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NXP Semiconductors (NASDAQ:NXPI)

February 12, 2013 2:00 pm ET

Executives

Peter Kelly - Chief Financial Officer and Executive Vice President

Jeff Palmer - Vice President of Investor Relations

Analysts

James Covello - Goldman Sachs Group Inc., Research Division

James Covello - Goldman Sachs Group Inc., Research Division

Are we good to go? Terrific. Well, great. Thanks so much everyone for joining us this morning, I'm Jim Covello from Goldman Sachs. It's my pleasure to be hosting Peter Kelly and Jeff Palmer from NXPI. Guys, thank you so much for being here with us this morning.

Peter Kelly

Thanks, Jim.

James Covello - Goldman Sachs Group Inc., Research Division

Maybe if we could just start out -- I think, it's been about 10 days or so since you guys reported. Maybe just for folks, just 30 seconds to 1 minute, folks who didn't have the chance to get the download on the earnings report just to kind of frame where we are for everybody, if you could just give them the very quick overview of the earnings call and we'll take it from there.

Peter Kelly

Yes, sure. I guess we had a pretty good 2012. Product revenues were up 7%. So our HPMS segment was up 13% year-on-year and our ID business had an absolutely outstanding year at 40% growth rate. The fourth quarter was a reasonable quarter for us. It's a quarter that's usually seasonably down but was a bit better than we expected. And looking into the first quarter, we were actually able to raise our guidance a little as we move into the first quarter. So it was a nice earnings release for us, a strong year. Beat the fourth quarter and managed to raise as went into the first quarter. So it's a good earnings goal I think. On top of that, about the same time, we announced we'd done our first unsecured bond and then also, we're -- we still have a fairly substantial ownership from the private equity groups and they executed a successful secondary on Monday. So they now own about 42% of our stock and the stock has traded up since then. So a good quarter.

Question-and-Answer Session

James Covello - Goldman Sachs Group Inc., Research Division

How would you -- there is a lot of things to cover but since you mentioned the deal with the private equity folks, how would you like to see that ownership stake play out over time?

Peter Kelly

Well, it's interesting really. They're actually -- and I guess as none of them are in the room, I can be completely honest. They're really a great bunch of guys to have on your board. They -- you have instant access to some of the smartest people in the world. They'll make quick decisions. So they're terrific, really. But the whole process is they buy us in the end to sell to make money. So my expectation is over the next couple of years, as we perform or continue to perform, they'll sell down and eventually be out of the stock.

James Covello - Goldman Sachs Group Inc., Research Division

Okay. Now on the earnings -- it's been an interesting earnings season for semis because a lot of the semiconductor companies with sort of broad-based analog and industrial exposure, auto exposure, have really started to comment that things are starting to improve. You guys weren't quite willing -- not that you weren't saying it, but you weren't willing to go out quite as far on a limb as some of the peers either did before or even have since in the last week. Can you help frame that a little bit for folks?

Peter Kelly

Yes, yes. I mean we think we have a very, very strong competitive position and we think we'll outgrow the market. But we think the market is still quite weak. So our commentary was really on the macroeconomic environment. I guess we don't think in the end we're that smart that we really know how the market might perform. So our view is that the general market's still quite weak. But we have a high confidence that we'll outperform the market, and we expect to grow at least 150% better than anything we see from a market perspective. So if we're wrong and our competitors are right and the market is generally better, then we're kind of okay with that because we think we'll do that much better.

James Covello - Goldman Sachs Group Inc., Research Division

Now you guys have been terrific about beating the numbers you put out there really for the -- almost the whole time you've been public. And so I think the market has come to expect some degree of conservatism in the comments you might be making versus your peers. But some of your peers came out, some of your niche-ier peers, let's call them, in the last week and really kind of laid it on pretty thick about how significant the improvement in the order rates are. What would be the reasons why you guys wouldn't see that?

Peter Kelly

I guess possibly size, and I can only really comment on what we see. And when we give our guidance, what we try and do is give a range of reasonable outcomes. So it would generally be really unlikely for us -- I know it did happen in Q3. But it'd be really unlikely for us to exceed the top end of our guidance. And our expectation is that we'll really hit the midpoint. But things do move around. But our view at the moment is that the guidance we gave for the first quarter was pretty reasonable and we'll see how things develop during the year.

