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Barnes & Noble (NYSE:BKS)

Q4 2013 Earnings Call

June 25, 2013 10:00 am ET

Executives

Andy Milevoj - Vice President of Investor Relations

William J. Lynch - Chief Executive Officer, President and Director

Michael P. Huseby - Chief Financial Officer

Mitchell S. Klipper - Chief Executive Officer-Barnes & Noble Retail

Analysts

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

John Tinker - Maxim Group LLC, Research Division

Marjorie Gochberg Kellner - Harvest Management, L.L.C.

Stuart Quan

Richard Shottenfeld

Operator

Good day, and welcome to this Barnes & Noble Year-End Earnings Conference Call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to the Vice President of Investor Relations, Mr. Andy Milevoj. Please go ahead, sir.

Andy Milevoj

Good morning, and welcome to Barnes & Noble's Fiscal 2013 Year-End Earnings Conference Call. Joining us today are our CEO, William Lynch; Mitch Klipper, CEO of Retail; Michael Huseby, CFO; and Allen Lindstrom, Corporate Controller, as well as other members of our senior management team.

Before we begin, I would like to remind you that this call is covered by the Safe Harbor disclaimer contained in our press release and public documents and is the property of Barnes & Noble. It is not for rebroadcast or use by any other party without the prior written consent of Barnes & Noble.

During this call, we will be making forward-looking statements, which are predictions, projections or other statements about future events. These statements are based on current expectations and assumptions that are subject to risks, uncertainties, including those contained in our press release. The company disclaims any obligation to update any forward-looking statements that may be discussed during this call.

At this time, I'll turn the call over to William Lynch, Chief Executive Officer of Barnes & Noble.

William J. Lynch

Thank you, Andy. As we announced in this morning's year-end results, Barnes & Noble Retail and Barnes & Noble College delivered a very solid performance in fiscal year 2013, while NOOK sustained heavy losses due to the shortfall during last year's holiday season in our new product sales for HD and HD+ tablets. We've implemented a strategy to get the NOOK business on track, and I'll talk more about that in a minute.

Overall, the company generated $6.84 billion in total sales for the year. Despite the significant NOOK inventory charges and EBITDA loss, the company still generated slightly positive EBITDA for the year.

Starting with the Retail business, revenues totaled $4.57 billion, with core comps essentially flat versus fiscal year 2012. Year-on-year, Retail EBITDA grew to $374 million, a 16% increase over fiscal year '12. The growth in EBITDA was primarily attributable to a 70 basis point gross margin expansion and lower expenses. As we look to fiscal year 2014 for Retail, we expect to open up 5 new stores and close 15 to 20 stores, consistent with prior years.

Barnes & Noble College also had a very solid year with sales of $1.76 billion. Full year comps decreased 1.2%. EBITDA in the College segment for fiscal year '13 was $111 million, slightly lower than a year ago, primarily due to investments in digital education. College had its best year in the past decade in terms of new contracts. College sees a strong pipeline of new contract growth in the current fiscal year 2014, which is expected to provide net adds and grow the school account base we serve.

With respect to the NOOK segment, the business incurred $475 million EBITDA loss for fiscal year 2013, much higher than our previous expectations. This loss was driven primarily by NOOK inventory-related charges of $222 million, which includes an additional $133 million that the company recorded during the fourth quarter as a result of a shift in strategic direction. The company's primary focus is to continue to offer millions of customers buying their eContent from Barnes & Noble, an amazing digital bookstore experience, while also significantly reducing NOOK losses.

To accomplish this, we've implemented a three-part strategy comprised of the following initiatives: First, we will sustain our efforts that started in Q3 to significantly reduce operating expenses in the NOOK segment. We began executing on that plan following the holiday, and in Q4, lowered year-on-year NOOK segment expenses from $78 million in Q4 '12 to $52 million in Q4 '13, excluding a noncash goodwill impairment charge. So we were able to cut expenses $26 million year-on-year in Q4, a 34% decline in spending versus the same period last year. We are implementing further cost reductions as we make an important shift in our hardware strategy, which will substantially shrink the losses in the NOOK business.

