Kayne Anderson Energy Development Company (NYSE:KED)
Q4 2008 Earnings Call
February 9, 2009 5:00 pm ET
Monique Vo – Vice President of Investor Relations
Kevin S. McCarthy – President, Chief Executive Officer, Co-Portfolio Manager & Director
Terry A. Hart – Chief Financial Officer & Treasurer
J. C. Frey – Vice President, Assistant Treasurer, Assistant Secretary & Co-Portfolio Manager
David LeBonte – Head of Energy Research
My name is Angelia and I will be your conference operator today. At this time I would like to welcome everyone to the fourth quarter 2008 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question and answer session. (Operator Instructions) I would now like to turn the call over to Monique Vo, Vice President of Investor Relations.
Welcome to the earnings call for the Kayne Anderson Development Company for the quarter and fiscal year ended November 30, 2008. Before we begin this afternoon I’d like to remind you that our call will include statements reflecting assumptions, expectations, projections, intentions or beliefs about future events. These and other statements not relating strictly to historical or current facts are intended as forward-looking.
Generally words such as believe, expect, intend, estimate, anticipate, project, will and other similar expressions identify forward-looking statements which generally are not historical in nature. Forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ from the company’s historical experience, its present expectations or projections.
For a description of the factors that may cause such a variance I would direct you to the forward-looking statement discussion in our annual report on Form 10K and our quarterly reports on Form 10Q. These reports are available free of charge through our website at www.KayneFunds.com and at www.SEC.gov.
You should not place undue reliance on forward-looking statements. The company undertakes no obligation to update or revise forward-looking statements. There is no assurance that the company’s investment objectives will be obtained. With that, I will now turn the conference over to our President and Chief Executive Officer Kevin McCarthy.
Kevin S. McCarthy
Thank you for joining us today for our fourth quarter conference call for KED. Joining me today are Terry Hart and Jim Baker in Houston and J. C. Frey and David LaBonte, in Las Angeles. First we’d like to review market conditions for the MLP sector both during the quarter and since the beginning of the year. Then, we will review KED’s performance during the quarter ended November 30th as well as the performance of our four largest private investments. Next, Terry will discuss our financial performance and guidance based on our most recent portfolio. Then, we’ll open the phone lines for our Q&A session.
Fiscal year 2008 was a terrible year by almost any measure. With the collapse of the credit markets, the disappearance of many of Wall Street’s most prominent firms and the onset of the worldwide recession. As a result, we saw substantial declines in the overall capital markets, the energy markets and the MLP market. Calendar 2008 was the worst year for the Dow since 1931 and the worst year for the S&P 500 since 1937. The MLP market was affected as well with the Alerian MLP index declining over 38% during our fiscal year.
Much of this decline occurred in the fourth fiscal quarter when the decline in the financial markets both intensified and accelerated. During our fourth fiscal quarter the Alerian MLP index declined 33%. This quarter decline was more than two times the largest previous annual decline of that index. In addition to the absolute poor performance we also saw record volatility in this sector. From 1996 to the end of our third fiscal quarter there were only two days when the Alerian index changed more than 6%. In the 90 days that followed there have been nine days, a full 10% of the trading days where the changes exceeded 6%.
As a result of the severe decline in MLP prices, MLP yield at all time highs during our fiscal fourth quarter the market cap weighted average yield at November 30th was 11.7% almost twice the 6.4% at the end of fiscal ’07. Likewise, the spread between MLP yields and the 10 year treasury rose 174 basis points compared to an average of 238 basis points over the last five years.
The reasons for the poor performance in the MLP sector are numerous and interrelated. Clearly, the weak performance of the broader capital markets had a significant impact on buyers of MLPs both retail and institutional. Since 2005, a significant amount of new capital investors of MLPs came from hedge funds. The troubles in the hedge fund industry which have been well publicized as well as the reduced sources of leverage for these funds caused certain funds to sell a significant portion of their MLP holdings.
To a lesser extent, dedicated MLP closed end funds including KYN and KYE were required to sell MLPs in order to maintain their leverage ratios. Finally, as the overall market declined, retail investors were reducing portfolio leverage, reducing exposures to [inaudible] securities and moving to cash. Quite simply, there was an abundance of sellers and a dearth of buyers for MLPS.