James Covello - Goldman Sachs Group Inc., Research Division

And then just finally on the near term before we move into some of the product areas, on the inventory levels you see both at yourself, the disti and then your customers.

Peter Kelly

Well, at disti, we tend to run 2.4 months of inventory, and if you look back over the, actually quite a long number of years, you'll see other than the third quarter of 2011, when we run 2.7, we typically run 2.4. So we manage that quite tightly. Certainly, the disties would like less and we'd like more but we think 2.4 is about the right level. In terms of our end customers, I think generally inventory levels look okay. The one area that we struggle a little bit with is in basestations. The supply chain there is just very, very difficult to predict, and we see some significant movements on a quarterly basis in revenue based, we think, just on what's going on with inventory levels as opposed to end shipments, end shipments to customers. But there's not been -- nothing terribly worrying or terribly exciting about inventory levels.

James Covello - Goldman Sachs Group Inc., Research Division

Okay, I want to come back to the basestation market in general. But before we do that, if we just kind of work through the different segment areas, and we start in the Portable & Computing segment. You guys had a terrific year in that market, I think it was up 14% year-over-year. A lot of it was driven by a design win. So -- and then you talked about other design wins that you expect to ramp in 2013. Can you talk a little bit about that market and the ability to continue to outperform in that area?

Peter Kelly

Well, we -- yes, we have a number of design wins in the mobile space. I guess when we got into that about a year ago, we came in as a second source, but our performance has been such that we've managed to be pretty much the single source supplier now. We think that the really important thing for us is not just our first design win but kind of, how we position ourselves for follow-on products, and we think we've positioned ourselves quite strongly there. I don't know if you have any comments, Jeff.

Jeff Palmer

No, I think that's appropriate, Peter. It's not a one-inning game, right? It's a multi-inning game and we think we're well set up for future opportunity.

James Covello - Goldman Sachs Group Inc., Research Division

Do you think the bigger growth opportunities in that market are expanding your footprint within your existing customer base or expanding the customers?

Peter Kelly

I would say both.

James Covello - Goldman Sachs Group Inc., Research Division

I said bigger, you have to pick one.

Peter Kelly

I know, I know, but it's -- no, but I think there's opportunities both in terms of kind of expanding within a customer. But also with some of the designs, there's an ability to go out and position ourselves more strongly with other customers in the same space.

James Covello - Goldman Sachs Group Inc., Research Division

I asked you this question at the Analyst Meeting a few months back. But one of the things about your target model that we'll get into in more detail later, it's based on margins improving over the course of the cycle. And one of the things that you and I discussed at the time was the trade-off between these very significant revenue opportunities that are operating profit, significant operating profit dollar accretive, but obviously, a little margin-dilutive, especially in some of the earlier stages of these product ramps. How do you think about that trade-off at this point?

Peter Kelly

Well, we don't think they're dilutive from an operating margin perspective. We think they can be from a gross margin perspective. And we are -- I guess the way I answered the question at that time, if I had a choice of 25% operating income and lower gross margin versus 20% operating margin, high gross margins, I'd always go for the higher operating income. I think one of the things we want to make sure that we get out there is we think there's plenty of growth in our space. And we think it's important to get to 25%. But once we get there, if we had a choice between consistent compound growth of 5%, 10%, whatever percentage -- at 25%, as opposed to very, very weak revenue growth at 27%, 28%, we would stay at the 25%. So we think profitable growth is what it's all about. We need to be fair. We also need our customers to be fair to us. But if we can drive 25% operating income and above market growth rates, certainly as a first step, that would be -- we'd be pretty comfortable about that.

James Covello - Goldman Sachs Group Inc., Research Division

So if we move from the Portable & Computing segment to the ID segment, so as good as the growth in Portable & Computing was at 14% year-over-year, the ID segment was extraordinary at 40% year-over-year. Can you talk about some of the drivers there, both last year and then how repeatable that is into, not the growth rate, but the growth into 2013?

