Vitesse Semiconductor's CEO Discusses F2Q13 Results - Earnings Call Transcript

| About: Vitesse Semiconductor (VTSS)

Vitesse Semiconductor Corp. (NASDAQ:VTSS)

F2Q13 Earnings Call

May 7, 2013 4:30 pm ET

Executives

Ronda Grech – Vice President-Communications

Christopher R. Gardner – President and Chief Executive Officer

Martin S. McDermut – Chief Financial Officer

Analysts

Quinn Bolton – Needham & Co.

Brian Yurinich – Craig-Hallum

Aaron Martin – AIGH Investment Partners

Operator

Good day, and welcome to the Vitesse Semiconductor’s Second Quarter Fiscal Year 2013 Earnings Results Conference. Today’s call is being recorded. At this time, I’d like to turn the conference over to Rhonda Grech, Vice President of Communications. Please go ahead.

Ronda Grech

Good afternoon, and thank you for joining us for Vitesse Semiconductor Corporation’s fiscal year 2013 second quarter conference call. With us from management today are Chris Gardner, Chief Executive Officer; and Marty McDermut, our Chief Financial Officer.

Our fiscal year second quarter ended March 31, 2013. Results were reported in our press release issued this afternoon. We also filed our March 31, 2013 quarterly report on Form 10-Q with the SEC today. The press release, along with complete financial information for the quarter and our latest full year are available on our website at vitesse.com.

I would like to point out that during the course of this conference call, we will be making various remarks about future expectations, plans and prospects of the company that constitute forward-looking statements for purposes of the Safe Harbor provisions under Section 21-E of the Securities Exchange Act of 1934. Actual results may differ materially from those indicated by these forward-looking statements as a result of various risks and uncertainties, including those that are detailed in the Company’s SEC filings.

For further information about these risks and uncertainties, please read the Company’s SEC filings including our annual report on Form 10-K for the year ended September 30, 2012. These documents contain additional important factors that could cause actual results to differ from current expectations and from forward-looking statements contained in this conference call.

Furthermore, the company is under no obligation to and expressly disclaims any obligation to update or alter any of the forward-looking statements contained in this call, whether as a result of new information, further events or otherwise unless required to do so by law.

Next, I’ll review definitions for some metrics the company provides which are not in accordance with generally accepted accounting principles, commonly known as GAAP. Non-GAAP income or loss from operations is calculated as GAAP income or loss of some operations adjusted for stock-based compensation, amortization of intangible assets and restructuring and impairment charges.

Non-GAAP net income or loss is calculated as GAAP net income or loss adjusted for stock-based compensation, amortization of intangible assets, restructuring and impairment charges, and the gain or loss on compound embedded derivative. A reconciliation table is provided in today’s press release. It is now my pleasure to introduce our CEO, Chris Gardner.

Christopher R. Gardner

Thank you, Rhonda. Good afternoon, everyone. Welcome and thanks for joining us today. We’re pleased to report that while total revenues were down slightly compared to the first quarter, our product revenues grew sequentially in Q2.

Overall product revenues were up 3% from Q1 based on extremely strong growth in new products which were up 44% sequentially, and up over 100% from the year ago quarter. At $7.1 million, new product revenue now represents 29% of total product revenue. We saw our strength across the board in our new products for both Carrier and Enterprise markets.

Unfortunately, we did not close an expected IT deal, plus total revenues were slightly below our expectation. We managed expenses very well. As a result, operating income was within our guidance range. We had another very strong quarter for design wins, and we continue to take market share in our target markets.

Design wins for new products in the first half of 2013 are nearly double what we did in the first half of 2012. Later in the call, I’ll provide some color on where we’re seeing the strength.

On a housekeeping note, we held our annual meeting of shareholders on March 7. The shareholders approved the election of the slate of directors proposed by our Governance Committee. I’m very pleased to welcome Ken Traub and Matt Frey to the Vitesse Board of Directors, and I’d like to give my personal heartfelt thanks to exiting directors, Bill LaRosa and Grant Lyon, for the contribution and dedication over the last several years.

Let me turn it over to Marty now who will review results for the quarter.

Martin S. McDermut

Thank you, Chris, and good afternoon, everyone. I’ll start with a review of our second quarter fiscal 2013 financial results followed by a balance sheet summary and conclude with our third quarter fiscal 2013 guidance.