Second, we intend to continue to enhance our digital bookstore service and reading apps. We add over 4,000 new digital titles a week to our digital catalog from authors and publishers all over the globe and have one of the world's largest selection of books and magazines at very competitive prices. We get extremely high ratings from our millions of customers using the NOOK digital bookstore service, both on our NOOK devices or those using our NOOK third-party reading apps. Our commitment to digital customers haven't changed, and existing and new NOOK customers can expect further improvements in the catalog of eBooks, periodicals and education content and a best-in-class reading experience from us going forward.

Third, we are adjusting our hardware and device strategy to de-risk the NOOK business plan. The company is away -- is moving away from independently building our own tablets and intends to partner on future tablet programs with partners to design co-branded tablets with NOOK content. Leveraging a scale manufacturing partner in tablets offloads risks associated with building the products ourselves and will allow us to keep pace with innovations in the rapidly changing tablet market. Our aim is to sell great tablets connected to our vast content catalog and high-quality bookstore service as we've done, but do so without the sizable upfront risk.

In terms of existing NOOK HD and HD+ tablets, these are great Android devices offering an amazing NOOK reading experience and fully enabled with Google Play. The customer response has been extremely positive to our recent price drops, which has led sales -- which has led the sales and thus far have been ahead of expectations in May and June. We plan to offer existing inventory of HD and HD+ for sale in amazing prices through the holiday as we transition to the aforementioned partner model on tablets.

With respect to our popular Simple Touch eReader line, we plan to continue to design, innovate and launch new products. We've had the highest-rated eReaders in the market for several years and can manage this device business efficiently. Customers who own our dedicated eReader products like Simple Touch and Glowlight comprise the majority of our digital book sales, and designing and selling these devices have been key to our digital customer acquisition and content growth model. So our developed -- device development model on eReaders isn't changing.

To summarize, we are 100% not exiting the device business, but we are materially adjusting our approach in the competitive and capital-intensive tablet market. Overall, the underpinning of our new digital strategy remains the same today as it has since we first entered the digital market, which is to offer customers any digital book, magazine or newspaper on any device. The new partnership model on tablets should significantly reduce NOOK losses going forward as we provide ongoing enhancements to our bookstore service and launch new eReaders. As with all of our NOOK devices, we will support customers buying tablets and eReaders from us with world-class sales and post-sales support in our Barnes & Noble stores.

Turning to the company's balance sheet, we emerged from fiscal year '13 with a stronger balance sheet than the company had ended in fiscal year '12. As of the close of fiscal year '13, the company had $160 million in cash on hand and borrowings of $77 million under our $1 billion revolving credit facility. This compares to $50 million in cash on hand at the end of last year and $324 million in debt on the revolver. So cash increased $106 million versus last year, and borrowings from the revolver decreased $247 million.

In terms of NOOK Media's balance sheet, the subsidiary has been financing itself since October and had approximately $148 million in net cash to end the quarter and no debt. We plan to have NOOK Media self-finance by continuing to reduce our costs, converting existing NOOK device inventory that has been paid for into cash and with cash flow from Barnes & Noble College and cash payments from Microsoft.

To close, our Retail and College businesses had very solid years and remain valuable and profitable businesses for the company. In terms of the NOOK segment, we believe it has great potential going forward. The management team has been focused on shrinking the expense base of the NOOK business, and that work started successfully last quarter with a 34% year-on-year decrease in OpEx, excluding the noncash goodwill charge. We are taking additional actions to further reduce expenses in the NOOK segment, driven in large part by adjusting our approach away from producing our own tablets and moving to a partnership model. This will help us reduce investments and losses from hardware but still provide our Barnes & Noble customers access to high-quality tablets connected to a terrific digital bookstore. We plan to continue to design and produce the best single-purpose black-and-white eReaders on the market, and we intend to partner with a technology leader to make sure we are delivering the very best color tablets to our customers. You can expect to hear more details on our device strategy in the coming months.

Lastly, we will continue to offer customers the high-quality HD and HD+ tablets at a [indiscernible] reduced low prices, providing customers amazing tablet values through the holiday.

Thanks. And now, I'll turn it over to Mike Huseby, our CFO, to get more into the specifics of the company's full year and Q4 financial performance.