Peter Kelly

Yes. It's a business that we're very, very positive, and very bullish about. I think in ID, people tend to get really obsessed with NFC, which is about 5% of our overall revenue. If you look at our ID business, automatic fare collection very, very strong. It's grown substantially over the past few years. And there's some ridiculous statistic, but I think it's over 1 billion people use our technology every day in fare collection. eGovernment passports is an easy one to look at. But [indiscernible] the bits [ph] driver's license, my bits [ph] driver's license has an ID chip in it. There's all sorts of government cards, whether you're looking at food stamps, whether you're looking at identification cards. There is just a phenomenal opportunity within the government space. Clearly, mobile transactions will still continue to be an opportunity for us. And then tags and labels, I know Jeff's daughter is helping us with the tags and labels space there with Skylander (sic) [Skylanders].

Jeff Palmer

So Skylander (sic) [Skylanders] is a game that Activision rolled out last year to phenomenal success. I think we've shipped something like 16 million systems so far. And where we have a tag in the little character plus an NFC reader chip in the basestation. There's a lot more markets for our technology than just mobile transactions and so on.

James Covello - Goldman Sachs Group Inc., Research Division

Right.

Peter Kelly

But we'd expect continuing double-digit growth in 2013. Authentication is obviously an interesting market. And I think beyond that, how we all access the cloud is something we should all be pretty scared of. So again, we think there's an opportunity within our ID business to drive improved security and drive additional revenue for ourselves.

James Covello - Goldman Sachs Group Inc., Research Division

I believe the core ID business is the area where you have the least competition. Do you think your success in the market is going to attract incremental competition and do you worry about that in either share or margin?

Peter Kelly

Yes, yes. We -- I guess we don't have sleepless nights but we continue to invest very, very heavily in our core business. We think we have a pretty substantial lead. It's not just about the hardware but the software, the certification that's been able to manufacture this stuff. But we don't intend to rest on our laurels. It's the single biggest set of investments we have. And we think it's a market that we are successful in, we will continue to be successful in. But we need to make sure that we continue to invest in that. And I guess one of the good things is when you are the market leader by a huge percentage, you can invest more than anyone else. And we plan to continue to do that.

James Covello - Goldman Sachs Group Inc., Research Division

While your overall guidance for the first quarter was certainly above the market, you did guide to a mild correction in the ID segment in the first quarter.

Peter Kelly

Yes.

James Covello - Goldman Sachs Group Inc., Research Division

You know, after the period of really, really robust growth you've had, is there any concern that what is -- what starts as a mild correction in the first quarter gets more significant as we go throughout the year?

Peter Kelly

No, we don't think so.

James Covello - Goldman Sachs Group Inc., Research Division

And is that based on design wins that you see? Or, you know, what ...

Peter Kelly

Yes, it's based on our order book, our design wins and the relationships we have with our customer base around the world. So we think we understand our market quite well.

James Covello - Goldman Sachs Group Inc., Research Division

You mentioned NFC and the attention it gets. I mean, I've certainly been pretty vocal about how I wish people were less focused on NFC. Can you talk a little bit about where you are, where you think the market's going, and both the market and your positioning. I mean, I think your positioning is one thing. That's less of a question to me than is the market itself, right? It's just I struggle to find the real use case for it at this point given the point-of-sale terminal doesn't really have NFC capability at this point.

Peter Kelly

Well, that's actually a more difficult question. I might let Jeff answer that.

Jeff Palmer

Jim, I think it's really about the business model, and I think there's a lot of participants who are trying to figure out how they benefit from the rollout of NFC. I think one thing that we see is that we're seeing the phone companies and the phone OEMs adding NFC functionality to their handset, but they're deactivating it until they have a strong enough base of customers. And to your point where you kind of alluded to a chicken-and-egg between the handset and the point-of-sale terminal, the reality is, most point-of-sale terminals that are being rolled out today for contact with banking are already future-proofed to support NFC-enabled handsets. So that argument of chicken and the egg, I don't think really is valid. I think it's really a matter of who's going to participate when we all start doing things with our phone. The carriers would like to be the point of access. I know MasterCard and Visa aren't going to acquiesce their control over our wallets. But I think it's just there's still business cases trying to be netted out. In terms of where we see the market, we exited 2011, we thought there was roughly 35 million NFC-enabled handsets, fewer than we would have liked that year. As we exit 2012, we see there's probably 110 million NFC-enabled handsets, of which we probably shipped 100 million. We think that based on third-party research, we still think that by 2015, probably 50% of all smartphones will be NFC-enabled. And if you look at some of those estimates, you're talking 1 billion smartphones in 2015 and 500 million NFC-enabled handsets. So we clearly think the trend is towards the adoption of the technology. I know we all like in Wall Street for things to happen overnight, but I think this is going to be one of those ones that it happens over a longer and slower period of time.