Another part of the performance of MLPs during the second half of 2008 can be attributed to the sharp and substantial decline in commodity prices. From their peak in July, oil prices declined by more than $100 a barrel or 69%, natural gas prices declined by 58% and NGL prices declined by 73%. While much of the MLP revenue stream is fee based and not dependent on commodity prices, some MLPs are exposed directly and indirectly to commodity prices.
While many of these MLPS had hedged a significant portion of their direct exposure, the magnitude and severity of the decline had a material effect on their operating performance and impacted their stock price performance. On a relative basis, MLPs fared better than other sectors of the energy industry such as exploration and production companies which declined 56% from their peak in July and oil fill service companies which declined 66% from their peak.
Finally, the Lehman Brothers’ bankruptcy had a distinct negative impact on the MLP market. Lehman was one of the leading underwriters of MLPs under the past several years and their retail system was a large holder of MLPs. Lehman Brothers was also a large owner of MLPs for its own account and managed a dedicated MLP hedge fund that was forced to liquidate a large portion of its holdings. We believe that a substantial amount of the selling pressure in the MLP market during September and early October was the result of the Lehman Brothers bankruptcy.
As we look forward in to 2009, we’re focused on several key issue for the MLP sector. First and foremost is the availability of capital. As with many industries, capital availability for the MLP sector has diminished over the past six months for both investment grade and non-investment grade companies. While a large capital program was once viewed as an asset that commanded a premium valuation because of the growth it would create, such programs are now often viewed as a liability.
Several MLPs have capital programs that much be funded with external capital and we’re watching these companies closely to see if they can either find outside capital or joint venture partners or successfully renegotiate their capital commitments for debt covenants. While we’re encouraged by the recent capital markets activity by several of the largest MLPs, as capital markets become even more accessible before MLP equity prices trade closer to historical valuation levels.
We think that the current capital markets and commodity price environment will cause MLP cash distribution growth to slow substantially in the first half of 2009. We believe that most MLPs will be cautious in raising their distributions at a time when it’s critical to retain cash to maintain liquidity. While we’ve seen isolated distribution cuts in the midstream sector, we believe further cuts will be eliminated unless commodity price dislocation continues well beyond what we and the marketplace anticipate.
We firmly believe that MLPs will adapt to market conditions, they will adapt to the limited availability of outside capital by concentrating on the most profitable capital projects. While growth and distributions will moderate from recently levels, higher yields will continue to provide attractive risk adjusted total returns. We believe the long term growth process for our existing portfolio of private MLPs continues to be strong but 2009 will present challenges as a result of the state of the economy, the credit markets and the commodity markets.
While we believe that our private MLPs are well conditioned to weather the current market downturn, they will likely take a cautious stance towards our organic growth projects and acquisitions in the near term. We believe that the IPO market for MLPs which is currently shut will improve as the broader MLP market gains momentum. We also expect to see many attractive new investment opportunities for KED as more and more small companies struggle to secure the capital necessary to grow their business.
The most frequent question I receive is when will the markets come back? The recovery of the MLP sector is largely dependent on the recovery of the financial sector, the general economy and the economy market. A full recovery to prior valuation levels could take some period of time. We can’t forget the demand for energy products both domestically and internationally will continue to grow over the next several decades. Commodities will continue to be produced in areas that are farther and farther away from end users and existing infrastructure assets.
Midstream MLPs which provide the critical link between producers and consumers will see demand for their services increase over time. As a result, we continue to be optimistic about the long term prospects of both the infrastructure sector and the companies in our portfolio.
Turning now to performance for the fourth quarter ended November 30th, KED’s total return was better than the Alerian MLP index. KED had a total return of -26% as measured by the change in adjusted NAV which includes cumulative dividends. This compares to the Alerian’s total return of -31%. The decrease in NAV was principally the result of unrealized losses in our portfolio.
We experienced unrealized losses in all the segments in which we invest with substantial declines in the market value of our public MLPs and publically traded debt as well as lower marks on our private MLPs in part on a discount to the value of comparable public MLPs so declining valuations in the public market led to declining valuations for the private MLPs. For fiscal year 2008 KED also a better total return in the Alerian index. KED’s total return was -27% for the fiscal year compared to -34% per the Alerian.
