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Executives

Gene Skayne - IR

Bob Mao - CEO

Jay Zager - EVP and CFO

Analysts

Lin Yang - Barclays Capital

Rohit Chopra - Wedbush Morgan Securities

3Com Corporation (COMS) F3Q09 (Qtr End 02/27/09) Earnings Call March 19, 2009 4:30 PM ET

Operator

Good day and welcome to this 3Com's Quarterly Earnings Conference Call. Today's conference is being recorded. At this time for opening remarks and introductions, I would like to turn the call over to Gene Skayne, Head of Investor Relations. Please go ahead.

Gene Skayne

Thank you, operator, and good afternoon, everyone. Let me start by going over today’s agenda. We will start with the Safe Harbor statement. Following that, I will turn the call to Bob Mao, 3COM’s Chief Executive Officer, who will provide an update on our business. Bob’s comments will be followed by 3Com’s Chief Financial Officer, Jay Zager, who will add insight into our financials. Following Jay’s comments, we will open it up to questions.

So first, our Safe Harbor disclosure: the remarks to be made on this conference call contain forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These include forward-looking statements regarding integration activities, strategic initiatives, future financial performance, financial condition, and cash flows, future expense controls and savings, product and solution development plans and strategy, and market position. These statements are neither promises nor guarantees but involve risks and uncertainties that could cause actual results to differ materially from the forward-looking statements. These risks include the risks detailed in the company’s SEC filings.

On this call, we will also discuss several non-GAAP financial measures. The most directly comparable GAAP measure and the required reconciliation can be found one, in the tables at the back of the press release announcing our results; two, attached as an exhibit to our Form 8-K for this earning’s release; or three, on the IR portion of our website, www.3com. The press release together with other related financial information is available on the investor relations section of our website.

Now I would turn the call to Bob.

Bob Mao

Thank you, Gene and thank you, everyone for joining us on the call as we review our results for the third quarter of our fiscal year 2009. I am pleased to report that despite a general recession environment where revenue generation is particularly challenging, 3Com delivered another solid financial performance in the third quarter. We delivered significant year-over-year improvements in operating profit and earnings per diluted share on both GAAP and non-GAAP basis. We achieved record non-GAAP gross margin of 57.4% during the quarter.

Non-GAAP operating profits of $36.7 million or 11.3% of revenue came in at the high end of our guidance. Non-GAAP earnings per diluted share of $0.13 exceeded our guidance for the quarter. And quarter end cash balance of $560 million also came in higher than guidance. And revenue came in $5 million below the low end of our guidance of $330 million.

Our total revenue in the third quarter was $324.7 million a decline of 3.5% from the same period last year and 8.4% lower than the previous quarter. Our China-based sales segment continues to be the primary driver of our financial performance, showing a 6% growth in dollar terms over the same period last year, while recording a modest sequential decline of 4.7%. Our geographic diversification in general and our China business in particular is proving to be a very important factor in our ability to increase our year-over-year profitability while operating in very challenging global economic environment.

The ongoing global economic crisis continues to have a significant adverse impact on our business, with all of our regions except China recording sequential and year-over-year revenue declines. Although China's economic growth slowed from the recent pace of around 12% per year to high single-digits, it is a bright spot in otherwise bleak economic landscape.

The Chinese government continues to aggressively pursue its stated goal of achieving economic growth of 8% in 2009. And recently reaffirm that commitment was more than a half of our revenue generated in China. Our China operations have proven essential to stabilize our revenue and improved profitability.

One of our stated strategic goals is to focus on growing revenue into enterprise market, especially outside of China. We continue to find that our unique ability to offer a fresh new set of high performance networking solutions that enable enterprise customers to take the money they save on the infrastructure and reinvested in their business is resonating with them.

In fact, given today's economic climate enterprises are also taking a closer look at the vendors they are doing business with, and showing a desire to find a good partner that can deliver the performance they need at a value that enables them to do more with their tightening IT budgets.

I'm pleased to report that during the last quarter we won several large contracts in all of our key geographies.

Our internal estimate indicate that enterprise business account for approximately 75% of total networking revenue in the quarter up from 69% in the same period last year.

