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Brocade Communications Systems, Inc. (NASDAQ:BRCD)

Morgan Stanley Technology, Media & Telecom Conference

February 25, 2013 4:55 pm ET

Executives

Lloyd A. Carney - Chief Executive Officer, Director, Chairman of Corporate Development Committee and Chairman of Financing Committee

Daniel W. Fairfax - Chief Financial Officer, Principal Accounting Officer and Vice President of Finance

Analysts

Kathryn L. Huberty - Morgan Stanley, Research Division

Scott Schmitz - Morgan Stanley, Research Division

Kathryn L. Huberty - Morgan Stanley, Research Division

Good afternoon, everyone. I'm Katy Huberty, Morgan Stanley's Tech Hardware Analyst. With me is Scott Schmitz, who covers the storage companies with me. And we are very excited to host Lloyd Carney, new CEO of Brocade, for his inaugural presentation, a fireside chat; and Dan Fairfax, CFO of Brocade. The way we're going to run this is I'm going to turn it over to Lloyd, given that he's a month into the job, open up with some remarks, and then we'll jump into Q&A. Lloyd, thank you.

Lloyd A. Carney

Thank you. Thank you for having me, and thank you, all, for showing up. It's such a crowded room. So before we start things off, I'm an IT guy. I came out of -- I was Chief Operating Officer of Juniper Networks. I was the president of 2 companies, one Micromuse, which was bought by IBM; one Xsigo Systems, which was bought by Oracle. But I'm a networking guy, hardware, software, all my career and I'm pretty excited about being in Brocade. This is -- there's an inflection point happening in the industry right now, which is rare, because if you were in a data center 20 years ago, and I froze you in time and I woke you up 20 years later, you'd recognize the top-of-rack switch [indiscernible] switch, the core switch. Nothing much has changed in the networking center because it's been dominated by a single player all those years. So it wasn't to their benefit to innovate that in that arena.

With what's happening with the Intel processor, its multicore processors, the memory pricing, and you're finding more and more now that things were network-designated devices. Standalone appliance and data center are now just software sitting on a virtual machine on one of multiple cores. So you see a virtual firewall, virtual routers, virtual load balancers, and that new infrastructure requires a new fabric in order to make all this work efficiently. And that fabric is an Ethernet Fabric. So Gartner last week came out with a new Magic Quadrant for the data center. And a direct quote from Gartner, "If you're building a data center, Brocade has to be in the shortlist." We have a superior product in that space, superior architecture, and there is a trend that cannot be turned back. And if you want to bet against Intel, go ahead. I mean, what Intel is doing with the multicore and what's happening with memory pricing, more and more of it, the functionality that normally was carried by switches or fixed appliance is going to be in these virtual machines, and for them to be optimally connected, you need a fabric, and we have the best fabric. And that's one of the exciting things that's happening in the industry and one of the reasons why I chose to join Brocade. And of course, we have a solid Fibre Channel business, which years ago -- 3 years ago, Cisco declared the Fibre Channel was dead, FCoE is the future. Well, FCoE is now a top of-the-rack solution. FCoE end-to-end is dead. And even Fibre -- even Cisco is about to launch their new Fibre Channel product.

So our core business, which is about 70% of our business, is solid Fibre Channel growing high margins and the inflection point on the networking side on the Ethernet -- or inside in Fabrics, we have the best product in the marketplace. So exciting time for me to be at Brocade, exciting time for the industry because there is change coming.

Question-and-Answer Session

Kathryn L. Huberty - Morgan Stanley, Research Division

Great. And we're excited to have you, as I said. You touched on a little bit, but I would love to hear more about after your experience in the networking industry. You've worked at larger companies, Juniper, Nortel, you've worked at some smaller companies, which you've sold to larger-technology companies. What is it about the opportunity at Brocade landed you in this position?