Michael P. Huseby

Thank you, William. This morning, before the market opened, we released our fourth quarter and year-end results for fiscal 2013, which ended on April 27. Consolidated sales decreased 7.4% for the quarter to $1.3 billion and 4.1% for the full year to $6.8 billion. Retail sales, which include results for Barnes & Noble's Retail bookstore and BN.com businesses, decreased 10% for the quarter to $948 million due to an 8.8% comparable bookstore sales decrease, store closures and lower online sales. Sales of NOOK products in the Retail segment declined during the fourth quarter due to lower unit volume. Retail core comparable store sales, which exclude sales of NOOK products, decreased 5.8% for the quarter, primarily due to the comparison versus a year ago, which included a high level of sales from The Hunger Games and Fifty Shades trilogies. On a full year basis, Retail sales declined 5.9% to $4.6 billion. Full year comparable bookstore sales decreased 3.4%, which was in line with our company guidance, while core comparable store sales were essentially flat.

Fourth quarter College sales increased 10.7% to $252 million, driven by an increase in comparable store sales and new store growth. On a comparable basis, College sales increased 7.5% as compared to the prior year as the spring back to rush -- back-to-school rush season extended into the fourth quarter. On a full year basis, College sales increased 1.1% to $1.8 billion as new store growth offset the decline in comparable store sales of 1.2%, also in line with the company guidance.

Fourth quarter NOOK sales, which include sales of devices, digital content and accessories, were $108 million, decreasing 34% as compared to the prior year. The decline was primarily driven by lower device unit volume. Digital content sales decreased 8.9% for the fourth quarter, given the device sales shortfall and the comparison to the high level of eBook sales from both The Hunger Games and Fifty Shades of Grey trilogies a year ago. On a full year basis, digital content sales increased 16.2%.

Gross margins were adversely impacted by NOOK inventory-related charges of $133 million during the quarter and $222 million for the full year. While previous quarter charges were driven by higher-than-anticipated levels of finished and unfinished goods and the holiday sales shortfall, the current quarter charges are attributable to the adoption of more aggressive promotional strategy given NOOK's shift in strategic direction and management's evaluation of the current and expected competitive landscape for tablet pricing.

Fourth quarter Retail gross margin declined 390 basis points due to sales deleverage on a comparable store sales decline. However, on a full year basis, gross margin improved 70 basis points, benefiting from a positive mix shift towards higher-margin core products and increased vendor allowances.

Fourth quarter College margin decreased 40 basis points resulting from higher occupancy costs. On a full year basis, College margin increased 30 basis points, benefiting from a higher mix of higher-margin textbook rentals.

Selling and administrative expenses decreased 230 basis points for the quarter. Retail expenses improved 290 basis points for the quarter, primarily as a result of lower net legal and settlement expenses. College expenses levered against the sales increase previously discussed. NOOK expenses included a noncash goodwill impairment charge of approximately $18 million as the company determined that impairment indicators arose during the quarter, and recurring losses have led to revisions in NOOK's strategic plans. Excluding the impairment charge, NOOK expenses declined $26 million versus a year ago driven by lower advertising, legal, variable sales costs and other cost management measures.

On a full year basis, consolidated expenses as a percentage of sales were flat with the prior year. Retail expenses declined 90 basis points as strong expense management, coupled with lower net legal and settlement expenses, mitigated the sales decline. College expenses delevered 60 basis points on new stores and increased expenses for digital education initiatives.

Full year NOOK expenses delevered on decreased sales, the impairment of goodwill and increased costs to support international expansion under our Microsoft commercial agreement. Interest expense was $9.5 million for the quarter versus $8.6 million a year ago and $35 million on a full year basis, which was flat with the prior year.

The company's EBITDA loss increased $112 million for the quarter as compared to the prior year as a result of the substantial NOOK inventory-related write-down and the other factors just discussed. Retail achieved EBITDA of $374 million for the year, increasing 16% over the prior year, as the sales decline was mitigated by a higher mix of higher-margin core products and lower expenses. College's EBITDA was $111 million, which was slightly lower than a year ago, primarily as a result of investments in digital education.

NOOK's EBITDA loss increased to $475 million as a result of lower sales, full year inventory-related charges of $222 million and the goodwill impairment charge of approximately $18 million. The company's consolidated EBITDA decreased $166 million for the year as a result of these factors.