The percentage of revenue coming from enterprise business has remained at about 80% in our China based sales segment over to past year, but has grown in the rest of the world to 60% in the current quarter from about 53% in Q3 of last year. The remainder of our revenue was generated in small and medium business market which was particularly hard-hit by the current recession.

Despite a current slowdown in this market we expect SMB to remain a key market for our products. We see large enterprises demanding more value from their networks and a more responsiveness and better partnership from their suppliers.

With our focus on enterprise networking our young, broad, well managed product line and our investment in the direct touch sales and support model, we believe the current environment offers us unique opportunity.

Our network security business, TippingPoint had another solid quarter delivering both sequential and year-over-year revenue growth while improving profitability.

3Com achieved this third successive quarter of profitability on a GAAP basis and continued a string of profitable quarters on non-GAAP basis through a combination of improved gross margin along with improved operational efficiency and cost control.

Our non-GAAP gross margin was 57.4%, an improvement of nearly 4 percentage points over the same period in the previous year. This is the highest gross margin we have ever achieved.

The improved gross margin is a result of changing product mix including new products, the shift of greater portion of our business to the enterprise market and solution selling that generally carries higher gross margins.

We delivered GAAP earning of about $0.05 per diluted share and non-GAAP earning of $0.13 per diluted share in the third quarter, exceeding our guidance and prior year performance.

Finally our quarter end cash balance reached $560 million, an increase of almost $100 million from the previous quarter. The higher cash position is the result of strong generation of cash from operations.

Now I will turn to the individual geographies and segments, starting with our China based sales segment.

Our China based revenue continued to drive our overall financial performance delivering year-over-year revenue growth of 6%.

Direct touch sales increased 17.2% over the same period a year ago and now represents almost 70% of our China based revenue compared with 61% the last year and 65% last quarter. We are pleased that sales to Huawei were higher than expected, coming in at [$50.8 million] during the quarter. This represents decline of 8.2% from the same period last year and 12.5% sequential decline.

Our China based revenue accounted for almost 59% of our total revenue in the quarter. I would like to remind you that our China based revenue consist of revenue generated in China, Hong Kong and Japan. While the China export economy has been hard hit by economic slowdown in the key export markets of Europe and North America.

The internal China technology market that 3Com addresses is proving much more resilient, resulting a significant wins in the quarter.

During the quarter, our China team won major contracts to provide networking solutions for customers in a variety of vertical markets. For example we won two projects for subsidiaries of Sinopec, one of the major petroleum companies in China. For those projects we delivered wired and wireless switching and routing solutions that include our new network management offering, IMC.

Another win was the Kingsoft Corporation, one of the most prominent software companies in China. Where we delivered solutions that comprises our switches and IMC.

Other customer wins include China Nonferrous Metal and Mining Group. The large state owned enterprise was investment and development of mines in China and abroad and Southwestern Jiaotong University. But we continue to do well in our traditional verticals such as government and education. You can see from the above wins that we are successfully expanding into other verticals including energy and mining.

Now I turn to other regions of North America, EMEA, Latin America and Asia-Pacific. We continue to focus and make headways in the enterprise market, winning significant marquee accounts this quarter.

In EMEA we are successful in winning a contract with Volia, the largest ISP in Ukraine to build a new LAN infrastructures solution. Volia reviewed competitive offerings and chose 3Com for our ability to deliver the performance and scalability needed to handle bandwidth-hungry applications.

The IT team not only determined that the 3Com solution met its technology needs, but also recognized that it is designed to ultimately result in lower total cost of ownership. Our other large EMEA wins included a core-to-edge switching and routing solution for a Telefonica O2, the only integrated telecommunications operator in the Czech Republic and Abington Hospital in South Africa, a significant core-to-edge win in the key vertical market.

We also won several key accounts to provide voice-over-IP and core-to-edge wired and wireless solutions within our other regions, including Jordan School District, one of the fastest growing districts in Utah, Mexican National Water Commission and the Department of Education, Training and the Arts in Queensland, Australia.

While we are encouraged by these wins, we are concerned with the depths and the duration of the current recession. The impact of the economic crisis is reflected in our revenue performance in the quarter. We recorded sequential and year-over-year revenue decline in the third quarter with EMEA, particularly hardship.

Now I will comment on our TippingPoint segment. The high end network security business continues to show resilience in these challenging economic times as customers focus on securing their networks and data storage facilities.