For the second quarter of fiscal 2013, total revenue, which consisted almost entirely of product revenue, was $24.8 million, down $1 million from the first quarter due to lower intellectual property revenue which totaled $64,000.

Product revenues were $24.7 million, up slightly from the $23.9 million in the first quarter. Excluding our distributors, our top ten end customers in the second quarter contributed approximately 48% of our total product revenues.

For the second quarter, there were no 10% customers and our geographical sales split was 57% from Asia-Pacific, 29% from the U.S., and 14% from other areas.

Chris will go into more detail on the market breakdown of the revenue in the next portion of the call. In the second quarter, total gross margin with IP was 54.1%. Product margin was 54% which is comparable to the first quarter. Product margins reflect the pressures from early production ramp of new products and the shift in mix to lower margin EOL and mature products.

Generally, newer products experienced lower margins and so we’ve had time to improve yield and optimize costs. Operating expenses in the second quarter totaled $17.3 million down from the $18.6 million in the prior quarter and $18 million in the year ago quarter.

Our R&D investment in the second quarter was $9.8 million lower than the $10.5 million in the first quarter, and slightly higher than the $9.6 million in the year ago quarter. The lower sequential amount is primarily due to the timing of masked expenses.

SG&A expenses for the second quarter was $7.4 million, down from the $8 million in the first quarter and $8.4 million in the year ago quarter. On a non-GAAP basis, second quarter operating expenses totaled $16.2 million as compared to $17.3 million in the first quarter. Depreciation expense for the second quarter was approximately $550,000. We expect it to be about $600,000 in the third quarter.

Stock compensation expense for the second quarter totaled $1 million, and is expected to be about $1.2 million in the third quarter. During the second quarter, we reported GAAP operating loss of $3.9 million and a non-GAAP operating loss of $2.8 million. Non-GAAP operating loss excludes the amortization of intangibles and stock-based compensation expenses.

For the second quarter, our GAAP net loss was $4.8 million or $0.13 per basic and fully diluted share. On a non-GAAP basis, we had a net loss of $3.8 million or $0.10 per basic and fully diluted share. Our second quarter was favorably impacted by a tax recovery of $1.1 million for tax withheld on a royalty payment received in the prior year.

Moving on to the balance sheet, at the end of the second quarter, we had a cash balance of $36.8 million, as compared to $37.1 million at the end of the first quarter, and $23.9 million at the end of the fourth quarter last fiscal year. As a reminder, we raised $17.1 million in net proceeds from a follow-on offering in the first quarter of fiscal 2013.

During the second quarter, cash provided by operations totaled $370,000. Cash generated from increased collections of accounts receivable and higher liabilities was partially offset by our loss.

In the second quarter, capital expenditures was $300,000, and we expect them to be about $700,000 in the third quarter. At the end of the second quarter, accounts receivable totaled $8.4 million, and days sales outstanding were 31, down from the $9.6 million and 34 days at the end of the first quarter respectively.

At the end of the second quarter, inventory was $12.6 million and accounts payable and accrued liabilities were $19 million, both approximately the same as at the end of the first quarter.

At the end of the second quarter, working capital decreased to $31.9 million, compared to $42 million at the end of the first quarter. The decrease primarily results from the recognition of $8 million of debt occurring in the second quarter.

Our short term debt is comprised with $7.9 million principal Term A loan and is due on February 2014. Our long-term debt principle totaled $55.8 million, and is comprised of our Term B loan and our 2014 debentures, none of which is due until October 2014.

We anticipate cash on hand will permit us to pay the amount due in February 2014. To meet the remaining debt obligation due in October of 2014, we’ve been exploring strategic alternatives to repay this debt and engage the services of financial advisory firms, to assist us in evaluating possible strategic and financing transactions.

These transactions might include an extension of the maturity date and other modifications of our Term A and Term B loans, the refinancing of indebtedness from proceeds of one or more new credit facilities, and the repayment of indebtedness from sales of legacy assets and other alternatives.

So next, I’ll turn to our outlook for the third quarter of fiscal 2013. These are estimates based on our current knowledge and are subject to change, as such is covered under our Safe Harbor statement.