Consolidated fourth quarter net losses were $118.6 million or $2.11 per share, and fiscal 2013 consolidated net losses were $154.8 million or $2.97 per share.

As referenced in our earnings release this morning, the company is currently in the process of finalizing its evaluation of certain prior year financial statement amounts, which may result in a revision to the financial statements. The company's analysis is ongoing, but it does not believe that these amounts will be material to the financial statements or financial information contained in this release. Accordingly, the financial information presented in this press release remains subject to change based on this process.

At year end, the company had cash of $160.5 million and borrowings of $77 million under its $1 billion revolving credit facility. Cash flows provided by operating activities were approximately $117 million, primarily attributable to lower inventory levels. Merchandise inventories decreased $151 million or 9.7% versus the prior year-end balance. This decrease included lower trade book inventory at Retail on higher-than-anticipated core sales trends and improved core inventory management, lower NOOK inventory due to reduced net realizable value, partially offset by an increase at College for new store growth. Consolidated CapEx for fiscal 2013 were $166 million, which was relatively flat with the prior year.

In fiscal 2013, we opened 2 Retail bookstores and closed 18. College opened 49 new stores and closed 10. Looking ahead to fiscal 2014, our intention is to reduce NOOK losses and liquidity uses by implementing the strategies we discussed and outlined in today's earnings release, as well as by selling through the existing NOOK inventory on hand. As William mentioned, this inventory was substantially paid for in fiscal 2013, creating a cash flow timing benefit upon its sale in fiscal 2014. We expect Retail comparable sales to decline in the high single digits as the bookstore cycle against the Fifty Shades trilogy during the first and second quarters, continuation of the secular industry challenges and expected further declines in NOOK product sales by Retail. College comparable store sales are expected to decline in the low single digits in fiscal 2014.

We expect CapEx to be approximately $155 million in fiscal 2014, which includes approximately $75 million at Retail for new stores and existing store maintenance; approximately $47 million at College for new and existing stores; and approximately $33 million at NOOK in support of digital initiatives, including internal development and investments in hardware and software. We plan to open up to 5 Retail bookstores in fiscal 2014 while closing approximately 15 to 20.

With that, we will open the call for questions. Operator, please provide the instructions for those interested in asking questions.

Question-and-Answer Session

Operator

[Operator Instructions] And we'll take our first question from Matthew Fassler with Goldman Sachs.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

My first question relates to the composition of your digital business. Can you give us a directional sense of how much or percentage of your online book sales, your digital content sales align with the tablets or the eReaders you're going to continue to make on your own and your apps, in other words, the proportion of digital sales that's not related to the color tablets that you're going to start outsourcing?

William J. Lynch

Matt, I think what we've said about that in our statement is that the majority of the content sales come from non-tablets from the black-and-white eReaders historically from customers over the life. It's been our primary customer acquisition vehicle for content. There's some selection bias too in that, in that those people who buy single-purpose eReaders are the ones who are the biggest readers. So -- and the second part of that is we just got into the tablet business in 2010 when we launched NOOK Color.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Understood. A second question related to NOOK results, just to help us understand what went into that inventory charge. Is that the sum total of the discount, the original list price that you expect -- or the sum total of the discounts from original list price that you expect to have to book to ultimately sell through the good versus as a smaller number than that?

Michael P. Huseby

Yes, Matt, the composition of the write-downs, the majority of it in the quarter has to do with the device obsolescence, the finished goods. And other components of it have to do with what's in the channel partner, I guess pipeline, where we anticipate some price support and other promotional allowances, as well as accessories that go with the devices and what we anticipate happening with the accessories and return volumes and that type of thing. So it's a combination of those, as well as some reserve for parts and components that we are obligated to take and either build out, which we're doing to the extent that it makes sense economically to do that, or that we may be able to -- may be obligated to honor and not build out. So there's a combination of 5 or 6 things. But the majority of it relates to finished goods and expected pricing and ROV[ph].

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Okay. And then one final question. Obviously, you took down NOOK expenses a lot. I know that one significant component of your cost structure had been advertising and marketing as you've worked to build the NOOK brand for hardware and for content. I'm not sure how much of the R&D process is expensed rather than capitalized. But as you think about the reduction that you achieved, any buckets that contributed disproportionately to it?

