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Hovnanian Enterprises, Inc. (NYSE:HOV)

February 26, 2013 2:00 pm ET

Executives

J. Larry Sorsby - Chief Financial Officer, Executive Vice President and Director

Jeffrey T. O'Keefe - Director of Investor Relations

Analysts

Susan Berliner - JP Morgan Chase & Co, Research Division

Susan Berliner - JP Morgan Chase & Co, Research Division

Hi, good afternoon, everyone. Hope you at least had some time to go outside and get some of the warmth outside, but we're very pleased to have Hovnanian here with us. It's Larry Sorsby, the CFO, who will do the presentation, and then we'll open it up to Q&A. And Larry? Up to you.

J. Larry Sorsby

Thanks, Sue, and thanks to JPMorgan for inviting us back again this year. Let's just start by what a difference a year makes. As Sue and I were reminiscing from 1 year ago to today, I think our bonds were up 50 points or so and the stock is up and the market for homes are up, and all is well with the world again. So it really has made a huge, huge difference. I'm going to -- our structure were really to say as little as possible in the presentation, leaving as much time as possible for Q&A. So I'm going to attempt to accomplish that. Maybe if I learn to push the right button. I can actually advance this.

Clearly, the U.S. housing market is in recovery. I'm going to just talk a few slides on our view of kind of where we are in this. This shows U.S. housing starts since a little before World War II. You can see where the quintessential cyclical industry. What you see here by the red circles are the most recent peak, and then to the left of that, the 3 previous peaks. Not a whole lot of difference in the cycle in that particular perspective.

If you look at the far right-hand bottom corner and see the circled in blue, that's the most recent trough. And then if you look at the 3 prior troughs, it is significantly different -- the 3 prior troughs, being about significantly better and the current trough being about 50% worse than the previous 3 troughs. So we're in an unprecedented downturn. And if you ignore the last 3 years, I guess, the last 4 years now, and look at what 2012 was, that by itself, would be the worst housing market in the last 70 years.

So in spite of this fact that the U.S. housing industry has been in a very nice recovery this past year and a very modest recovery, really, the previous couple of years to that. On a historical basis, we're still quite a bit lower than any other time in the last 7 decades. And that's with the background that population has grown from 132 million in the 1940s to about 310 million today.

So lots more upside than downside, even from where we are now. But the most interesting part of this slide to me is, as you look at the kind of green hashmarks that we've put here on a horizontal basis, that shows decade average demand on an annual basis. And although in particular years, we might have overproduced or underproduced on a decade, the decade basis, virtually all the decades around that 1.4 million to just under 1.5 million starts, other than the decade of the '70s when we had some subsidized housing, some other particular things that got us to 1.75 million.

So from our perspective, it's kind of like once we get above 1.4 million, 1.5 million starts in the future, maybe the lesson learned is that's a yellow blinking light in our face saying, be cautious about how aggressive you are on trying to grow in that kind of a scenario because there may be a downturn in the not too distant future. So we're a long ways from that at this point, but just one of the lessons that we think we've learned.

Also, what's been happening in terms of home prices. This is the Case-Shiller 20 city composite index. And it's up 6% since December of '11. I think the new one came out this morning, and it was up, once again, as well. Now this is on existing homes, and we're seeing similar things not quite to this extent on new homes, but prices are starting to rise. What's really been happening on a affordability perspective, hard to paint a better picture from a homebuilders' perspective from affordability. The higher this index is, the better. It means that homes are even more affordable. And the combination of home price declines that we saw during the downturn, combined with unprecedented historical low interest rates, have led to this very, very high affordability index.

What does that do for you? Well, people can buy more house than they thought they could when interest rates are in the 3s than when there are in the low double digits; that's for sure. But today, they're loading up options just as they were in the bull market run. And this is one of the reasons that they can actually afford it with the low interest rates and the lower prices than they there were in mid-2000s.

Foreclosures, delinquency rates, not talked about quite as much as it was a year ago, but they're still higher than the normal by quite a bit. The red line here represents total delinquency rates. And they have been coming down on a macro trend basis, but they're still not down to what you would call normalized, being just under kind of 6%. And then as you look at foreclosure rates, we're finally starting to see a decline occur after a long time of it being pretty stable at a high rate. So as delinquency rates fall, you got to see foreclosures come down as well. They were delayed a bit because of judicial foreclosure states and robo-signing and a bunch of others stuff. But it's not really a huge concern of most new homebuilders today.