Our TippingPoint business showed both sequential and year-over-year revenue growth in the quarter. Revenue in the third quarter increased 40.8% over the same period last year and grew 7.3% over the prior quarter. Last quarter we provided intrusion prevention solutions to global financial service firm ING and [Europe Information France] and Turkish Telecom among others.

During the third quarter, we made a decision to more tightly integrate the security business into our network business. The general administrative functions have already been integrated into 3Com, and work is continuing to integrate supply chain as well. The integration of these functions should contribute to further spending reductions.

Now I would like to comment on our sales marketing and R&D strategy. As we focused on the unique opportunity to offer enterprise customers a strong price performance alternative in the market, we continue to make investments in dedicated direct touch sales people to address this market.

As a result, we are participating in a lot more deals than in the past. Since the beginning of this fiscal year, we have seen the pipeline of new projects more than double. We are seeing a significant growth in our pipeline across all regions, both in terms of number of opportunities and their value.

Our value proposition is clearly resonating in the marketplace resulting our being invited to participate in an ever increasing number of large scale project. Despite the challenging economic conditions, we are determined to expand our price performance leadership position in the networking industry.

We continue to make investments in new product and solutions that we offer to our customers. Today engineers make up almost half of our worldwide population. We will displace our entire array of networking, security and related products, including video surveillance product at the premier networking industry tradeshow Interop scheduled to take place in Las Vegas May 17th through to 21st, we hope to see many of you there.

Let me now turn to our business development activities. While every company in the global economy is feeling the impact of the current economic crisis, we also see opportunities that we are uniquely positioned to pursue at this time.

One such opportunity is India. Last quarter, we signed an exclusive distributorship agreement which Inspira Enterprise India. A firm founded by local entrepreneur was a proven track record of business development.

Having previously been one of the most successful managed telecom service company in India, i2i Enterprise. Under the terms of agreement Inspira were dedicate team of people to focus exclusively on selling and servicing 3Com solutions in India. Inspira will emphasize integrated end-to-end 3Com solutions starting with core networking, security, surveillance, IP video surveillance and converged solutions focusing on the enterprise market. We are very excited about the opportunity. This new relationship creates, in one of the world's most vibrant emerging market.

As we continue to implement our strategy in very turbulent times, making judicious investment in customer facing positions, we are carefully watching our spending to ensure we weather this economic storm and our position to win in the marketplace. Last quarter we indicated several steps, we planned to take in order to control our spending, including greater scrutiny of all hiring, delaying company-wide [mirror] increases and cutting back on all other discretionary spending.

I am pleased to report that our non-GAAP operating expenses declined sequentially by more than $12 million. We have seen lower spending in our major expense categories as example, our Q3 '09 travel and related expenses declined 30% from the previous quarter. We also took a hard look at our capital spending plans, and we were able to reduce third quarter spending to $1.3 million from $3.7 million the previous quarter.

During the third quarter we decide to freeze [mirror] increases for the remainder of this year. And to extend the limits on all non-customer related spending. We continue with our ongoing assessment of business conditions to determine any additional access that may be warranted.

In summary, we are pleased with our overall performance during the quarter. We delivered our operating profit and earnings per share commitment to our shareholders. We achieved our third sequential profitable quarter on a GAAP basis and continued our string of profitable quarters on non-GAAP basis. We generated more than $100 million in cash from operations during the quarter. That we are delivering these results in the midst one of the most dramatic economic downturns in several generations is a refraction of our strategy and our execution against that strategy.

We are well positioned to weather the current economic crisis, and are poised to grow once the economy stabilize and more normal economic conditions return.

I would also like to take a moment and comment 3Com employees worldwide. For having stepped up to meet the challenges presented by the extraordinary global economic condition. We are all very proud of the dedication and professionalism they bring to their jobs everyday.

Now I will turn the call to our CFO, Jay Zager.

Jay Zager

Thank you, Bob and good afternoon, everyone. We are pleased with the financial results we are presenting today particularly in this extremely difficult economic environment, despite reporting sales that was slightly below the low end of our guidance we reported non-GAAP operating profits to the high end of our guidance, we achieved record gross margins, we saw sequential improvements on our operating margins and we generated $100 million in cash from operations.