Now, I’d like to turn to KED’s stock price performance. For the first three quarters in the fiscal year 2008 KED shares traded very close to NAV with the average being a discount of 2.3%. During the fiscal fourth quarter KED began trading at significantly wider discounts to NAV. This was true across the board with other closed end funds and BDCs. During the fourth quarter KED saw its share price tumble and the discount widen for several reasons including a very weak broad market, continued sell off of MLPs, uncertainty about our dividend, tax loss selling and extremely weak performance by the BDC sector.
During the fourth fiscal quarter KED stock price fell 58% from $22.85 to $9.63. KED outperformed other BDCs which were down 67% but underperformed other MLP closed end funds which were down 47%. The month of December 2008 was not a good one for KED as tax loss selling and problems in the BDC space accelerated as the year drew to a close. KED’s stock price dropped 22% from $9.63 to $7.51 at the end of the calendar year. Stock price performance in 2009 thankfully, has been markedly different. From its low on December 30th, KED stock price has risen 91% to Friday’s close. Over the same time period, BDCs have declined a further 21%, closed MLP funds have risen 28% and the Alerian MLP index has risen 18%.
In the fourth quarter we declared a distribution of $0.35 per share down from $0.42 last quarter. In past quarters our distribution included a portion of our net released gains. While we still have net realized gains that have not been distributed, we believe it is more appropriate to retain this cash until there’s more certainty in the financial markets. We’ve decreased our dividend to be more in line with the dividends and interest generated from our portfolio.
In terms of our portfolio, at the end of our fiscal year, 51% of our portfolio was invested in private MLPs, 33% in public MLPs and 16% in second lien loans. With a sale of Millennium in September for a combination of public MLP units in cash, our portfolio has moved away from its target 70% private MLPs. Overtime, we intend to rotate out of some public MLPs in to additional private MLPs.
As of November 30th, the three largest holdings are private MLPs, Direct Fuels, International Resource Partners and VantaCore. Our fourth largest position is Eagle Rock Partners, a publically traded MLP who’s units we received in the Millennium transaction. The fifth largest position is our investment in ProPetro. What we like about our private MLPs portfolio is the diversification. We have on transmix and terminal MLP, one coal MLP and one aggregates MLP.
Our second lien portfolio is a mix of different energy related subsectors, midstream, upstream, oil field service and power generation companies. About 60% of our portfolio is in high yield bonds which have pretty active markets and about 40% is in second lien bank loans. These trade with less frequency but still provide us with a measure of liquidity.
Now, I’d like to provide and update on our top four private investments. For each one we’ll go in to the financial results of 2008, expectations for 2009, each company’s liquidity situation and valuation. I will also note any changes we’ve made to our year end valuation. As Terry will discussed, we’ve updated our November 30th NAV in connection with our dividend reinvestment program. As a result, our NAV on January 22nd was $15.22 compared to $16.10 on November 30th. I would also note this January NAV reflects the payment of our dividend where the November 30th NAV did not.
Our largest private holding is in Direct Fuels, a specialty refiner and wholesaler of gasoline and diesel in the Fort Worth area. While the year started off very well, financial performance for 2008 ended far below expectations. The combination of Direct Fuels’ poor performance in the second half of the year as well as falling MLP prices caused us to postpone the planned IPO for Direct Fuels.
In terms of what caused the poor performance, it’s helpful to step back a moment to describe Direct Fuels operations. As some of you may recall from our analyst day, transmix refining or processing is their core business. Transmix occur when refined products are mixed together during the shipment by pipeline. Direct Fuels buys that mixture, separates it back in to gasoline and diesel that meets industry specs.
Direct Fuels’ secondary business is wholesale gas and diesel distribution where they purchase gasoline and diesel from the Houston refineries, store the product in their terminals and resale the product to independent gas stations and distributors. Between the two businesses, the partnership is the second largest unbranded fuel provider in the Dallas/Fort Worth area.
Typically the margin the company receives are relatively consistent from year-to-year. During the last half of the year the spot margins, that is the difference between the purchase price or the cost of the product and the sales price of the product remain strong. Unfortunately, the company has an average inventory holding period, that is the time from they purchase the product to the time they sell the product of 16 days.