William J. Lynch

I think the ones Mike listed are the ones, Matthew, that where we saw most of the savings, and it was across the big OpEx buckets. So it's across both marketing, as you mentioned, headcount. You mentioned legal. We also saw some benefit in other consulting line items. We said direct charges as it relates to supporting the device business. So it's a whole host of them.

Operator

We'll take our next question from John Tinker with Maxim.

John Tinker - Maxim Group LLC, Research Division

Could you discuss a little how you see the partnership working for the tablet, the color tablet device?

William J. Lynch

Sure, John. Well, first of all, we know this is a sizable change from our existing strategy. It will -- the other thing we know is we can sell a lot of tablets through our channels. We've got media-hungry consumers. We've got millions of them that order from our digital bookstore. And so what we've said is we want to capitalize on our design capabilities and work with a third-party to source co-branded tablets that we can sell through our stores and online, connect it to our digital bookstore. Exactly how that work -- will work, I don't have the specifics today. We're in those discussions now. But what we did know is we want to move away from taking on all that risk ourselves. And as we've seen the tablet market, especially in the area we competed in which is sub-8-inch, got extremely competitive, and it was very capital-intensive to build our own tablet. So we have a lot of interested parties that we're in discussions with. And I know that's not the exact specific you want, but as I said, you can expect further announcements from us in the future.

John Tinker - Maxim Group LLC, Research Division

Okay. Your cash is up obviously well compared to last year. So how much of that is Microsoft putting money into NOOK? And where are they on their actual sort of -- they had an initial cash injection and they had -- and agreed to incremental cash injection. Can you just update us on where they stand?

William J. Lynch

Clearly, we've -- what we said when we created NOOK Media is we were reinventing the Retail business and the Retail balance sheet. And so if you look at the Retail balance sheet year-on-year, it improved significantly, and that was a function of all the things Michael said, including just the operating profits that were delivered along with better working capital management year-on-year. In terms of Microsoft, we did take in the Microsoft investment. We have been partnering with them on our milestone and obligation. In fact, just yesterday, our latest Windows 8 app went live, NOOk App in the Windows 8 store. To date, we've been honoring our commitments and they've made their payments, and so that partnership continues.

John Tinker - Maxim Group LLC, Research Division

The -- sorry, if I can ask another question or 2. The -- I understand you are actually beginning to reduce some of your inventory in the Retail stores, you're carrying less titles. But also, could you update us on what you think your physical book market share is now? I think it used to be about 17%. But as the Targets and the Walmarts perhaps begin to pull back a little, are you seeing any increase in your share?

Mitchell S. Klipper

John, this is Mitch Klipper. As far as bringing down the titles at the stores, we haven't taken down the titles substantially over the last 2 to 3 years. We're always adjusting the titles up and down as we see fit based upon the sales trend. We may have taken out the depth of some of the titles but not the individual titles, so I don't know where that is coming from. As we've expanded into some of these other areas like NOOK and Toys, we have rearranged the stores to accommodate the titles, so probably down 1%, 2%, 3% over the last couple of years potentially. Some stores have actually gone up. As far the market share, it stayed about the same over the last couple of years.

John Tinker - Maxim Group LLC, Research Division

I think in the last quarter, your Chairman Riggio announced he was to start looking to take the Retail store business private to that. Are there any updates on his plans, because we're now at the end of June?

Mitchell S. Klipper

No update.

Operator

We'll now take our next question from Marjorie Kellner from Harvest Management.

Marjorie Gochberg Kellner - Harvest Management, L.L.C.

I was just wondering when you would expect to have an update considering it's been an awfully long time?

William J. Lynch

Yes, Marjorie, the company doesn't intend to comment further on the proposal. And what we've said is unless and until a definitive agreement for the transaction is entered into or the strategic committee determines to conclude the process, we will not, and that's our statement today as well.

Operator

And we'll take our next question from Stuart Quan with Roystone Capital.

Stuart Quan

I had a few questions. The high single digit negative comp guidance for next fiscal year, what is that for core comp?

Michael P. Huseby

We haven't broken that out for next fiscal year. We haven't given guidance on that.

Stuart Quan

Okay. Can you give us any sense of this...