So with that kind of as a background of the industry. I'll talk a little bit specifically about Hovnanian and our fourth quarter results. But just as background, we're the 6th largest publicly-traded homebuilder in the U.S., based on deliveries. We were funded by a gentleman named Kevork Hovnanian in 1959. His son, Ara, is our Chairman and CEO today, and the Hovnanian family continue to own mid-30% kind of ownership of the common stock of the company. We currently build in 189 communities and 37 markets throughout 16 states. We've color-coded those states here by our publicly reported market segments. Just to give you a perspective, but we truly are a national homebuilder.

We also have a very product array. Some of our peers focus just on entry-level or just on luxury. We like to do a little bit of everything, and although it's a little more complex business model to build, first time, first time move up, second time move up, active adult, age restricted, luxury. We do it attached. We do it detached. We do urban renewal as well. We think that it's one of the things that allowed us to grow a little faster in the bull market run than some of our peers, and it's one of the things that allowed us to maybe rebound a little quicker than some of our peers in this downturn as well because those that really focused on entry-level housing, it got crowded. So in a market like Phoenix, we were one of the first to kind of do -- first and second time move up or luxury, and found a niche that almost no one was filling. So it worked pretty well for us.

This slide in blue shows Hovnanian revenues from when it peaked at about $6 billion in revenue in 2006 as it fell, and it very, very closely was correlated to national starts falling, which is the red line here. So as national starts fell, our revenues fell from a peak of about $6 billion, down to just over $1 billion in 2011, and then rebounded in 2012 to about $1.5 billion. So I guess the corollary of this is we believe as the U.S. housing industry rebounds and starts were up, we think we'll be able to continue to grow revenues as well.

This shows you our fourth quarter results. This is almost seems like ancient history since it was October 31, and actually our first quarter was over January 31. We just haven't reported it yet. But net contracts for our fourth quarter were up 46% in dollars, 23% in number of contracts. Community count was down 12%. So contracts per community, and this is very important point, were up 38% during our fourth quarter. So we are selling more homes per community, and that's another thing that can drive revenue without having a corresponding increase in community count. Deliveries were up 41%. Backlog was up almost 30%. Revenues were up 43%. Land related charges were almost nonexistent. Homebuilding gross margin was up almost 300 basis points. Total SG&A was down almost 700 basis points. So everything was pointed in the right direction. And we were able to report income before taxes and gains losses, on extinguishment of debt of $3 million. First time that we had a gain on income on net basis since, I think, 2006. So it's been a long run, but we were happy to finally get out of the hole.

And how we've done that? Well, revenue growth is a powerful thing when you have fixed costs from an SG&A perspective, for the most part. So you can see in the upper left-hand quadrant here, just the last fourth quarter revenue growth, we have grown it from $270 million to $487 million in the fourth quarter for a total of $1.5 billion for the year. And then if you look right below that, in the lower left-hand quadrant, the yellow graph here, you can see, what happened to SG&A. 17.1% down to 10% of revenues, and that's because we really had fixed dollar amount of SG&A. For the full year, we were running at 12.8%, higher than this 10%, lower than 17.1%. Normal SG&A is 12 -- excuse me, is 10% kind of a range. So we still could grow revenues further today without any kind of increases to speak of on the SG&A dollars that we spend. So we still have some more operating leverage.

The other thing that we have some powerful leverage on as we grow revenues is interest expense as a percent of revenues as well. And that's here in red, growing from 12 -- or declining from 12.8% down to 8.2%. I wish I could tell you that 8.2% is normal; it's not. Close to normal is 3.5%. So we have a long way to go to continue to bring our interest expense as a percent of homebuilding revenues down. So we'll continue to grow revenues without a corresponding increase in debt. And start to see this number continue to provide operating leverage, which you combine that with the homebuilding gross margins in the upper right-hand quadrant here, you can see our trend on gross margins from 16.5% in the first quarter to 18.3% in the fourth quarter. And although last year, we had a very smooth upward trend in gross margins, our last 2 conference calls we've told you that we expect some choppiness in gross margins. The trend will still be up in the aggregate basis, but I think there will be some choppiness quarter-to-quarter rather than just a smooth upward trend. And that combination has led to the operating profitability in the fourth quarter. So that's what we've been doing. We've actually had some good success from it and we're going to continue to see that success going forward.