Under most normal circumstances the price movements within this 16 day period are immaterial and balance out. However, from late July throughout the end of the year we saw really and unprecedented decline in gasoline and diesel prices with unleaded gas falling from $3.51 a gallon to $1.11 a gallon. This change in inventory value eroded much, if not all of the company’s spot margin during certain months of 2008.
We’re working closely with Direct Fuels to reduce its exposure to commodity price risk in this wholesale business. Among the steps the company is undertaking is evaluating or exiting the wholesale gas operations which aren’t as profitable as the wholesale diesel operations, increasing its commodity hedging program, working with shippers to reduce transit time and altering its purchasing contracts to reflect an average monthly price rather than a three day spot price.
As a result of the poor performance during 2008, as well as the write off of IPO costs, Direct Fuels may have some difficulty meeting certain debt to EBITDA covenants in the first two quarters of ’09. Direct Fuels is in discussions with its banks regarding delaying the step down of certain leverage covenants in its credit facility by two quarters. Since mid June, Direct Fuels has made progress and significantly reduced its debt from over $75 million to $42 million and will continue to reduce debt through working capital reductions and potentially additional equity contributions. Our November 30th valuation of Direct Fuels is $15 per unit, down from $20.80 per unit on August 31st. This valuation did not change in our January update.
VantaCore, our second largest private holding is a private MLP in the aggregates and asphalt business. As part of its strategy to acquire small to medium size aggregates companies in August, 2008 it acquired Southern Aggregates, a sand and gravel operations near Baton Rouge Louisiana, for $48 million.
In general, it was a good year for VantaCore, especially in light of the difficult environment in the construction industry. The company’s base business with McIntosh, generally performed in line with budget which was slightly less than 2007 results. McIntosh performed much better than most diversified competitors largely as a result of its location. As we’ve mentioned before, Clarksville Tennessee is one of the fastest growing medium sized metropolitan areas in the country with a diversified industrial complex plus the large and growing Fort Campbell military base.
The Southern acquisition which was completed in August has underperformed acquisition economics. The principal reason for this was the impact of Hurricane Gustav which directly hit Southern Louisiana and caused extended power outages for periods of up to two to three weeks. This severely limited construction activity in the area for an even longer period. Southern also delayed a planned pricing increase in to early 2009 in the face of a softening economy in the fourth quarter.
In the interim, the company is actively targeting improvements in order to lower its unit production costs and has been able to add several new customers. Volumes in 2009 are expected to be lower than in 2008 as the recession impacts overall building activity across the country and in VantaCore’s markets.
I would point out that we think there’s significant upside to the budget for two reasons. First, President Obama’s infrastructure program is expected to have a positive impact on the aggregates business. Second, Dow Coring and Hemlock Semiconductor announced in December a plan to construct a $1.2 billion plant in Clarksville which is expected to add up to 1,000 construction jobs over the next several years.
VantaCore has strong credit metrics with a net debt to EBIDTA of 2.2 times and leverage representing only 30% of total assets. As of November 30th the valuation for VantaCore is $17.75 per unit, down 15% from its valuation on August 31st primarily driven by lower EBITDA projections for 2009. This valuation also did not change in our January update.
Our third largest private investment is in International Resource Partners or IRP, a fully integrated coal production company in West Virginia. Its operations include surface mining of steam coal used in power plant and underground mining of metallurgical coal used in steel production. IRP had a banner year as EBTIDA was ahead of budget by more than 50%. Much of its surface coal was fully contracted in 2008 which meant it couldn’t benefit fully from the substantial run up in steam coal prices during the first six months of 2008.
IRP was able to capture substantial value on its met coal business largely as a result of its coal marketing group. On the operations side, like many central coal producers, IRP struggled to hit production targets in surface mines but was largely able to meet its targets in its underground met coal operations.
As we enter 2009 both steam and met coal prices are down significantly from mid 2008 levels. This is not expected to have significant impact on the profitability of its surface or underground operations as over 95% of its 2009 production is under contract. However, lower met coal prices are expected to result in lower profits for the company’s coal marketing business, profitability levels that are more in line with historical levels.