Lloyd A. Carney

I was -- I just sold the last company to Oracle and was looking for an opportunity to run another public company, because I've run public companies before. I ran public companies a couple of occasions where I've come in as the CEO or COO. And I'm an engineer at heart. So the most important thing for me always is technology. Do I have a technology base that's differentiable? And in our Fibre Channel space, second to none, Fibre Channel product portfolio. Our OEM partnerships are the best I've ever seen. And we have IBM as a partner, we have Hewlett-Packard, we have Huawei, we have Fujitsu. You name them, they resell our product that we've branded our product name. Even Hitachi now even resells our fabric solutions -- so our Fibre Channel solution. So you're looking at a company with a strong solid run rate of core products that is not declining like people thought is was declining. High margin products, and the fabric. The fabrics that compete with us today are the Juniper Fabric, which uses the QFabric, which uses the ASIC chipset that I developed 10 years ago when I was there. Very complicated, not very scalable solution, and then you have the Cisco end-to-end fabric solution, both of them requiring you to replace, end-to-end, your infrastructure. With our solution, and I can't take credit for this, the team thought this through thoroughly and our fabric solution and/or operates anybody else's switches. So you can create a cluster of Brocade switches and connect Cisco switches into it, connect Juniper switches into it, and it all works seamlessly. Our clusters looks like one logical switch, easy to deploy, easy to maintain, easy to manage. It is, without a doubt, don't take my word for it, read the Gartner report. I mean, it's no doubt the most elegant solution in that marketplace today. So technology always draws me in because I'm an engineer at heart. And then the OEM relationships, when we go -- when I realized, and I knew all of the senior team, all the OEMs except for Hitachi. And I reached out to Jack the first week I was there and I never heard from him. [ph] OEMs are 70% of our business. I mean, so high-6 [ph] within our business. So they're an important constituent for us. And even before I reached out to some of them, they are reaching out to me to and say "Hey, welcome aboard, glad to have you here." And so we're in better shape now, I believe, with our OEM partners than we were 5 years ago or 2 years ago. Five years ago, a lot of them work with both Cisco and us, with Cisco making the evolution towards, going to be -- declare themselves to be next great IT company, some of those people they partnered with them are now natural enemies of them -- of theirs, so I mean, the HP guys, the IBM guy, the Dell guys. They don't look a them the say way they did 5 years ago when they worked with them. So we are actually in better position now than we've ever been as far as relationships with our OEMs, and they're asking us to do more with them. They're encouraging us, challenging us to do more with them. So that is another one of those great things that makes you pretty excited about being at Brocade.

Kathryn L. Huberty - Morgan Stanley, Research Division

Sure, yes, the interest in Brocade fabric solution comes through very clear in all of our survey work, and I think most investors understand that the product is incredibly good. One of the hurdles that the company has had is a clear, consistent execution around go-to-market. And I think you have had some news out today about a new head of sales. You're looking for a new head of marketing. But it's probably more than just 2 people. What is it at Brocade? And I know you're a month in and so you're still looking into all this, but what is it that Brocade needs to do to improve the go-to-market execution?

Lloyd A. Carney

We have pockets -- well, first of all, on the Fibre Channel side, the go-to-market is second to none. Just -- OEM products.

Kathryn L. Huberty - Morgan Stanley, Research Division

The OEM relationships, yes, of course.

Lloyd A. Carney

On the IT side, we've had challenges. And it has been difficult for us to compete head-to-head, port-to-port, against an entrenched player who has 80% of the marketplace. You have to have more of a value prop than just buy ports a little cheaper than yours. People won't change because of that. With fabrics, with this inflection point where there's a whole new architecture that requires you to peek your head up and say, "Wait a minute, is there a chance for me to think about this differently than I've done for the last 20 years?" Then it gives us something to go in with. And so I think it's fortuitous to us that the Gartner report came out last week. It's fortuitous to us that the team has created an attack team, a focused IT sales exec who went after fabric. We now have over 900 fabric customers. We expect to exit the year at about 100 million run rates on the fabric side, and that is just without us really having a good enough concern as we could on the fabric side. My first hire is Jeff Lindholm. We announced it today at 1:30 pm. Jeff worked with me, at Wellfleet Bay Networks years ago, worked with me at Juniper, where he ran all the sales for me. At Bay Wellesley, Jeff ran all of Asia-Pac for us. A strong IT executive, understands how to compete against -- with Cisco, with superior technology on the SANs of Asia-Pac. If you look at our go-to-market, we're weakest geographically in Asia-Pac. And, oh, by the way, Fibre Channel is growing double-digits in China. And the Chinese are doing -- they're just looking at what we're -- what the U.S. did and Europe did and just copying it. They're not trying to figure out whether we should use NAS, or we should try to use [indiscernible] like, what's the Bank of America do? What's the --

Kathryn L. Huberty - Morgan Stanley, Research Division

They're using mainframes in the Fibre Channel SAN?

