, the number of global 1000 customers purchasing more than $1 million of product from us jumped from 77 in 2011 to 102 in 2012. As I indicated earlier, we had 27 customers purchasing more than $1 million in Q4 alone. That’s up from 15 in the same quarter of 2011.

Many of these larger sales involve virtual data center or VDC projects that have been at the centerpiece of our business expansion strategy for the past several years. As you know, we have positioned Datalink to take advantage of the market share from siloed products to data center infrastructures that unify networking, compute, and storage platforms to drive greater business agility and efficiency.

These unified data centers are also a core building block of cloud environments that allow businesses to achieve business impact such as agility, operational efficiencies, and scalability without the security and regulatory concerns of storing data in the public cloud.

As evidence of the continued success of our virtual data center focus, we sold 20 VDC projects in the fourth quarter alone, up from 7 in the comparable period of 2011. We closed 82 virtual data center deals in 2012, more than double the 35 that we closed in 2011.

By their nature, these VDC projects are also helping to increase wallet share from individual customers because they involve a wider range of products and services. Most VDC customers also use our implementation services, as well as our one-call support service, so that they can resolve issues with their VDC deployment within a single contact instead of having to call multiple product vendors.

Our other professional services, managed services, and advisory services, like our new cloud-enabled offerings, can also be added on. Just to give you two examples of that, the first example is a benefit management services provider that did $8 million in business with us in 2012. We helped them build out two virtual data centers including NetApp storage, Cisco networking, VMware, Quantum, and Symantec, complemented by our project management implementation and integration services.

And the second example, we’re getting more wallet share in another way. We have a customer that spent another $8 million with us in 2012. They’re a prominent healthcare provider. They started out purchasing products and services for several of their smaller departments. Those initial purchases included NetApp and Isilon storage systems, Silicon Graphics servers, Symantec backup, and Quantum tape libraries, as well as services and implementation of one-call support.

But in Q4, this same customer chose Datalink to design and deploy a $1.3 million storage refresh with NAS-based tier one and tier two products from multiple OEMs, and that project also includes design implementation and one-call support.

Let me touch on one other topic before we go to guidance. As you know, one of the milestones of our fourth quarter was the acquisition of StraTech, an IT solutions and services firm based in Cary, North Carolina, with offices in eight other states.

This acquisition closed on October 4, 2012, and has significantly increased our footprint along the eastern coast, gave us a second customer support center, and increased our one-call capacity as well as providing enhanced fail over and redundancy, expanded our managed services portfolio, and added 70 skilled employees as well as over 400 new accounts.

As Greg mentioned, the StraTech acquisition was accretive during the fourth quarter, adding approximately $13.4 million of revenues and $0.03 per share. This is a real achievement for the first quarter post-acquisition. It shows that the StraTech team continue to stay focused on business, even while we were integrating the two companies. It’s also a strong sign that we will continue to contribute to Datalink’s success and bottom line by leveraging StraTech expertise.

Now I’d like to just address our guidance. Our strong fourth quarter 2012 performance left us with a record backlog going into the first quarter, and accelerated activity that has carried over with the strong sales pipeline. Based on that pipeline, historical seasonal trends, our expectation that the sales pace of Q4 will continue in Q1, and with the addition of StraTech revenues, we project overall revenues of $127 million to $137 million for the first quarter of 2013, compared to $119.1 million for the first quarter of 2012.

First quarter 2013 net earnings results are expected to be between $0.03 and $0.08 per diluted share on a GAAP basis, and between $0.15 and $0.20 per diluted share on a non-GAAP basis. This compares to net earnings of $0.12 per diluted share and $0.17 per diluted share on a GAAP and non-GAAP basis respectively for the same period in 2012.

The lower GAAP net earnings per share are primarily due to accelerated amortization of acquisition intangibles. With that, I’d like to turn the call back to the operator so that we can take your questions.

Question-and-Answer Session

Operator

[Operator instructions.] Your first question comes from the line of Mark Kelleher from Dougherty Inc. Please proceed.

Mark Kelleher - Dougherty Inc.

If I look at StraTech and the $13.4 million of revenue, if I annualize that, I get about $53.5 million. Is that a slowdown? I thought we were at a $65 million run rate at the purchase. Was that some integration issues there? What were you expecting from StraTech in the quarter?

Paul Lidsky

We were expecting them to deliver about $15 million, and that would be below the run rate of a $65 million or so company, but we always see some disruption in the first quarter. So the answer to your question is, yes, it was under what we were planning, but we were planning for a lower fourth quarter due to just the disruption you experience when you do an acquisition.

Mark Kelleher - Dougherty Inc.

And that disruption lasts one quarter? Two quarters?

Paul Lidsky

It’s usually one quarter before everybody gets to know the company and where to go for help. So yes. Usually about one quarter.

Mark Kelleher - Dougherty Inc.

The managed services you mentioned had a nice pickup. Is there a way to break that out as a percentage of service, or a percent of total revenue? Or some way to indicate how big the managed services are?