The worldwide economic slowdown is also impacting volumes of met coal [inaudible] to the volumes of the marketing business are expected to return to pre 2008 levels as well. IRP expects to utilize the excess cash flow it generated in 2008 to repay a portion of its credit facility which will reduce leverage to less than 1.5 times 2009 EBITDA. Our November 30th evaluation for IRP is $16 per unit, down 33% from $24 per unit on August 31st primarily due to lower trading multiples for publically traded coal companies.
For example, on November 30th the average publically traded coal company was trading at three times EBITDA. Our most recent NAV reduced the valuation to $15 per unit due to the continued pressure on coal prices since November 30th.
ProPetro, our fourth largest private investment is an oil field service company with operations in the Uinta Basin of Utah, Permian Basin in Texas and the Midcontinent area. As you may remember from prior calls we installed a new management team in the middle of the year and brought back Bill Martin the previous owner of the Uinta Basin business. As a result of the changes instituted by the new management team, ProPetro’s performance improved substantially in August and September.
Unfortunately, just as the operations began to improve, commodity prices collapsed causing E&P companies to reexamine their budgets and reduce drilling expenditures. We’re encouraged that ProPetro is experiencing much higher utilization rates than its competitors and is gaining market share during the downturn. Nevertheless, 2009 is expected to be another difficult year for ProPetro. The next several months will be very important as exploration companies finalize their 2009 drilling programs.
In our August earnings call we reported that ProPetro was in discussions to sell certain of its Midcontinent assets and unfortunately the discussions were discontinued because of a sharp drop in the potential acquirers stock price. ProPetro’s liquidity situation continues to be tight and management is taking steps to reduce the company’s cost structure to enable it to weather a downturn in activity.
This is obviously a very difficult situation to be in and the recovery of our entire principal amount is unlikely in the current environment. The oil field service business is a very cyclical business. ProPetro’s strategy is to continue to manage the business to increase its market share in its core businesses, to reduce costs to levels that are consistent with the current level of business activities and to work with the first lien lenders to give ProPetro time to wait for the cycle to turn.
From a value standpoint, we believe that there’s little downside based on their most recent valuation in January of $5 million which was reduced from our valuation at November 30th of $10 million. To the extent that we continue to operate through the cycle, the potential for more substantial recovery increases greatly.
In terms of our balance sheet, as of November 30th, KED had $57 million in borrowings under our $100 million revolving credit facility. This had a borrowing bases of $71.1 million on that date. That puts us at 80% of our borrowing base at November 30th. Our debt to total assets at November 30th was 26%. We believe this conservative level was appropriate given the current state of the capital markets and the leverage problems that are affecting some other BDCs.
With that, I’ll now turn the conference call over to Terry Hart, our Chief Financial Officer.
Terry A. Hart
As of November 30, 2008 KED’s NAV was $162.7 million or $16.10 per share. This represents an increase of $1.23 per share compared to the unaudited NAV that KED announced on January 9, 2009. The principal reason for the increase is removal of our valuation allowance on our net deferred tax asset. This increase was slightly offset by the change to our estimated posted closing adjustment related to the sale of Millennium Midstream Partners.
Our unaudited NAV that was announced on January 9th included a valuation allowance of $12.9 million or $1.27 per share on our net deferred tax asset. The valuation allowance was based on the amount of the deferred tax assets that we estimated could be utilized within three years and our belief that this methodology was consistent with industry practice. We know that the valuation allowance for deferred tax assets has been a focus for taxable closed end funds like ourselves and we’ve had numerous discussions with our auditors over the past four months regarding our approach.
Under FAS 109 no valuation allowance is required if after weighing all the objective evidence its more likely than not that we would be able to utilize our entire net deferred tax asset prior to expiration. During the audit of KED’s financial statements we were able to demonstrate that we met the more likely than not standard and that we would be able to utilize the full amount of our deferred tax asset prior to expiration. As a result, we were required to reverse the previous announced valuation allowance.
KED also changed its estimated post closing working capital adjustment related to its sale of millennium which reduced NAV by $400,000 or $0.04 per share. This change in estimate is based on information that became available to Millennium in January 2009. Generally accepted accounting principles require this type of subsequent event to be reflected in the financial statements as of November 30, 2008. As a result, our revised net asset value at the end of the quarter was $163 million or $16.10 per share which compares to a net asset value as of August 31, 2008 of $224 million or $22.19 per share.