Net contracts, up 46% in dollars during the fourth quarter, year-over-year; up 23% in number of homes, year-over-year, for the fourth quarter. Net contracts per community from 5.5 contracts in the fourth quarter of '11 to 7.6, very, very powerful leverage, up 38%, and contract backlog was up 34%, ending the year $742 million of contracts in backlog at the beginning of the year of 2013. So setting it up for additional growth in 2013.

What have we been doing on the land front is a question we get a lot and since January 2009, we've been reloading our land position at prices at or near the bottom of the real estate cycle. And we've controlled a total of almost 22,000 homesites in 378 communities. If you ignore the joint ventures, which is 3,100 lots in 28 communities, it's 350 communities for about just under 19,000 homesites. So we've been very active. We continue to be active. Our land calendar at the corporate land committee is quite busy these days. It is a challenge. All of our peers are out there trying to find land to grow as well, and as we have had this faster absorption pace, we're burning through communities faster than we anticipated. So it's hard to go community count while at the same time we are able to continue to grow revenues because of the more homes per community that are selling.

What does it look at for from a liquidity perspective and maturity ladder? This really kind of shows our maturity ladder. You can see nothing due in '13, a modest $37 million in '14, $85 million due in 2015. Recently, last fall, about $800 million of debt coming due to 2016. We pushed out to 2020 and 2021 and lowered the interest cost on that on a cash basis by about $17 million a year. We were happy to do that. And we continue to keep a close eye on all of these red bars. These are unsecured notes. And at some point, we'll decide to refinance those; it's available to refinance today. I'm just not anxious to pay to make [ph] whole call, which is quite expensive on some of these issues, nor am I anxious to increase my interest cost, which I might have to do in the aggregate on that 2014 through 2017. So we have plenty of liquidity to either refinance the '14s and '15s as they come due or to pay them off with cash, so I'm in no hurry to have to do something in the near-term. If the market provides me with a great opportunity, I'll do it.

So kind of in summary, it's not rocket science. Lot supply is down for the industry. The pipeline of approved or entitled land parcels are down, and no one has really been taking stuff through the approval process. The number of builders are down. Most of the private builders are out of business, don't have sufficient capital to investment and do the next deal. So the builders that are surviving, primarily the publics, are going to gain market share. Foreclosure supply is down. Population is up. Sentiment about buying homes is up. Households are unbundling, creating demand for housing. Consumer confidence is rising. Rents are rising. So people are more anxious to buy today than they were a year ago, and we think that trend is going to continue.

With that, Sue, I'll open it up for Q&A.

Question-and-Answer Session

Susan Berliner - JP Morgan Chase & Co, Research Division

Great. Well, let me kick it up with questions, and please, let me know if anyone in the audience has questions.

J. Larry Sorsby

Plenty of seats up here if you all want to migrate up. Feel free. It's like church, and everyone's coming down the aisle.

Susan Berliner - JP Morgan Chase & Co, Research Division

So I guess I want to start off on the land banking relationship. How that's working out? If you did it on your own, what the differential in margins would be? And how we should think about, going forward, with the land banking? Is that something that will just be redone or extended or anything on that realm?

J. Larry Sorsby

I think what you're referring to is the GSO land banking transactions, and we've got 2 different buckets with GSO. We initially agreed to do $125 million and that was followed a few months later with a second $125 million arrangement. So it's a total of $250 million in the aggregate. We've kind of filled the first $125 million bucket and are in the process of identifying and filling properties into the second $125 million bucket. It's working great from our perspective. I think if you talk the GSO, they'd say the same thing from their perspective. I had a meeting with them a few weeks ago where to they said they'd love to entertain doing more with us. We don't have any leads right this second, but I think the door is open and we'll just have that discussion at the appropriate time. And we'll see what happens. And in terms of the effect on margin, it really depends on -- I guess, the first thing is, I would say, it's probably not something you should even attempt to model in any financial model because it's such a small percentage of our current deliveries and will be for some time. Keep in mind that, although it's $125 million that we've already filled, those are communities who have lives over the next 3 years. So every quarter is just a tiny percentage of the deliveries that might be coming from one of those communities. So I just don't think it's going to move the needle very much in terms of margin. And that would be assuming that they didn't buy any land that we had on our balance sheet. And if you'll recall, I think the first $60 million or so of land was stuff that was on our balance sheet that we then subsequently sold to them, that won't affect margins at all in terms of gross margin. It actually hits interest expense. And then, if they buy the land -- if we find land and they buy it and then we option it back from them, it will affect margin only from the perspective that you will pay more for the land than if we use our capital to do so. But I don't think it's enough to move the needle much from a margin perspective. Did that answer all your questions?