For the third quarter of fiscal 2013, we estimate revenues will range from $25 million and $27.5 million. Product margins are expected to be between 51% and 53%. Total revenue gross margins could be 1 to 3 points higher. GAAP operating expenses, including R&D and SG&A, are expected to range from $18.5 million to $19.5 million.

And with that, I’ll turn the call back to Chris.

Christopher R. Gardner

Thanks, Marty. So I’ll start today with detail on our revenue by market, and then I’m going to give some analysis on products and customers, particularly the ones driving our new product ramps.

Our Carrier business was $13.2 million in Q2 or 53% of total product revenues down about 6% sequentially and up 37% from a year ago quarter. New products grew strongly in the quarter, up over 70% sequentially. This is partially offset by a decline in EOL revenue, which was down $600,000 in the quarter and very substantial weakness in China. While we did expect China to be soft in Q2 due to the Chinese New Year holiday we were surprised by the magnitude of the weakness. Huawei for example was down by more than 30% sequentially or about $1 million.

We know that this is not share loss and we do expect China recover somewhat in the second half. Enterprise revenue was $10.9 million in Q2, which is about 44% of total product revenue and up 12% sequentially, generally older products including some that are EOL are being replaced by new generation of switches and PHYs, particularly for applications and SME and cloud networking. New products at Enterprise grew 22% to $3.4 million.

We expect continued growth from new products in Q3. As some customers transition from prior generations and other new customers start to ramp. In addition to product revenue, we license intellectual property to a growing number of customers. IP revenue with less than $100,000 as Marty mentioned in Q2 compared to $1.0 million in Q1 and expected bookings slipped out of the quarter this quarter, and we didn’t have any other deliverables that we can execute too.

As most of our IP today is license fee. It does remain challenging the forecast on a quarter-to-quarter basis. Our dealer pipeline though remains strong with opportunities for both PHY and Switch Cores in consumer, industrial, and even automotive applications. We continue to estimate that IP revenue will come in around 7% to 10% of revenues on an annualized basis

The transition of revenue from older legacy products to our new product portfolio accelerated dramatically in the quarter. The transition is critical, as it enables our future revenue growth. As such, it’s usual look of what we call the vintages of our revenue. We have some older products about 10% of our SKUs that are going through an end-of-life process that we’ve described before.

In Q2 2013, revenue from EOL products was $4.3 million, down about $300,000 from Q1. We expect EOL revenues to decline in average rate about $0.5 million per quarter through 2013, but we do anticipate they’ll decline a bit more than that in Q3.

Our second category we classify as mature. Some products are early in their growth phase and some are older and beginning to decline. In Q2 this portfolio was down about 8% sequentially the entire drop due to the weakness in China. The rest of 2013 and into 2014 we continue to expect mature product revenues to trend with the market.

Products are classified as new if they’re released since 2010 and are part of our new enterprise or carries in its strategy. This quarter, we saw a step function revenue as customers begin to accelerate their production ramps. New product revenue grew to $7.1 million from $4.9 million in Q1 up 44% sequentially. This is a bit stronger than expectation and I think demonstrates the design wins recorded in 2011 and 2012 are coming to fruition. Bookings for new products grew in the quarter, so we expect solid growth again in Q3. Last October, we guided that we could double revenue from new products to $30 million in 2013; we are on track to meet that goal.

In my view, this growth has been driven not by strength in the overall market per se, but by increased market share. All these revenues from new customer designs typically won in 2011 and perhaps early in 2012 that are now starting to move into the early production phase. Generally, we’d expect these revenues to continue to grow and for these products to remain in production between four to eight years or even longer.

I will note that the pace of this new product ramp is putting some pressure on our margins as Marty mentioned. Many of the new products are not yet up to full production yields and much of the growth is from our Enterprise product that typically carry lower overall margins than the corporate average. We expect margins to fully recover into our target range of 57% to 62% as we get time to reduce the manufacturing cost in these new products and as the Carrier products ramp to become a majority of the revenue.

Growth drivers in the Enterprise side are new SKUs and SME and new platforms and applications for cloud networking. HP and several others are starting to ramp with our new sparks family of integrated Gigabit Ethernet switches and PHYs for Layer 2 SME applications. Many of these designs represented in equipment refresh cycle where we’ve added market shared compared total last cycle.