Now, I’d like to review our results of operations first for the fourth quarter and then for the year. Investment income was $1.3 million and consisted primarily of interest income on fixed income investments and short term investments in repurchase agreements. KED received $4.2 million of cash dividends and dividend distributions of which $3.6 million was treated as a return of capital.
Operating expenses were $2.4 million including $1.1 million of base investment management fees, $700,000 of interest expense and $600,000 of other operating expenses. We had net investment loss of $700,000 which included $500,000 of deferred income tax benefit. Net realized gains were $9.3 million which consisted of $16.1 million gain related to the sale of Millennium that was partially offset by net realized loss of $1.3 million and a deferred income tax expense of $5.5 million. Net unrealized losses were $65.8 million which consisted of $104.5 million of unrealized losses from investments net of a deferred income tax benefit of $38.7 million.
In summary, KED had a net decrease in net assets resulting from operations of $57.3 million during its fourth quarter. Moving now to the results for the full year, investment income was $7 million and consisted primarily of interest income on fixed income investments and short term investments and repurchase agreements. KED received $18.5 million of cash dividends and distributions of which $16.4 million was treated as a return of capital.
Total operating expenses were $12.6 million including $5.1 million of base investment management fees, $4.3 million of interest expense and $2.4 million for other operating expenses. Base investment management fees were equal to an annual rate of 1.75 of average total assets excluding any deferred income taxes. Net investment loss was $3.5 million and included $2.2 million of deferred income tax benefit.
Net realized gains were $7.5 million which consisted of the $16.1 million gain on sale of Millennium which was partially offset by net realized losses of $4.2 million and a deferred income tax expense of $4.4 million. Net unrealized losses were $70.8 million which consisted of $106.4 million of unrealized losses from investments net of a deferred income tax benefit of $39.4 million and a deferred income tax expense of $3.8 million related to the company’s conversion from a regulated investment company or RIC to a taxable corporation effective December 1, 2007.
As of November 30, 2008, KED had borrowed $57 million under its revolving credit facility at an interest rate of 4.25% and its borrowing base was $71.1 million. As of February 5, 2009, KED had $57 million borrowed at an interest rate of 1.66% and its borrowing base was $69.2 million. As of both dates we are in compliance with all of the terms of our revolving credit facility.
Now, let’s turn to our guidance. We announced our guidance in a press release on January 9, 2009 and there have been no material changes since that date so I’ll just summarize it here. Let’s start with dividends, distributions and interest income that we estimate can be earned from the portfolio.
Our portfolio as of November 30, 2008 consisted of $92.1 million invested in private MLPs with an average yield of 10.7%, $60.9 million invested in public MLPs and MLP affiliates with an average yield of 16.2%, $20 million invested in fixed income securities of private companies with an average yield of 13.4% and both the dollar amount and yield exclude our investment in ProPetro. $2.8 million of investments in repurchase agreements with a yield of .3% and this represents our repurchase agreements at fiscal yearend less the $3.5 million dividend that was paid in January, 2009.
Based on this portfolio, we estimate dividends, distributions and interest income will be approximately $5.6 million per quarter. Please note that this estimate does not include the impact of return of capital which will reduce net investment income reported under GAAP. Additionally, this estimate does not include interest income from our ProPetro investment as we do not anticipate receiving cash interest payments during fiscal 2008.
Let’s now turn to our estimates of interest expense and operating expenses. Based on the $57 million borrowed under our revolving credit facility as of November 30th, we estimate interest expense to be approximately $500,000 per quarter assuming a LIBOR rate of 1.9%. It is worth noting that LIBOR is currently significantly below this level at .45%. We estimate our base management fees to be approximately $800,000 per quarter and other operating expenses to be approximately $600,000 per quarter. We do not provide guidance on realized gains or incentive management fees.
Now I’d like to turn the call back over to Kevin.
Kevin S. McCarthy
That’s the end of our very extensive prepared remarks and at this time we’d like to begin the question and answer portion of the call.
(Operator Instructions) Presenters there are no questions at this time.
Kevin S. McCarthy
Thanks very much. I think between the analyst day and this conference call we overwhelmed them with questions. We’d obviously be happy to follow up with any questions anyone may have after the call. Thanks very much.
Thank you for joining us. This concludes today’s conference call. You may now disconnect.
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