Susan Berliner - JP Morgan Chase & Co, Research Division

Yes. Now I have I think a 5-parter, which Jeff is cringing as I say that. So with regards to liquidity, future liquidity, assuming that you guys want to spend a lot more on land, what are your options right now? I assume there is no more secured debt capacity. You can issue additional debt per your indentures. What would be your appetite for convert, and what would be your appetite for equity?

J. Larry Sorsby

Yes. Well, the first thing I'd say that is we do still have sources of liquidity and we still can do secured debt. It's called the non-recourse debt at the community level, non-recourse to Hovnanian Enterprises. So we've actually been pretty successful doing a handful of those kinds of transactions shortly after we have acquired property, and there's no limit to our ability to do that. We're also generating even more cash flow as we close homes that we're reinvesting, so that's a source of cash, obviously, to reinvest in new land. And then on top of that, and again, we've had this targeted quarter-end cash between $170 million and $245 million, and we've repeatedly stated, we're comfortable at the lower end of that range. The only reason I've not been able to get to the lower end of that range is I can't find enough land opportunities that hit our underwriting criteria of a 25-plus percent unlevered IRR at the then current home prices, then current absorption paces, then current construction costs; we never assume the market is going to get better. So the reason we've not been able to show you a number lower or on the low end of that range in terms of our cash balance has been, we haven't found enough opportunities to meet our criteria. So our guys are running as fast as I can. Our land committee is quite busy, but the fact that we are kind of burning through communities faster generates more cash. I got to pedal faster to just keep up with the amount of deliveries that I'm having to stay even, much less to grow. Now we did grow our land position in the last half of fiscal 2012, and we're working hard to continue that trend in 2013. I do not believe that capital will be the limiting factor.

Susan Berliner - JP Morgan Chase & Co, Research Division

And appetite for a convert and equity?

J. Larry Sorsby

Equity is certainly not high on our list of things to consider, and it won't be until we've returned to solid profitability and are trading at a multiple of earnings and a stock price materially higher than today. So we think there's other sources of capital if we do need it that are far cheaper than diluting our shareholders at $5 a share.

Susan Berliner - JP Morgan Chase & Co, Research Division

Got you. And then I just want to turn to the DTA. Can you refresh us on exactly where you stand right now and when you expect to get that back on your books?

J. Larry Sorsby

900 and what, Jeff?

Jeffrey T. O'Keefe

937.9 million.

J. Larry Sorsby

900 and call it $38 million. $938 million of deferred tax asset valuation allowance, which means, we won't have to pay income taxes on the first roughly $2 billion of revenue that we generate -- pretax profits, I shouldn't say revenue, excuse me, pretax profits that we generate. That will come back onto our books at such time as we're in our second full year of solid profitability and can look forward and project solid profitability for that third year, is my belief.

Susan Berliner - JP Morgan Chase & Co, Research Division

And then if we can turn to the markets, can you just review with us kind of the hottest markets out there and then the ones that are kind of lagging behind?

J. Larry Sorsby

Yes. I'll give you the 2 goal post. I would say the hottest market in the country right now is probably the Northern California coastal market, kind of the Bay Area. We've had communities that have raised prices, 100,000 plus in the last 5 months or so. And absorptions are on fire out there and we're consciously trying to slow down absorptions by raising prices and we're probably not slowing it down as much as we want, because it's hard to find land that works in that market today as well. That market might be followed closely by the Phoenix, Arizona market, which continues to be quite strong, as well as the southern California market. On the weaker side of the equation, I would say, would be the suburban New Jersey markets. We're doing quite well on the Hudson River, New Jersey side of the Hudson River overlooking Manhattan. We have a 57-storey high rise that we've already raised prices very significantly and head strong sales pace. But when you get to the suburban markets, New Jersey has been sluggish in terms of the rebound. It might be slightly up compared with to where it was, but it's not up anywhere close to what the rest of the country is up. And I'd say everything else is really doing quite well to one degree or another. I would lump everybody else in the doing-very-well category.