Meraki, now part of Cisco, is a lead customer providing systems in the cloud networking space. This is a good example of a brand-new market where we’re very well positioned and we’re now starting to see early movers ramping to production. While we consider this an enterprise application, requirements within the clouds stretched from traditional enterprise towards features more typically seen in carrier applications. Our E-StaX switches in 1- and 10-Gigabit PHYs are perfect fit for this fast-growing segment. As a result, we are seeing and closing a lot of new opportunities.

Drivers in the carrier segment are Ethernet deployments for a broad variety of new networking equipment, including edge routers and 4G base stations and backhaul equipment that are using our 1 Gigabit and 10 Gigabit SynchoPHY products family. Growth here is coming from our traditional carrier customers including Ericsson, Alcatel-Lucent and ZTE, as well as from the traditional enterprise customers such as Cisco and Juniper, who are deploying more products into the carrier markets.

These customers are converting over prior generation products to our carrier-enabled SynchroPHY products. As a good example, a point in the press release we did last week with Huawei describing our SynchroPHY products within a 4G cloud RAN application for China Mobile.

We also saw a very strong growth in our carrier Ethernet switch engines, but from a relatively small base. As I’ve note in the past, we won a significant number of switch engine designs and applications such as 4G base stations and backhaul, Ethernet access devices in small cell. It always takes a long time for the carrier platforms to go through testing, qualification, lab and field trials so we don’t expect to see this ramp materially until early next year.

That’s why our growth through 2014 is largely dependent on design wins taken in 2011 and 2012. We’ve estimated in the past that almost 90% of our new product revenue through 2014 comes from designs captured during those two years. In fact, we estimate that we shift less than 10% of the total lifetime revenue from these designs. And thus far in 2013, we’ve seen a substantial increase in our market traction both in terms of new opportunities and design wins.

In the first half of 2013, we recorded nearly double the number of new product design wins when compared to the same period in 2012. Strength is across the board with our switch engine products seen in the most recent gains. Nearly 80% of our total design wins are from the new product portfolio, but we also continue to win some new designs with older products, which extends their lifetime.

Our design win rate is increasing. In 2010, we typically won 20% to 30% of our design opportunities. Now, that number is between 40% and 50%. Our improving market traction comes from three areas: first, time and market. We’ve now been selling carry-Ethernet silicon not PowerPoint for over two years.

Customers have deployed product and they’ve seen it work. Many of our customers were among the first to achieve MES 2.0 compliance, a major milestone for carry-Ethernet systems. Many have received industry awards for their new platforms that includes our silicon. We’ve developed credibility in this segment and we have reputation for best-in-class features in technology even against our much bigger competitors.

Secondly, we have a complete product portfolio focused at segments of the enterprise and carrier markets where we can add clear differentiation. Our technology portfolio addresses the most critical needs of this emerging market, carry-Ethernet service delivery, network timing and network security. No one else offers this kind of comprehensive product portfolio.

And finally, same-store sales, as customers deploy our products and ramping the production they are starting on second or even third-generation design. They had made investments with Vitesse and we now enjoy the position of an incumbent in many of the platform. While, this is not a guarantee of future success, it does give us a significant advantage as we sample our next generation of products. In the first half of 2013, we reported more than 100 design wins from the top 20 same store sale customers including many Tier 1s.

Among our stronger segments is our Carrier Ethernet switch engine. This market segment has take some time to develop but we’re now seeing very positive signs that our product differentiation is compelling. In the IP edge market where we focused, we’re finding multiple applications that we can address uniquely with the combination of Carrier-class features, very low power, and fast time to market. We estimate the serviceable market here reaches $700 million by 2016.

In the IP Edge we address three of the fastest growing segments. One, cloud access which is converging Enterprise and carrier networks, we already have some solid design wins in this segment, which are now moving to production. We’ll see more in the next few quarters. We make good progress in network interface devices, commonly known as Ethernet-access devices or EADs.

Our Serval family of switch engine is perfect match for this application. We won half a dozen or so customers in this segment in the last six months, and we have a growing list of new opportunities.

And finally we continue to win, in the 4G market. This quarter we won a major new design and one of the leading Femtocell providers. As 4G start to replace 3G we’re seeing increasing requirements for our synchrofied timing technology in are carry-Ethernet switch engines in application as small as enterprise class Femtocell. We expect these kinds of opportunities to grow and contribute to revenue in late 2014 and into 2015.