James Covello - Goldman Sachs Group Inc., Research Division

Okay. And so Peter, you mentioned it's 5% of revenue today even though it gets a lot of attention. You've been able to significantly outgrow the industry with the gains in portable computing and ID and basestation. And so you have not required a contribution from NFC over the last 18 to 24 months to outgrow the market. Do you require participation from NFC to continue to outgrow the market?

Peter Kelly

No. I think as we look at it in the long term, our assumption on NFC is that the radio will eventually be integrated with a combo chip and, to be honest, we've been surprised it's taken so long. We thought it would have happened much more quickly.

James Covello - Goldman Sachs Group Inc., Research Division

The integration you mean?

Peter Kelly

Yes, the integration. Yes. But we think our strength in the secure element will continue. We'd expect that to be an above average contributor. But we're not to -- it's nice to ship the radio but we've kind of -- we've been surprised we've been allowed to ship it so long.

James Covello - Goldman Sachs Group Inc., Research Division

But you don't need a robust NFC market to outgrow the market?

Peter Kelly

No, absolutely not.

James Covello - Goldman Sachs Group Inc., Research Division

Okay. If we can just shift to auto a little bit. You know, obviously, semi content for vehicles has been going up, but there's a number of competitors that are focused on seizing the opportunity. How do you see both the continued vehicle content increasing? And then the competitive positioning in the market where, unlike ID, this is a place where kind of everybody is?

Peter Kelly

Well, guess the first thing in automotive, one of the good things is even if someone does seize the opportunity, it's 5 years before it actually has an impact on you. But we think we have a very strong position. We're expecting probably 0% to 2% SAR growth next year. We had thought semis would be a little bit stronger than that and we'd be a bit stronger on top of that. We have a very good position in radios. We have a really strong position in keyless entry. And I guess one of the things we're quite excited about is, over time, Car-to-X, the idea that automobiles will communicate more effectively with each other and also with basestations at the side of the road. It will drive, according to the economic -- European Economic Community anyway, it's probably the single biggest advance in road safety since the introduction of seat belts. It's going to have a big impact on flow control and kind of how we all get to work in the morning. I guess it has the potential to stop speeding, which is a bit of a nightmare for me personally. But no, I think, again, we're very strongly positioned from an auto perspective. And that's a market that -- you're certainly not going to see 30%, 40% growth like you did in ID. But it's a $1 billion business for us that drives excellent margins and I think will continue to grow quite well in the coming couple of years.

James Covello - Goldman Sachs Group Inc., Research Division

Great. We shift over to the Infrastructure business. That's been another success story. You guys have talked about design wins, in particular in China that will ramp in 2013. How do you feel about those? And it sounds like some of those products could be released in the earlier part of the year as opposed to the latter part of the year that could help to drive some incremental momentum sooner rather than later.

Peter Kelly

Yes, we have a very strong position in LTE. So we have design wins with kind of pretty much everyone who -- everyone who counts. So at this point, it's more a question of when do things start to roll out. But we think we're really well positioned in China. We have a great position in Europe. Can we talk about the [indiscernible]?

Jeff Palmer

We talked about our Base business.

Peter Kelly

Yes. Yes, so no, we think we're well positioned, we have the design wins. It's just a question of when the rollouts start to happen.

James Covello - Goldman Sachs Group Inc., Research Division

Do you expect any of that to contribute to the March quarter numbers or is that something that would begin to contribute in the June quarter?

Peter Kelly

I would say it's more -- it'd contribute in March but you'd see more growth in June and Q3.

James Covello - Goldman Sachs Group Inc., Research Division

And again, you mentioned the goal of 1.5x the market is the goal for the growth. You've certainly been able to achieve on that. Of all the segments that we've just talked about, on a go-forward basis, which are -- what is the 1 or 2 most important to make sure we hit that 1.5x the market goal?