Lloyd A. Carney

Yes, slap them in there. So -- and that's the market where we're not as well-positioned. Jeff comes with a lot of experience in that market space, a lot of connections in that market space, and he knows how to scale technology. I mean, this is one of those things where it's a different value prop to sell a new paradigm shift in technology than to just sell another one of the same thing. And again, what crossed the space, we have really talented salespeople, who've proven their ability to do this and we now need to leverage those salespeople who sold over 950 customers of this product, to figure out how to refine that process, duplicate that process and expand that process against -- across the fee [ph]. So you don't get to $0.21 in earnings and $5 million to $8 million for the quarter in revenue without a lot of things going right. So a lot of good things there. My job is not to break anything and then second, how do we grow the IT business to be a high-margin, high-profit business for us?

Kathryn L. Huberty - Morgan Stanley, Research Division

Okay. So on the go-to-market, it does come back to the profit. You don't have 80% share install base to defend, then you have to own all of that. You can work with partners, create an ecosystem that is interoperable with different technologies that you think Brocade has the best product, and that's why you'll win in the market.

Lloyd A. Carney

Yes, it always comes down, if you're making a technology transition, you're making an architectural transition as it's happening with fabrics, as will happen with SDN. SDNs are all in vogue right now, and we have an SDN solution and we'll be talking more about that as the year goes -- proceeds here, but there are significant shifts going on in the marketplace that is to our benefit. And if there are only one shift, then it will still be good opportunity, but there's 2. There's the softer layer being defined that will revolutionize the way you manage this from a networking standpoint. As apropros -- as what happened with VMware and hypervisors, I mean, that's the level of shifts you're going to see. Because, the dirty little secret in the networking world is 10% of every -- I mean, any port you're going to base on a full port [ph], a 1-gig port, you're lucky if it's 10% of your life. You basically gave Cisco $1 and got $0.10 back for it and you say, "Well, that's great." Well, that's not so great. Well, if you look at our architecture, where all of our ports are active at load balances, the team, see [ph] has to worry about spanning 3 headaches. We're giving you a dollar for a dollar. And that architecture, if you're a hosting provider, if you're building on a big data center, if your business depends on how efficiently you deliver services. If you're trying -- if you're a hosting provider, you're trying to sell me hosted services, whether you're going to host my Oracle service and or my Salesforce capability. You want to be more competitive than the next person who's trying to host that service for me. So it really does matter, down to the penny, how efficient you are. And we enable all of those partners, to all those customers, to have a more efficient infrastructure. So it comes down to technology but it comes down to the fact that there are technology shifts going on, that we've never seen before in the data center. 20 years, nothing -- what did your phone look like 20 years ago? What is the PC you're typing on looks like 20 years ago? I mean, time stood still in the data center because there was some benefit off the players there not to rock the boat, and to keep selling a port that's only 10% utilized. Well, time kind of stood still for the server vendors and that crashed and burned. Well, it's going to crash and burn networking space and you got SDN to change it for you and you have fibre to change. And with those 2 inflection points, we're well-placed to take advantage of this new data center buildout.

Kathryn L. Huberty - Morgan Stanley, Research Division

So as I mentioned, you've been at the company for about a month now. What have you been surprised by, positively and negatively? You talked about why you came to the company. What have you been surprised by?

Lloyd A. Carney

The most surprising thing was the OEM relationship. We kind of know that we did it well and I have had OEM relationships throughout my whole career. I've never seen an OEM ship ran so tightly. We can deliver a blade into a server for one of our OEMs more efficiently than they can do it themselves. When they say, "Here's a design spec. Get me this blade to do XYZ in the server," we do better than anybody else. I mean, we have 5 OEM partners who tell me that they come to us before they would go to their own organizations because of how efficiently we do it. It is definitely world-class, best-of-breed. That was surprising at how good that was. I guess, if I said, "What was something that we could do better?" The marketing outreach. Not enough people know that we are in the IT business. People still see us a Fibre Channel SAN company. We spend money on marketing, and I'm not sure we're getting the best value for that spend on marketing. I think it needs to be more targeted, more focused and more aligned with the strategy that we're running as a company. But -- and the people, I mean, people are outstanding. I mean, we have great people across the piece.