Andy Milevoj

Hey, Stuart?

Stuart Quan

Yes?

Andy Milevoj

Hey, Stewart, it's Andy. The only thing I would point out that Mike alluded to in today's speech is that when you're thinking about where comps will unfold over the next 12 months, obviously, Q1 and Q2, you had the significant impact of Fifty Shades last year, which is going to impact the core comp. The difference between the headline comp and the core comp is the device sales. So as you're looking at core versus the total comp, obviously, the core will be impacted by that comparison for the first half of the year.

William J. Lynch

And just maybe to provide a little more color on the impact of Fifty Shades, it was worth 4 to 5 points of comp for us last year. It was that big a book.

Stuart Quan

Okay. And then what -- in total, can you give us a sense of what the total hardware sales were last fiscal year?

Michael P. Huseby

We didn't break out content and hardware sales.

Stuart Quan

Okay. And last question is on the CapEx. I think you said $75 million for Retail with 5 new stores. How much of that $75 million is for the new stores?

Mitchell S. Klipper

These stores were on $2 million to $3 million a piece, so you can do the math. The rest is maintenance CapEx, upgrading our systems.

Stuart Quan

Okay. It seems like as if it jumped up from what you ran this year. Is that...

Mitchell S. Klipper

Pretty much the same. We do have some new initiatives on the technology front, upgrading some of our systems to stay current with the requirements. So it's really a big piece. The bigger picture would be on the technology front.

Michael P. Huseby

And the new store count is slightly higher as well.

Mitchell S. Klipper

Built new stores last year, we're seeing 5 stores next year.

Operator

[Operator Instructions] And we'll take our next question from Rick Shottenfeld with Coyote Capital.

Richard Shottenfeld

I'm going through the numbers. So of the $475 million you lost in the NOOK division, $222 million of it was write-downs of hardware. So that left you with about $253 million in normal operating losses. I guess you said you reduced it on a quarterly basis to $52 million, which you've got a $208 million loss run rate for next year. But how much of that is developing color tablets and the expenses associated with that? Can you sort of give us a ballpark idea of what further reductions we could expect from getting out of developing color tablets?

William J. Lynch

We haven't quantified that. But clearly, when you look at everything that's involved with -- we were really pursuing of a spoke model as it relates to color tablet development across everything. And it wasn't just the hardware, it was the software preparing for that. It was the promotion of those tablets ourselves, going to market. It was working with third parties to launch it. It was preparing the app stores, et cetera. And so there were significant costs involved in launching those products. But in terms of the specific breakout, we haven't provided that.

Richard Shottenfeld

Is it a substantial portion of the $208 million? Is it -- or were the reductions you already made in anticipation of getting out of that business? I'm just trying to get some sort of sense of where to expect NOOK losses next year. It sounds like they'll be significantly lower, but I'm just trying to get some sort of idea where that will be.

William J. Lynch

Here's what we've said, Rick, as it relates to that. We've said that we lowered costs in Q4, as you noted, and you read that $52 million number. And we've said we're pursuing further cost reductions. So that's what I would guide you to there.

Richard Shottenfeld

Okay. So now in the bookstores this year, you generated about 370 -- you generated $374 million in EBITDA. You said the CapEx should be about $75 million, and there'll be a slight decrease. But it sounds like the bookstores themselves will generate about somewhere north of $200 million in EBITDA. And so we should be generating a significant amount of cash at the traditional bookstore level. What are the company's intentions for that cash? I mean, I know what you said, you would bring sense to the NOOK division, so we're not going to be burning anymore of the bookstore cash at NOOK. What are your intentions with that cash?

William J. Lynch

Yes, Rick, I think where we are right now is we don't have anything specific to announce from the board and decision on how that cash is going to be used if your implication is will there be a dividend or some other return of capital, et cetera. All those things are being considered, but there's nothing to announce today.

Operator

We have no further questions. I would now like to turn the conference back over to Mr. Milevoj for any final or closing remarks.

Andy Milevoj

Great. Thank you, and thank you all for joining us on today's call. Please note that our next scheduled release will be our first quarter earnings release on or about August 20. Have a great day.

Operator

And this does conclude today's conference call. Thank you all for your participation.

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