Peter Kelly

I think the ID business is very strong. I think industrial infrastructure could surprise us. P&C will continue to do well in 2013. I think just coming back to I&I, we're very focused on the basestation business. But even within our emerging business, we have a set of audio amplifiers that we've released that could do quite well for us in 2013.

James Covello - Goldman Sachs Group Inc., Research Division

Yes. So if we can move on from the product segments and maybe start talking about some of the margins and some of the restructuring that you've done and then, ultimately, the balance sheet, one of the drivers of your margins this cycle has been the shift toward HPMS. And it went from 60% of sales in 2010 to 75% last year. Is that something you see continuing? Where do you see that mix winding up as we go forward?

Peter Kelly

Yes. Absolutely, I think it will continue. Our Standard Products business will only tend to grow at the level of the industry overall. So over time, it's -- we'd expect it to be no more than maybe 20% of our business and the HPMS business, as it grows to become a bigger and bigger part of our business.

James Covello - Goldman Sachs Group Inc., Research Division

Yes. And you seem like you've had quite good predictability in the margins within the HPMS business. The margin volatility in the Standard Products business has been extreme. Is there an ability to see less volatility in the margins around the Standard Products or do you just think that's a way of life?

Peter Kelly

I think there's a couple of things. Standard Products had an absolutely fantastic 2011, just off the charts. And in 2012, it's had a number of issues. I think 2012 is more of a transition year for them. Q1 on 2012, we saw a fairly -- a big hit in terms of pricing. And then the second half of 2012, the volumes have been a little bit less predictable than we would've liked. So it's been hit with some underutilization charges. So yes, it's been a bit unpredictable in 2012. But I'd expect it to become a little bit more predictable in 2013 as things have stabilized. And I think it's really just a question of going through a transition from just a phenomenal 2011 to a kind of pretty tough 2012.

James Covello - Goldman Sachs Group Inc., Research Division

Yes. Another focus or area that could benefit the margins going forward is your focus on increasing and monetizing your IP portfolio. Can you talk a little bit about that?

Peter Kelly

Yes, yes. In terms of trying to get to 25% EBIT for 2013 or sort of as we exit 2013, there's a couple of items. That -- we're going to take down our SG&A by about 200 basis points and that's really a question of just how we manage our investments in people. So we're pretty sure we know how to do that. In terms of gross margin, there's -- we plan to improve our gross margin by 300 basis points, and it's really in 3 areas. One is just around managing our wafer costs and front-end costs. The second area is really around how we do some basic blocking and tackling in NXP, things like gold to copper conversions. But the third area is how we exploit our IP portfolio. We have 6,000 patents. So we have a very, very strong IP portfolio, but we've not really managed it as well as we could do historically. Now it takes time to do that. And over the last 3 years, we've been investing in that portfolio. We kicked off a lawsuit about 18 months ago really to begin to condition to the market that we were not happy and we would not allow people to use our IP if they go forward without reimbursing us for it. So we're kind of 80%, 90% of the way there, but we think as we get through 2013 and as we exit the year, we should be in a position where we can pull out probably $10 million a quarter on a consistent basis from our IP portfolio.

James Covello - Goldman Sachs Group Inc., Research Division

Going back to the Analyst Meeting, which I wrote up as one of the better ones that I had attended. 2 of the things that really struck me about that meeting were your willingness to offer up a $4 earnings target potential on only $5 billion in revenue, which requires very little cyclical growth relative to the $1 billion, $2 billion or so that you were doing at what was really not a very robust part of the cycle. And then secondly, the fact that you were putting your own money into the company, not company grant, but you were making a personal investment in the company. And obviously, that's been a terrific investment for yourself. Can you update us on both of those? I mean, on the $5 billion revenue, what's your confidence in at least $4 worth of EPS at this point?

Peter Kelly

Yes. Well, I guess first of all, yes, I did make a lot of money on the personal investment. Yes, I think if you look at this as an HPMS business, the key thing is, what's the operating income that we can run? Because the revenues are not -- you know, you're not going to see huge swings like you maybe would with an SoC supplier in our revenues. So I think a gross margin of 50% and I think an OpEx level of 25% is not rocket science for a business like ours. And if you then, if you're running 25% operating income, you can work out the math pretty quickly. We start -- if you look at our net interest costs, we brought our net interest cost down from 320-ish in 2011 to 260 in 2012, so I'm guiding 195 to 200 in 2013. And if you have anything like a reasonable level of cash in the business, then you can see that coming down again in 2014. And the great thing about us being a European or a Netherlands-domiciled company is our tax rate is actually very, very low on a go-forward basis. So even as we kind of burn through our carryforward tax losses, our long-term tax rate is round about 10%, which you don't get in many places. So 25% OI, relatively low net interest costs and I'm happy with the level of debt. Low tax rate. You can do the math, you get to $4 pretty quickly. So I'm okay with that. And I'm not -- I'm definitely not selling the stock.