Kathryn L. Huberty - Morgan Stanley, Research Division

Good. On the earnings call just a few days back, you mentioned that the company could look different in a year or 2 years from now. You're obviously going to look at what's working, what's not working, and you're willing to make changes. Can you expand upon what that might be? Would you ever consider breaking up the company? Does it make sense for Ethernet and Fibre Channel to be separate businesses? Or it almost sounds like Fibre Channel is the cash cow that can fund investments in the Ethernet, but what did you mean when you said the company can look different down the road?

Lloyd A. Carney

I think, what I meant is I'm in the middle of a process where I'm starting on a blank sheet of paper. Organizations, as they grow and age, tends to make structural changes because an environment at the time, or product decisions because of the environment at the time. And I've done this before many times. The only thing I've learned is you always assume that the right decisions were made prior to you being there, which is kind of a different way to think about it. But assume that the right decisions were made, but assume that conditions have changed. Revisit the conditions that those decisions were being made on, you might make a different decision. It's futile to try and figure out why the company did something 5 years ago. It's like, "What are the facts I have now? And with these facts today, would I do the same thing?" And that's the exercise we're going through. I mean, it's not lost on me or the Board that our stock prices have been flat for 5 years. My compensation is tied to stock performance. No one who has ever invested in the company and has ever been in it has lost money. And my goal is to move the stock price. And to do that, I need to move the top line and improve the bottom line. And we are rabidly focused as a team on doing that. All my team members know that that's the name of the game. I mean, we have not returned to shareholders in much value as we should have over the past 5 years. We need to fix that, and to fix that, we're starting on a blank sheet of paper, organizationally go-to-market, and that is, "What's the fastest-growing market segments? How are we positioned to compete in those market segments? What products do we have that meet those market segments? Where are the gaps that we have in meeting the requirements for those market segments? What are the things that we're doing that is not -- doesn't fit our model from a profitability, from a margin standpoint?" And once you decide on what market you should be in, based on market dynamics, market growth, market trajectory, then the next logical thing is, "Okay, these are the markets that you're going to be in. Do we have the right products? And how the products meet in the market segment and where we have gap, how do we fill those gaps?" So we partner with someone to fill those gaps, and we do [indiscernible] to fill those gaps. And there are some parts we might look at that say, "You know what? They don't fit our model. It doesn't meet the requirements of what our shareholders need us to be doing to return performance to them." So it means a blank sheet of paper. It means looking at why we did what we did and challenging ourselves to say, "Is there a better way to do it? Have the facts changes? I mean, can we be 1, 2 or 3 in these markets within some reasonable time period," reasonable time period being 2 to 3 years, where you get some emerging market things going on. But it means taking a hard look and that's what we're doing.

Kathryn L. Huberty - Morgan Stanley, Research Division

And there's been a debate, at least within the stock market, and maybe not in the industry, but in the -- amongst shareholders whether Brocade should be standalone or part of one of their OEM partners or part of another networking company. Do you have a strong view as to whether, given the big changes in the industry, Brocade needs to be standalone or whether Brocade should be leveraged somewhere else?

Lloyd A. Carney

I have been bought quite a few times. I've bought a bunch of companies with quite often myself. I'm in both sides of that coin. And the -- my litmus test is always, "What's best for the investor over time?" It's never, "What's best in the rest of this quarter?" It's "What's best for the investor over time? Can we as a management team deliver better return on our shareholders' investment?" And they run the company, it's their company, and I'm just a steward of the company. And we will ask ourselves that question every time we hit a cross in our fork in the road. So there's many things we can do. The best thing that I've learned, though, is if you have a long-term strategy, and you're executing against that long-term strategy, whether you're a standalone or you're acquired, you maximize your value. If you have a short-term strategy and your goal is, "I'm going to sell the company next week or the next month," you are so hosed. I mean, all you're doing is diminishing the value off of your product. So the best thing we can do is to decide what's the best thing long-term for the company, what's the best thing to align in the company to get shareholder value, and if someone comes along and we should partner with them, we should merge with them, whatever the scenario is, or we should stick it out, at least we have a long-term strategy. We know we will be successful on standalone. So that's the first thing we need to do, is to make sure that we have a long-term standalone strategy because that will drive the value of our enterprise, both individual shareholders and anybody else who wants to partner with us.