Q3 sales were $324.7 million, a sequential decline of 8.4% and 3.5% lower than a year ago. On a year-over-year basis, the strengthening of the Chinese currency provided $14.4 million or 4.3% growth. For the first nine-months of the fiscal year, sales were $1,021.9 million, an increase of 5% over the prior year. Most of this revenue growth was due to foreign currency translation.

On a GAAP basis, our net income for the quarter was $1.9 million or about $1.50 per diluted share. Year-to-date our net income was $99.6 million or $0.24 per diluted share. On a non-GAAP basis net income for the quarter was $49.1 million or $0.13 per diluted share, and for the first nine-months of the fiscal year non-GAAP net income was $139.4 million or $0.34 per diluted share.

With respect to revenue, our networking business had sales of $293.2 million, 6.7% lower than a year-ago and 9.9% lower sequentially. Looking within our networking business, our China-based sales segments had revenue of $190.4 million consisting of China direct touch sales of $127.9 million a year-over-year improvement of 17%.

Huawei sales of $55.8 million which was 8.2% lower than a year-ago and about 12.5% lower sequentially, and other sales of $6.6 million primarily reflecting sales in Hong Kong and Japan.

Overall, this represents a 6% improvement over the prior year period reflecting the currency translation benefits mentioned earlier and about 5% sequential decline.

As you may recall our non-compete agreement with Huawei expired at the end of the last quarter. So these data reflect the first quarter after that expiration. Huawei sales in Q3 represented about 29% of our total China based sales and were 17% of 3Com’s consolidated sales, compared with 18% of consolidated sales in Q2 and 18% of consolidated sales a year ago.

Our rest of world network segment had sales of $102.8 million, a year-over-year decline of 24% and a sequential reduction of 18%. Within rest of world network sales, North America had sales of $24.0 million, a 12% decline from the prior year period and a 21% sequential decline. EMEA had sales of $43.6 million, about 35% lower than a year ago and 16% lower than Q2.

Latin America had sales of $19.9 million, a year-over-year decline of slightly more than 3% and about 20% lower sequentially and Asia-Pacific had sales of $15.3 million down 21% from last year and 16% lower than Q2.

As these results detest, we have felt the affects of the global economic slowdown across each of our geographic regions. We have seen IT budgets being reduced or temporarily frozen, we have seen sales cycles extended and we have seen many companies postponing their network decisions.

In all of our regions the decline has been more severe in our run rate SMB business. The enterprise business has seen much smaller declines and in fact the pipeline of future opportunities for the enterprise business has seen substantial growth. We are participating in many more enterprise deals than we were year ago and when the global economic outlook improves we expect to see the benefits of this increased participation.

In the quarter, our networking business had a gross margin of 56.0% compared with 55.1% in Q2 and 52.1% a year ago. The networking business operating income was $35.9 million down 7.5% sequentially but about 20% higher than a year ago.

TippingPoint Q3 sales were $33.3 million an all time record and 40.8% increase from a year ago. You may recall that the year ago period included a one time unfavorable $3.2 million revenue adjustments.

Within this total product revenue was 21.4% and maintenance revenue was $11.9 billion and product revenue was $21.4 million. Maintenance revenue was $11.9 million. This compares with prior year product revenue of $14.8 million and maintenance revenue of $8.8 million. TippingPoint continues to build a strong maintenance revenue annuity stream.

TippingPoint gross margin in Q3 was 66.8% slightly lower than the prior quarter and prior year. These declines were due to unusually high inventory and product commitment reserves in the quarter.

TippingPoint recorded an $800,000 segment profit in the quarter compared with losses of $400,000 in the Q2 and $800,000 a year ago. And these Q3 results include a $600,000 charge associated with a retention bonus for key TippingPoint employees.

From a consolidated viewpoint, 3Com's Q3 non-GAAP gross profit was $186.4 million, or 57.4% of sales. This was our highest gross margin percentage in our history and represents a 3.8 point year-over-year improvements. We continue to benefit from the favorable impact of our new products, continued product cost reductions and the shift towards more enterprise sales which carry higher margins.

R&D expenses on a non-GAAP basis were $43.2 million or 13.3% of sales, compared with $49.4 million or 14.7% of sales a year ago.