Susan Berliner - JP Morgan Chase & Co, Research Division

What about Chicago?

J. Larry Sorsby

Chicago for us is doing pretty doggone well as well. I think we might be a little bit of an exception there. Our guys did a great job over the last few years finding little niche in-fill communities and closer in locations. And it's always in real estate location, location, location, but they've done very well and I think we've outperformed that market a bit. So it's probably -- that's more of a comment on us. The market itself might fall in to the New Jersey category.

Susan Berliner - JP Morgan Chase & Co, Research Division

And what about in terms of the product diversification you have? What's kind of the strongest segment out there? And is there anything kind of lagging?

J. Larry Sorsby

Yes. I would say that's the most encouraging thing, is really it's across all of our different product types we're seeing strength. In some markets, it might be the entry level. In other markets, it might be the active adult or the luxury. But really, from a broad-base across the country, I would say we're seeing strength in all of them, and I wouldn't say any particular segment is a leader or a lagger.

Susan Berliner - JP Morgan Chase & Co, Research Division

And I know you're reporting on March 6, but I guess, and not looking for anything specific forward, unless you want to, of course, but I guess in terms of the spring selling season, I know a lot of the stocks are down. It seems that some people kind of believe there is a little bit of a slowdown. And I'm not sure if it's just a comp issue, because obviously, EBITDA are, but what do you think is going on?

J. Larry Sorsby

Yes. I would answer the question this way. I'm not talking about anything specific to Hovnanian, but I would say that the momentum that the industry saw build during 2012, the improvement in the house industry is continuing to date in calendar 2013.

Susan Berliner - JP Morgan Chase & Co, Research Division

So you're not seeing any slowdown from the payroll tax increases, gas prices going up, nothing there?

J. Larry Sorsby

Yes. I was asked that in one-on-ones today and the candid answer to that is, I've not heard even a comment from any of our divisions on any of our financial calls, that they've heard a comment at all regarding those issues. So maybe it's out there and those people just don't even come to the site, but none of our teams, even anecdotally, have mentioned, that someone has complained about the payroll tax increase or that caused somebody not to qualify or something like -- certainty, wasn't helpful from my perspective, okay? But I can't say that we've seen any impact from a negative perspective on it.

Susan Berliner - JP Morgan Chase & Co, Research Division

And is there anything -- do you have a question -- anyone have a question? Is there anything from the government perspective, any more clarifications you're waiting for that you think will help improve the demand out there?

J. Larry Sorsby

Sure. I think all of the uncertainty that Washington continues to leap at all of our feet is not helpful. And the sooner we can get a clearer picture of what's going to happen on taxes. What's going to happen on spending cuts. What's the real impact, rather than the scare tactics of spending cuts. What will they really be? It will be helpful. It will just take a cloud of uncertainty out of the market. And I think once that happens, that this industry will just rebound even stronger than perhaps than it is today. Uncertainty is just difficult for companies to make decisions in terms of hiring people, giving raises, and that has a residual impact on people's ability to go out and buy a house. So I think there's some negative happening from it. But in spite of that negative that's happening from it, our industry continues to rebound from the worst housing market that we've seen since World War II. We got a long way to go to get anywhere near the top. I'm just hopeful that we have kind of a modest recovery trajectory rather than, what I call, the rocket ship recovery, because I don't think we can actually build as many homes as we'd typically be doing at this point in the recovery cycle from a labor perspective.

Susan Berliner - JP Morgan Chase & Co, Research Division

And I guess what worries you ahead, is it labor shortages, price increases from your manufacturers or land prices going up too much?