Kathryn L. Huberty - Morgan Stanley, Research Division

Good. I'm going to pass it over to Scott to dig into some of the details, and we'll make sure we leave time for a question or 2 from some audience.

Scott Schmitz - Morgan Stanley, Research Division

Yes, okay. Thanks, Katy. So Lloyd, again, maybe if you're free to chime in, but if we dive into some of the segments a little bit, the storage business, really outperformed all of last year on your 16-gig product strength. But why are you so confident that that business can continue to grow now that you're going to come up against difficult compares? You mentioned Cisco has a product coming out. Why do you think that business continues to grow or in the 2% to 5%, and maybe if you can address prior products like, when do you see that adoption rate, the curve in that adoption kind of slow, right? We see the initial uptake, but when does that...

Lloyd A. Carney

I think, and I'll let you chime in here, but I think one of the things as, with my 4 weeks of experience, Cisco coming out is one of the best things that can happen to us. Because the big pall, a big reason I think why our stock prices have been so deflated is because a lot of people think the Fibre Channel's going away. The biggest proponent of that strategy, of that theory was Cisco. Because when Cisco came out with FCoE in the future, they said, "Don't ever buy Fibre Channel again. FCoE is the future." And with them coming out late to market as usual with their solution, they're reaffirming the fact that, you know what? Fibre Channel is not dead. They're reaffirming the fact that a lot of people have realized in the technical [ph] level is that FCoE end-to-end is dead. FCoE as a top-rack solution? Yes, maybe, but FCoE end-to-end is dead. And the storage people know it, the people in the infrastructure players know it. And so if you were in -- going to get a rec [ph] approved to buy our product, to buy a Brocade Fibre Channel product, your CIO has heard so many times that the Fibre Channel is dead, or your CFO, that they're going to ask you, "Why are you buying Fibre Channel? Cisco told me it's dead. The industry pundits say it's dead. Tam Dolores [ph] says it's dead. Well, guess what? With Cisco coming out and saying, "No, it's not dead. We're actually going to ship our product there," that cloud goes away. It's actually easier now for my customers to justify buying my product than it was prior to Cisco's announcing they're going to ship this product. So in a way, it's good news, bad news, but it's more good news. And the other thing to it is the way Fibre Channel works, they're doing [indiscernible] operability between the 2 products. You can't take one of my Fibre Channel switches and plug in a Cisco Fibre Channel switch into it and it works seamlessly because the way you manage it, the way you the tools that you have overlaid on this product, it just doesn't work that way. So my install base, I'm going to continue to get my unfair share of that, and with the upgrades that we're doing right now at 16 gig, we're even calling it now Gen 5. These customers are upgrading, not just because it's the bigger pie but because of the new tools we've layered on top of it. I haven't seen a lot of customers because I've been busy, I've been on the road. But the [indiscernible] company in BC [ph], I go and I see them. Over 1/2 the customers I see who have gone to 16 gig, they didn't do it because of the pipe. They did it because of the new software features we have layered on that they pay us more to enable them to better analyze, manage, deploy their storage infrastructure. So I'm bullish, I mean, and before coming on site, the EMC guys are telling me how faster their Fibre Channel business is growing. I heard from my friends in Asia how -- and the Huawei guys, double-digit Fibre Channel growth in China. I mean, so I'm not in doubt this is going to continue to grow for a while.

Daniel W. Fairfax

Yes, and I would just add, too, that the fundamental market drivers that we saw last year, that really helped power that growth in that business, remain this year. So virtualization creating density of virtual machines in the rack, a higher density of the physical servers, really just calls out for a more efficient way to get the cooled storage, and that's why we talked about the robustness of the operating system, the enhancements that we've driven there, the additional bandwidth, all placed to the need of the data center. So the fundamentals are well in place for this business.

Lloyd A. Carney

And everybody thinks SSD is going to take over the world. Every major SSD vendor, as they move towards appliances, they put Fibre Channel interfaces on their SSD devices because that is the most efficient way to take advantage of the low latency you get with SSD. Instead of a rotational device, laying and rotating the disk up, it's just memory, solid state memory. Well, guess what? What's the best way to connect that storage into an infrastructure? It's Fibre Channel.