Sales and marketing expenses on a non-GAAP basis were $82.9 million, or 25.5% of sales compared with $80.7 million or 24.0% of sales a year ago and $87.0 million in Q2. This sequential decline in sales and marketing expenses was a direct result of the actions we put in place at the start of quarter to reduce discretionary, non-customer related expenses.

General and administrative expenses on a non-GAAP basis were $23.7 million or 7.3% of sales, compared with $21.1 million or 6.3% of sales a year ago. And headcount at the end of Q3 was 5,848 people, a net reduction of 50 people in the quarter and about 250 people lower than our year end level.

While we have not implemented any company-wide reductions in force, we have carefully managed our headcount this year resulting in this reduction. Operating profits on a non-GAAP basis were $36.7 million, or 11.3% of revenue compared with $38.4 million, or 10.8% of revenue in Q2 and $29 million, or 8.6% of revenue in the prior year period.

And through the first nine months of the fiscal year, non-GAAP operating profits were a $112.1 million, or 11% of sales. This profit level is substantially higher then our non-GAAP operating profits for all of fiscal year, 2008, which was $69.6 million.

Net interest expense was $3.3ml or other income was $16.5 million primarily as a result of the VAT software subsidy in China .No a non GAAP basis profit before tax was $49.9 million. Our tax provision of $800,000 primarily reflects tax expense in Jurisdiction unable to leverage our NOLs.

And as a result of these factors we have non GAAP net income in the quarter of $49.1 million, or $0.13 per diluted share compared with non-GAAP net income on a prior year period of $34.2 million, or $0.8 per diluted share.

Let me briefly turn to our balance sheet. At the end oft the quarter, our cash balance was $560 million compared with $461 million at the end of Q2. During the quarter we generated $100 million of cash from operations.

Notes receivable were $85.8 million a reduction of $28 million from the prior period. Accounts receivable were $114.1 million, a reduction of $17 million from Q2, and our DSO in the third quarter was 32 days compared with 33 days in Q2.

The reduction in notes receivable and accounts receivable were due primarily to lower sales in the quarter. Inventory was $107.1 million about $4 million lower than the prior quarter. Capital spending in Q3 was $1.3 million compare with first half spending $11.4 million and is part of our discretionary spending actions we also limited our CapEx spending in the quarter.

Our balance sheet has gotten stronger every quarter this year. To the first nine months of our fiscal year we have increased our cash position by almost $60 million, or simultaneously reducing our debt by $88 million and buying back $50 million of our shares.

While we see many changes in the coming quarters, as a result of the global economic environment our balance sheet leaves us well positioned to move forward with the execution of our core strategies.

Now, I would like to provide some insights in to the current quarter. And we do full year aware that in rapidly changing economic environment it has become more difficult to provide future revenue and profit projections.

Q4 revenues are expected to be lower than Q3 due primarily to the impact of the Chinese New Year. In addition, we continue to see the impact of the global economic slowdown on our business. As a result of these factors, we are projecting Q4 revenues to be in the $290 million to $300 million range reflecting sequential and year-over-year declines of between 7% and 10%. Within this total, we estimate that China-based sales were declined sequentially about 15%.

We expect direct touch sales in China to decline about 12% or sales to Huawei will decline about 20%. In the networking rest-of-the-world segment, revenue should be essentially flat when compared to Q3. And TippingPoint revenue should also be essentially at Q3 levels.

On a consolidated basis, we expect gross margins to be slightly below Q3 due to these lower revenue projections, while overall non-GAAP operating expenses will also be slightly lower than Q3.

As a result of these factors, we anticipate that Q4 operating profits on a non-GAAP basis should be in the $18 million to $23 million range. Using this range, non-GAAP operating profits for the full year would be between $130 million and $135 million compared with slightly under $70 million for all of fiscal 2008.

And earnings per share on a non-GAAP basis should be between $0.04 and $0.06. In using this range, non-GAAP earnings per diluted share for the full year would be between $0.39 and $0.41 compared with $0.23 for fiscal year 2008.

We also expect and we will continue to generate cash in the quarter although not as much as in Q3. During this quarter we will be paying our yearly bonuses to our Chinese employees and this will significantly reduce our overall cash from operations. We also expect to make a $13 million of prepayment on our outstanding loan balance on the quarter.