Paul Lidsky

Well, our managed service, StraTech gave us a big increase in managed services. And our managed services run about $2.5 million in the fourth quarter. So we think we’ll do $10 million or more of managed service this year. That’s going to be a very positive area for us this year.

Mark Kelleher - Dougherty Inc.

And the breakout of service versus product I would think is more leaning toward service in StraTech in the fourth quarter?

Operator

We just lost Mr. Kelleher. Hopefully he’ll call back in and join back into the queue. So I guess we’ll have to take the next person, which is Eric Martinuzzi, Lake Street Capital Markets. Please proceed.

Eric Martinuzzi - Lake Street Capital Markets

I know you just had a national sales meeting, assembled the team. I’m interested in hearing about trends as we come into 2013, because you guys sound a lot stronger than other things that I’ve seen this earnings season, at least from the OEMs. Wondering what commentary, either on the product side or customer demand projects that people are focusing on.

Paul Lidsky

I guess I would say a couple of things, Eric, in terms of our observations. As I said in my remarks, we certainly, in Q4 and heading into Q1 of this year, saw a very important return to a more normalized sales cadence. And at this point in time, on this day, and in this time, we see that continuing. So that was a trend that we talked about as a company, and obviously that we were able to experience in Q4.

So we talked about, really, how to take advantage of that. And the reality is that our pipeline suggests that customers are ramping up strategic projects, many of them around continued optimization of their data centers and others that would be more classified as the build-out of private cloud infrastructure and services.

At the same time, what we talked about as a company is that there’s been a growing requirement that we’ve seen in our orders, as evidenced in our orders, for services, beyond product. As I talked about in a number of our VDC implementations, we’re now selling project management, we’re selling more sophisticated integration services, data migration services, as well as a significant amount of consulting and strategic IT advisory services.

So customers are beginning to look at Datalink as more than a product company, but more along the lines of a solutions company that has a lot of offerings and the services as well as product category. So as a company we talked about those trends, and how we could leverage those in 2013.

As you heard Greg say, we certainly expect managed services to grow. We expect our Datalink-delivered services portfolio to continue to grow. And those are going to be trends we’ll see throughout the year.

Eric Martinuzzi - Lake Street Capital Markets

So really, it goes back to the wallet share. You’re not just passing along a hardware or software procurement from an OEM. It’s the full package.

Paul Lidsky

Yeah, obviously we saw a lot of hardware, and we’re proud to say so, but we are very focused on every sale, trying to maximize the services component, both through the 24/7 one-call customer support aspects, potential managed services, and expanded services, and on every deal that we do, we work hard to try to get that expansion.

Eric Martinuzzi - Lake Street Capital Markets

And then you mentioned something about the large deals, where you had to get skinny on margins for some of these highly competitive deals. This has happened in the past for Datalink in Q4 especially, and I always get concerned that it’s not just a one-quarter phenomenon. It wraps into the following year, and that the competition never lets up. What’s your comfort that this is a one-quarter issue as opposed to the new normal?

Paul Lidsky

Specifically, the deals that we’re talking about in the fourth quarter were three, specifically three, VMware orders for volume license and renewal agreements for three customers. We believe that that is a fourth quarter phenomenon. That’s as far as we know today. We hadn’t seen any all the rest of the year.

But there’s a new program in place where Cisco account executives can sell and get a credit for VMware licenses, and in the fourth quarter we had three cases where Cisco reps had customers who wanted to do large volume renewals, and went through their Cisco rep instead of their normal VMware license channel.

Those are very distinct from the rest of our mainstream business, which is why Greg called them out in his prepared remarks. So I would not suggest that that won’t happen again. Our best guess is it’s likely to more likely happen at the end of the year when those types of renewals take place.

And so far, those skinny margins you talk about, this year were very specific to those three deals. We continue to see margin pressure in the market as we see every year, but as Greg pointed out, if you back those out, our gross margins were what we would have expected to see, in the 23% range. So that would suggest that we’re holding our own in our normal day-to-day business.

Operator

Your next question comes from the line of Chad Bennett from Craig-Hallum. Please proceed.

Chad Bennett - Craig-Hallum

Can you give me an idea of how much of your business in 2012 and probably more importantly going forward is driven off of data center virtualization, and that trend, and specifically VMware and how kind of dependent you are on that trend continuing into this year?

Paul Lidsky

I would tell you that the virtual data center or however you choose to describe it has been a strong part of our business. As we said, we did 82 deals last year, up from 35 in 2011. And we would expect that to continue.

Now, the focus on our virtual data centers is far more on the storage, networking, and server components, which is to say primarily NetApp or EMC storage with Cisco UCS servers with VMware. But we don’t spend a lot of time focused on the VMware component. We don’t do a lot of VMware licensing throughout the year, because of the very low margins associated with it.

So when a customer buys a unified compute platform from us, they of course are getting VMware licenses, but it’s just bundled into the overall architecture. And so therefore the margin impact of that is much less than it would be if we were selling standalone licenses. And during the remainder of the year, selling individual VMware licenses is not a focal point for us. Selling virtual data centers is, and I think that will continue.