We also had a strong quarter for new product introductions, announcing several next generation products both switches and PHYs. Just last week, we introduced the next generation of our switch engine portfolio Serval-2. This product scales our industry leading Serval-1 to provide additional carrier grade features, higher scale and fully integrated 10-gig ports. Like Serval-1, it’s MEF CE 2.0 compliant. Serval-2 is targeted directly at 4G base stations in mobile backhaul, cloud-based networks and Ethernet business service delivery.

In addition, we announced our third generation of carrier class PHYs, which integrates security functions in both our 1-gigabit and 10-gigabit byproducts. We’ve created a patented version of the standard MACsec technology called Intellisec that extends the IEEE standard to enable encryption over end-to-end over any network, including multi-operator and cloud base networks. It delivers power and cost reductions of over 75% compared with existing alternatives such as IPsec. We worked with the major Tier 1 to implement this technology into our synchrofied products so that it can easily be added to any existing networking platform. These products provide our customers with a very straightforward, simple roadmap to higher feature sets, density, and bandwidth.

Several years ago, we embarked on a path to reinvent the task. We attacked emerging fast grow markets with brand new technologies. We’re now starting to see the successful realization of our strategy. While we’re not yet completely through the transition, we know that with our ongoing efforts, we can reach it from here.

Tracks in the marketplace is improving and we’re confident we’ve hit the mark in defining and executing our first generation of products. Customers are now deploying these new products into the marketplace, enabling it to double new product revenue on an annual basis. Recently we’ve introduced the next generation of products will give our customers a clear and compelling roadmap to making it simply to choose the task.

I’d like to end today by thanking all of our employees for their continued effort, acknowledge our shareholders for their ongoing interest and support. With that, I’m pleased to turn it over to Anthony for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) We’ll take our first question from Quinn Bolton with Needham & Co.

Quinn Bolton – Needham & Co.

Hi, Chris and Martin. Congratulations on the strong new product revenue. I wanted to start with the new product outlook. Chris, last quarter, you’ve given sort of a target for sequential growth of 30-plus percent, you ended up doing 44%, wondering whether you might be able to provide a similar look into the June quarter in terms of new product growth on a sequential basis?

Christopher R. Gardner

Well, yes. First, thanks, Quinn. So we’re not providing specific guidance on a breakdown like that. I will tell you that we do not expect to see quite the strength we saw in the current quarter. These production ramps sort of ebb and flow a little bit. And now we have again reiterated the guidance to get to that $30 million bogey, which we set some time ago. So we’re actually pretty pleased that we’ve been able to achieve that in the market that arguably isn’t what we’ve expected it to be back in October last year.

Quinn Bolton – Needham & Co.

Right. Now, it certainly looks like the choppiness in the end markets have not affected the new product ramp, which is encouraging. Switching over to the IT revenue, you talked about one potential license pushing out of the March quarter, I was wondering whether you can give us any feel for whether that deal closes in the June quarter or has that sort of pushed out by indeterminate amount of time?

Christopher R. Gardner

Yes. So I would probably characterize it a little differently in that while we always have multiple deals in the pipe. I think we had higher probability for one particular deal. It has slid into this quarter. I’d say the visibility on it maybe is no better than it was last quarter, but we do have several others. So, we are hoping to generate some IT revenues this quarter.

Quinn Bolton – Needham & Co.

Okay, great. And then Last question on just the new design win strength. I sort of assumed that the wins you’re securing now probably really don’t generate revenue until out in the fiscal 2015 timeframe. Is that sort of the right way to be thinking about when these designs that you’re securing over the last couple of quarters really start to impact revenue?

Christopher R. Gardner

In general, I would say that’s a good estimate. However, one of the things we’re seeing with kind of the second and third generations so called same-store sales is that these design wins can actually get to production more quickly than first generation designs. Customers know the product, they have written software around the product and often they can ramp a new blade within a system more quickly than they can develop an entire system.

In addition, we’re actually now working with customers and some of the Taiwanese ODMs to accelerate product development even on the carrier side through ODMs. So the customers themselves aren’t doing the designs; their offshoring and outsourcing that and we are enabling those ODMs to come to market. We have examples of carrier boxes actually going from start to sample within three months. So we’re really working hard to try and accelerate the business based on literally the completeness of our solution.