This payment will reduce the outstanding loan balance to $200 million and we paid down more than half of the original $430 million loan within the first two years. Despite these outlays, we expect our Q4 ending cash balance will be modestly higher than Q3 and we expect that for the full-year cash from operations will exceed $200 million.

Finally as Bob mentioned we will be attending the Interop Show in Las Vegas, this will be a great opportunity to see our extensive product and solution offerings. We look forward to see many of you with this important show.

And now I would like to open the meeting to questions. Operator?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). And we will go first to [Lin Yang] with Barclays Capital.

Lin Yang - Barclays Capital

Hi, thank you for taking my question.

Bob Mao

Hi [Lin].

Lin Yang - Barclays Capital

Hi. I was wondering if maybe we can start by talking about gross margin, it seems like you proceeded pretty solid margin this quarter. I know you mentioned the mix towards enterprise help, how do you see that going forward as you mentioned strength from SMB side of the equation?

Jay Zager

Yes, as I said in the Q4 guidance in general, we expect to see continued positive benefits from the product mix, from the shift to enterprise business and also from just general improvements in reductions in our costs.

The one caveat and reason why we are guiding slightly down is, as the revenues drop a little bit sequentially the fixed cost of goods expenses are amortized over a slightly smaller revenue base.

And we think that’s going to have a modest reduction sequentially in our gross margins, but as you can tell our margins are holding up pretty well and we believe that this gives us a very strong strategic in [methods] as we go forward.

Lin Yang - Barclays Capital

Okay. And then on the OpEx side, it seems like you took out a pretty nice chunk this quarter. How far along are you in terms of this data $100 million plan that you are targeting, should we expect maybe more cuts in the next few quarters?

Jay Zager

As we have reported before, I think last time we talked we said we are at $60 million. We are continuing to make improvements this quarter, we see some interesting integration opportunities with our TippingPoint operation as we follow them into our core business. We still see some longer term opportunities in supply chain, in IT, in finance but it’s taking us a little bit longer to realize these savings than we originally anticipated.

Lin Yang - Barclays Capital

Okay, great. And then finally if I could just maybe ask about the TippingPoint strategy, it looks like you appointed a new President back a month or so ago. Any call you can provide first there with this segmented business?

Bob Mao

Yes Lin, last month we announced that we are going to integrate the security business with the rest of 3Com because we see synergies more than just cost reductions. And we are very well on the path of developing specific programs and that you will see in the coming quarters.

Unidentified Analyst

Okay, great thank you very much.

Bob Mao

Thank you.

Operator

(Operator Instructions) No other questions. And we will go next to Rohit Chopra with Wedbush.

Rohit Chopra - Wedbush Morgan Securities

Hey guys, how are you?

Bob Mao

Hi how are you?

Rohit Chopra - Wedbush Morgan Securities

I had a question related to some of the moves made by competitors, let's just say over the last month or so. I was wondering if you can comment on what you are seeing out there, moves by Cisco, we saw some stuff by HP roughly a month ago. We are seeing moves by IBM right now; Juniper was laying out their, data center strategy. Could you talking what you need to do to remain competitive. Do you anticipate M&A or organic growth to get what you need to remain competitive?

Bob Mao

Okay, I guess the biggest news you are referring to is about Project California by Cisco. We have no present plans to put server blades on our switches. We continue to believe that we can work with server and storage vendors and together make much more efficient data center solutions.

And we are watching competitors out there moves like nothing else is really that out of the ordinary and as far as you are talking about merger acquisition primarily we plan to grow organically from the businesses side. Of course we are always on the watch out or looking for technology modules which could be very efficiently integrated into our product offering.

Rohit Chopra - Wedbush Morgan Securities

Thanks Bob. If I could ask you one other question is given your history at Nortel, is there anything that you find interesting and what they may or may not have up for sales?

Bob Mao

Today up to now we had not identified any specific opportunities on that front.

Rohit Chopra - Wedbush Morgan Securities

Thanks Bob.

Bob Mao

Thank you.

Operator

And at this time, we have no further questions from the phone line, so I would like to turn the call over to Bob Mao for any additional or closing remarks.

Bob Mao

Well, thank you everyone for joining our call today and we look forward to seeing you at Interop in May. Thank you.

Operator

This does conclude today's teleconference. You may now disconnect and have a great day.

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