Chad Bennett - Craig-Hallum

And can you give us a sense for, or level of expectation, I guess, around what you think you can grow your networking and server business this year versus your storage business? Obviously your networking and server business grew significantly in ’12.

Paul Lidsky

You know, it’s hard to say at this point, because storage is still growing at such massive rates that as you look at the percentages of networking against the storage, you almost can’t catch up. Now, we grew a point, up to 18%. But I think that what you’ll more likely see is in absolute numbers the service business will certainly grow at a steadier pace, probably in the upcoming year, 50% more than what we did, somewhere in that range.

But you’ll see storage continue to explode, and so when you look at the relative percentages, maybe we pick up another point along the way. I think, based on what you see in storage sales today, and given that our focus is in the data center, so that means that our networking business is not edge networking, it’s data center specific, I think what you’re going to see is we probably would tap out at around 20% of our overall product revenues being networking. But those numbers can be in the hundreds of millions of dollars over time.

Chad Bennett - Craig-Hallum

One last question. When you’re winning new customers, who are you taking dollars from?

Paul Lidsky

Well, that’s a great question. And it depends on the type of win. If we were winning a net new customer, someone who we had not done business with in the past, we would either be taking those dollars away from one of the competing OEMs. For instance if it’s a NetApp deal, then it we might have taken dollars away from EMC or somebody else, HP, Dell, someone. We could have taken dollars away from a stack provider like HP or Oracle, in those cases.

If it’s an installed base customer, or a current customer, where we’re expanding wallet share, then we’re likely taking dollars away from other competitive VARs, competitor VARs, or sometimes direct manufacturers. But in those cases, it’s more likely that if we already have the storage component, that for instance the networking is coming at the expense of another partner.

Operator

[Operator instructions.] Your next question comes from the line of [unintelligible] from Canaccord Genuity. Please proceed.

[unintelligible] - Canaccord Genuity

Just some clarification on the guidance. I know you hit the $49.8 million for services. Is that the cadence that you expect for service? I know before, services were pretty steady at the $38-40 million range.

Paul Lidsky

Well, you know, StraTech added - looking at just the service line only - about $6.7 million. So about half of their $13.4 million was services. So that gave us the jump from Q3 to Q4. About $6.7 million of that was the acquisition. But we are seeing our Datalink services growing by themselves too. So the answer to your question, I guess, is the $50.5 million level is sort of what we’re building off of.

[unintelligible] - Canaccord Genuity

And the other question on the margins, that you talked about, the [unintelligible] deals, I’m assuming they’ll show up in your lower product margins, and so you’d expect it to rebound in Q1? It’s a one-time thing, right? Like, Paul talked about Q1 you expect a rebound in margins?

Paul Lidsky

Yeah, we’ve always been targeting about 22% overall gross margin for the company. We have not seen those VMware license deals through Cisco in the past. And I don’t know whether we’ll see those again. I would guess if we see them again, at the end of the first quarter, it would mean the incremental revenue to us.

Gregory T. Barnum

And I would point out too that they’re not in our pipeline for the quarter today, which means that a Cisco rep would come to us with the opportunity, which would certainly make it incremental, and we would consider it at that time.

[unintelligible] - Canaccord Genuity

And the other question, last question I had, was you talked about Isilon wins in the last quarter. Do you [unintelligible] as part of your VDC stuff? Or do you just plug it into storage? And if you can talk about Isilon sales in the quarter?

Paul Lidsky

We typically account for those in our storage numbers. Our VDC numbers are based on the unified compute stack. So Isilon, by itself, would not be part of those numbers. They’d be in the storage numbers.

Operator

And we have Mr. Mark Kelleher back on the line. Mr. Kelleher, you may complete your question.

Mark Kelleher - Dougherty Inc.

Thank you. Sorry guys, I cut off there. And the question I was asking when I got cut off was the one you just answered, that half of the StraTech revenue came from services, so that’s very helpful. And I did miss a few minutes, so I apologize if you already answered this question, but if you look at the push of revenue into Q4, how much of that came from Q3, that there was a hesitation and suddenly it came into Q4, and how much was a budget flush effect, and how big would you say the budget flush effect was at the end of the year in Q4?

Paul Lidsky

That’s a tough one to answer. We had a huge last week of December, the largest week we’ve ever had. The week before, the second to last week of December, was the largest week we ever had. We processed well over $20 million of orders in that week. I guess you could say some of that would have been budget flush. The third quarter orders probably came in throughout the quarter. But that’s something we don’t track, and I would just be guessing with an answer.

Mark Kelleher - Dougherty Inc.

But of all those deals you saw push out in Q3, you had some very specific - was it 7? Nine?

Paul Lidsky

I think the answer to that is all but five. Seven deals we talked about and five came in, specifically.

Operator

And gentlemen, we have no more questions in the queue at this time.

Paul Lidsky

Thank you. Well, let me just thank everyone for participating on the call today. And we’ll look forward to talking with all of you again after we finish the next quarter.

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