J. Larry Sorsby

Yes. I mean all of that stuff worries me. I guess I get paid to get worried. But all of those things are real concerns. I would put it in a category. The thing me talk about the most, that we're working hard, that we can actually do something about, is trying to replenish land, because if the market recovers even more, land is going to be an even tougher commodity in the future, especially in those markets that haven't been taken anything to the entitlement process. So that one's probably way up there in terms of a worry. But we're actually doing something about it in our land calendar. The corporate land committee is quite busy, but it's a concern. I think it's a concern of all of our peers, because we're not the only ones out there looking for land. So I think it's a common concern. At the same time, I think it's inevitable. I don't think there's anything anybody can do about it to see both labor prices increase as the recovery continues because, frankly, we had a lot of labor concessions during the downturn, and they're just going to try to get back to where they were and then maybe make up a little bit of it. And they're going to have to do that if we want them to go hire people so we can build more houses. So I think that's inevitable. And on the material front, I mean commodity prices go up and down, so I'm not going to speak to that so much as I will branded products. But they too kind of held the line during this downturn, and they're going to want to try to edge prices up. Fortunately, depending on the what the vendor was, we lock prices for 2 to 3 years. We have about 3 dozen national contracts, kind of with staggered maturity dates. So we'll, overtime, see some cost pressure on that front as well. But I'm not overly concerned about it. But I do believe it's inevitable. And I'll just say that on a historical basis, we, as well as the industry I think, have been able to more than offset whatever costs increases happened by raising home prices and that's certainly seems to be true, at least at this point in the cycle as well.

Susan Berliner - JP Morgan Chase & Co, Research Division

I think one thing said, is interesting from our perspective, not being at a homebuilder is, it seems that every single homebuilder I speak to, when they go to purchase land, they don't think about price increases in their analysis, but it seems like that has to be happening to some extent, so what are we missing?

J. Larry Sorsby

I hope it's not happening. We're staying very disciplined to absolutely not assuming home price appreciation or absorption improvement, either one of those could cause you to pay more for land. Yes, I put that in the category of speculating for land rather than being a manufacturer of homes. You're buying land in the hopes that it goes up in value. That's just not a great business model from my perspective. And as investor -- every investor asked that question, Sue, and after they asked that question, I'll say, have you asked the builder that question yet? And someone said, yes, we assumed home price appreciation absorption and have not had 1 investor yet tell me that they found a public builder. And I don't think we lie. But I will also say that our division presidents believe that their peers and their market, whenever one of our division president lose out on a bid for a property, they immediately leap to the conclusion that the reason they lost is that their peer had some assumed improvement in the market. And actually, I just had the most adamant discussion on that was yesterday morning. Before we flew down here, we had a meeting with our Northern California guy on a pretty big land purchase. And I mean he just went on and on about how he was confident that KB, Lennar, D.R. Horton, Standard Pacific, I mean, all of them, were assuming home price appreciation that they weren't -- there wasn't any way they could be doing the deals in Northern California. So I mean we hear that all the time. We debate it internally. We're going to stay disciplined to our methodology. And I believe, because I don't see, and this is kind of the only analysis I can do is, I don't see a particular homebuilder getting a disproportionate share of deals in a market, much less across the country, that would lead me to believe that if they are assuming home price appreciation they're doing it on any kind of broad-based basis, maybe they did on 1 parcel or 2, and I have no facts and data on that, I'm just saying maybe. But I don't think anyone is violating in that principle on any kind of widespread basis.

Susan Berliner - JP Morgan Chase & Co, Research Division

And are there any new markets that you guys are looking to enter?

J. Larry Sorsby

That's not really high on our priority list. We're really focused domestically on the markets that we really contracted in. We got 16 different states, and a lot more markets than states and plenty of room for expansion there, so that's our primary focus. Having said that, if an opportunity that was just unbelievable came about, we'd look at it.

Susan Berliner - JP Morgan Chase & Co, Research Division

And I guess my last question would be, with regards to M&A, it seems that a lot of private builders are being gobbled up by you big guys. Should we expect that to continue? And it also seems like we have a lot more Canadian builders involved in the U.S. now; should we expect that to continue to expand?

J. Larry Sorsby

Yes. I can't really comment on the Canadian builders front expanding or not. But I would say, I would be surprised if there weren't more acquisition of private guys, and they're primarily being acquired for their land position not because for their expertise or their new market position for a particular builder. It's really primarily for the land position, and people are buying it for pretty much land value in most instances.

Susan Berliner - JP Morgan Chase & Co, Research Division

Great. Well, thanks very much for joining us.

J. Larry Sorsby

Thank you.

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