James Covello - Goldman Sachs Group Inc., Research Division

That was going to be my next question. So you're still a holder of what you bought at a much lower level. That's good to know.

Peter Kelly

Yes.

James Covello - Goldman Sachs Group Inc., Research Division

On the leverage, obviously, you guys have executed very, very well from over 4x to now down, I think, to about the 2.3x exiting 2012 net leverage, if I'm not mistaken. And obviously the stated goal is to get it down to 2x where you feel like it would be an investment-grade credit, and that's commensurate with the guidance for the lower interest expense for 2013. What's the right level ultimately? Obviously you guys are easily covering the debt levels now. What is the optimal capital structure? And then to get from the 195 to 200 of interest expense in 2013 to a lower number in 2014, which securities would you repay?

Peter Kelly

I think it's a couple of things. One is we do -- we think we can get to 2x net debt to trailing 12 months EBITDA probably the end of this year or early into 2013. I think after that, we have to decide what do we want to do with our cash. I'm very comfortable with a level of gross debt of, say, $2 billion. I think it's good from an overall cost of capital perspective. We're in the fortunate position where we don't have any real debt due in the short term. Our most expensive debt is we have just under $500 million of debt from 2018 that's 9 3/4%, and that becomes callable in August of next year. So that would be the obvious one to go after. I still probably have too much, from my perspective, floating rate debt. I'd like a bit more fixed rate debt. So I would make -- I'd take some actions probably in the next couple of years just to move that more towards a fixed rate level. But I feel pretty good about our capital structure. Definitely we'll pay down -- the focus in 2013, we'll pay down more debt. But after that, I think it just depends where we are. You know, does it make sense to continue to pay back -- pay down debt, buy back stock, pay a dividend, invest in the company? Whatever makes most sense for the shareholders.

James Covello - Goldman Sachs Group Inc., Research Division

So just concluding with the theme that I've kind of gone through throughout, which was going back to that Analyst Meeting and what you laid out there and what you talked about, two of the other things that really struck me were, for a company that's done so well since the IPO, I remember at that meeting you started off with a slide of "Here's what we've done wrong. Here's what we've gotten wrong." And for so many companies in this industry that have mis-executed, they kind of sit up on stage and pound their chest about stuff. And you guys start with "here's what we've done wrong," even though you've actually outperformed. And continuing with that theme on the last call, you talked about decreasing the SG&A expense from 14% to 12%, which again is an interesting move for a company that's beaten and raised most quarters. Why? And then, what is it about the company that causes you to continue to think that way?

Peter Kelly

Well, going from 14% to 12%, it's 12% of revenue. We do expect to be a much bigger company in the next few years. So although it would have an impact in 2013, it's more about getting the resources in the right place. I love finance, but I'd rather hire R&D people than accountants. So this is all about kind of making sure we can continue to invest in design, making sure we can continue to invest in our customer-facing people and making sure we have an adequate level of support costs. We just thought the ratio of our support costs have gotten out of sync really. And you know, some of our competitors run at 12%. So we don't think it puts us out in a space where we're on our own. We think it puts us in the right spot really. So it's more about to position ourselves for the future and not resting on our laurels, making sure we don't pat ourselves on the back too much. If we're going to be a great company, we have to continuously improve and not just wait for the -- to move up with the rest of the market.

James Covello - Goldman Sachs Group Inc., Research Division

Terrific. Peter, Jeff, Thank you, guys, so much for taking out the time. We really appreciate it. We'll have the break out in the Presidio, and we look forward to doing it again soon.

Jeff Palmer

Thank you very much, James.

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Source: NXP Semiconductors NV Presents at Goldman Sachs Technology & Internet Conference 2013, Feb-12-2013 11:00 AM
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