Scott Schmitz - Morgan Stanley, Research Division

So I just want to get one more in on the Ethernet side and then we'll open up to the audience real quick. But just -- I know you're moving away from some of this reporting Service Provider revenue, enterprise revenue, but if we just take it at face value last quarter, Service Provider was stronger. It's been strong in the last couple of quarters. Can you talk about how sustainable that growth rate is, where you're winning those customers, and then -- and on the flip side, the enterprise business, if we take it -- your numbers essentially declined for 2 quarters in a row. Just assuming that that's right, that that's even though you have a 2-tiered distribution, what do you think is causing the weakness in the enterprise side?

Lloyd A. Carney

Well, I'll start out but on the Service Provider space, service providers are all -- they're one of [ph] our target customers. Every service provider is now trying to get into the hosted business. They're all trying to build up large data centers. Some of the biggest spend, especially the wireless service providers who've seen their business ramp and their infrastructure growth take off, they're building up some of the biggest data centers around. And so we're having good success with interface and those service providers because they tend to be architects, they tend to -- 20 years ago, the early adopters were the financial guides. The financial guides had all the money. They're willing to spend. They bought one of everything, and they were wheeling and dealing. They are no longer the wheeler and dealers. The wheeler and dealers now are the people with the new hosting data centers, the data center guys who were part of the service provider infrastructure. They are where most of the money is. And so you'll find a lot of activity there where you're taking on fair share there, and we continue to have a focus there. On the enterprise side, the enterprise guys are splitting the assets. The enterprise guys are trying to figure out -- and we were with some today. "Do I do a make versus buy? Do I build my own data center? Or do I hosted data center application?" Whereas people will churn their storage every 3 years, 2, 3 years, and their storage every 2, 3 years, we've got customers in the enterprise who are setting their switches for 5, 8 years. I mean, so they're refresh cycles are not as aggressive as they used to be. So there's a natural, I don't want to say apathy, but a lull amongst the enterprise space driven by this whole hosted phenomenon where they're -- everyone is having to justify to their CIO, "Why isn't this a hosted solution? Why am I not in a cloud?" Right? What's going on? And so I think that's a natural part of where you're seeing the shift in the spend.

Scott Schmitz - Morgan Stanley, Research Division

We're running out of time, but as we can see if we can have a question from the audience? Is there any question?

Kathryn L. Huberty - Morgan Stanley, Research Division

Right over here.

Unknown Analyst

Thank you. In the -- on the Ethernet switch side, I mean, your partners or your OEMs on the Fibre Channel side don't have Ethernet products like HP or IBM, but on the Ethernet side, HP has a very broad set of IP products. IBM is trying to develop its own product. What chances are there for you to become an OEM vendor after Ethernet switches through IBM? I mean, it feels like they are 2 very different businesses inside your company at this point.

Lloyd A. Carney

Yes, no, there is a -- Hitachi is the only OEM partner I have right now that OEMs both my Fibre Channel products and my fabric. That's right. Hitachi is the only one who does that. Whereas HP has a good Ethernet portfolio, the 3Com assets that they bought and their old ProCurve product, and you have IBM and some networking products that they had acquired over the years. None of them have a fabric, a viable fabric. They're all losing to Cisco UCS. It is our job to try and convince some of these OEM partners to OEM our Fibre Channel products today, to take a good hard look at our fabrics. And getting this Gartner report that independently states that we have a viable solution's going to help us when we talk to OEM partners. But there is -- don't get me wrong, you'll never, in emerging technology, get an OEM partner to drive that into the marketplace for you. You have to do it on your own. And the good news is we have started that. With 950 customers, we have started that process. We have reference customers, reference accounts, white papers, a go-to-market that we know works. We need to do more of that to convince OEM partners to then OBM that fabric, but it's absolutely the goal of ours to not only have Hitachi be a reseller of our fabric, but at least another OEM partner resell our fabric within the next year.

Kathryn L. Huberty - Morgan Stanley, Research Division

Okay, good. We're out of time, so we're going to wrap it up there. Lloyd and Dan, thank you so much for your time.

Lloyd A. Carney

No, thanks, Katy. I appreciate it.

Daniel W. Fairfax

Yes, thanks, Katy, Scott.

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