Quinn Bolton – Needham & Co.

Okay. Great. And then just lastly, I was wondering if you had any thoughts on competitive landscape. It looks like Broadcom recently might have been for inter-op this week just announced the new family of gigabit PHY that look like they had 1588 capability with down to one nanosecond timing. I’m wondering whether you’re seeing that the physical layer device market become more competitive or do you feel like you still have a pretty good lead on us on 1588 technology. Thanks.

Christopher R. Gardner

Well, we’re very happy to see our competitors doing their best to catch up with us and I’d say that’s what we see in that release. There is a difference between time stamping accuracy and the ability to implement an accurate timestamp within a network. We have done the latter, which is much more difficult. Now, we have competitors coming out and saying they think they can do the former.

I’ll point out that while those products are now coming out, we’ve already moved on. So, our family of 1588, it was done a year ago, and our latest generation includes 1588 plus our Intellisec technology. So our recent customer engagements with all the Tier 1s are targeted at combining timing and security together. So, we think the competition is still arguably a year behind.

Quinn Bolton – Needham & Co.

Great. Thank you.

Operator

And we have no further question on the queue. So at this time, I’d like to turn the conference back over to Chris Gardner, CEO.

Christopher R. Gardner

It looks like we just got a couple of questions, Anthony; that we could maybe go to.

Operator

Yes. Actually, it does. So we’ll go and take our next question from Christian Schwab with Craig-Hallum.

Brian Yurinich – Craig-Hallum

Hi. This is Brian Yurinich on behalf of Christian Schwab.

Christopher R. Gardner

Hi, Brian. We almost missed you.

Brian Yurinich – Craig-Hallum

Sorry about that. Just a quick question, on the OpEx, it looks like on a non-GAAP basis, it kind of turned up just slightly higher than it was in Q1. Is that primarily just due to the timing that (Inaudible) cost and the change from Q2 to Q3?

Christopher R. Gardner

You’re asking why the Q2 is...

Brian Yurinich – Craig-Hallum

Is Q2 low because of tape-out and then we kind of go back at Q1 levels and Q3?

Christopher R. Gardner

Correct. That’s why you’re seeing a higher range in this coming quarter.

Brian Yurinich – Craig-Hallum

And then, should we expect – what should we think up for tape-out cost in Q4? Should they stay roughly the same as Q3?

Christopher R. Gardner

Probably just slightly lower, I would guess.

Brian Yurinich – Craig-Hallum

Perfect. That’s all I have.

Christopher R. Gardner

All right. Thanks.

Operator

And we’ll hear our next question from Aaron Martin with AIGH Investment Partners.

Aaron Martin – AIGH Investment Partners

Hi, guys. Congratulations on the things that look like they’re turning a little bit finally. Just to clarify, in your guidance of $25 million to $27 million, how much of that are we – obviously is going to be spread in IP in terms of what closes or not? How much of that are we calling for in product guidance?

Christopher R. Gardner

We don’t generally break that out. We kind of give you a hint based on the – in the change in margins. So our IP number has typically been sort of between zero and 1.5 million to 2 million. So I would say that’s the sort of the range that’s in that $25 million to $27.5 million.

Aaron Martin – AIGH Investment Partners

Okay, got it. And also in terms of the weakness in China, what gives you the confidence that you haven’t lost any market share there?

Christopher R. Gardner

Well, what we saw is we saw a weakness in a particular box at Huawei, one of their large carrier Ethernet transport systems. We sell probably four or five different products into that including PHYs and crosspoint switches and other things, all of them came down, right. So it wasn’t like we got displaced by a particular competitor around a particular socket. So we get pretty good view if we do get replaced because we lose business on one particular part, not all.

Aaron Martin – AIGH Investment Partners

Got it, okay. Thanks. Congratulations again.

Christopher R. Gardner

Thank you.

Operator

And that looks like we’ve exhausted all of the questions. So I’ll go and turn it back over to you. Please go ahead.

Christopher R. Gardner

All right. Well, thank you, Anthony. And again, I appreciate everyone joining the call today. And we’ll look forward to any follow-up calls here or talking to you during the quarter or at the next conference call Thank you.

Operator

Once again this does conclude today’s conference call. We thank you for your participation.

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