Richard McCready - EVP and COO
David Hamamoto - Chairman, President and CEO
Andy Richardson - EVP, CFO and Treasurer
James Shanahan - Wells Fargo
NorthStar Realty Finance Corp. (NRF) Q2 2009 Earnings Call Transcript July 31, 2009 11:00 AM ET
Ladies and gentlemen, thank you for standing by, and welcome to the Northstar Realty Finance second quarter conference call. During today’s presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator instructions) This conference is being recorded today, Friday, July 31st of 2009.
And at this time, I would like to turn the conference over to Richard McCready, Chief Operating Officer for Northstar Realty Finance. Please go ahead, sir.
Thank you very much. Welcome to Northstar’s second quarter 2009 earnings call. Before the call begins, I would like to remind everyone that certain statements made in the course of this call are not based on historical information. It may constitute forward-looking statements. These statements are based on management’s current expectations and beliefs, and are subject to a number of trends and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements.
I refer you to the company’s filings made with the SEC for a more detailed discussion of the risks and factors that could cause actual results to differ materially from those expressed or implied in any forward-looking statements made today. The company undertakes no duty to update any forward-looking statements that may be made in the course of this call.
Additionally, certain non-GAAP financial measures will be discussed on this conference call. A presentation of this information is not intended to be considered an isolation or as a substitute to the financial information presented in accordance with generally accepted accounting principles. Reconciliations of these non-GAAP financial measures to the most comparable measures compared in accordance with generally accepted accounting principles can be accessed through our filings with the SEC at www.sec.gov.
With that, I'm now going to turn the call over to our Chairman and Chief Executive Officer, David Hamamoto. David?
Thanks, Rick, and thanks, everyone for joining us this morning. In addition to Rick McCready, our COO, I'm joined today by Andy Richardson, CFO; Dan Gilbert, our CIO; and, Al Tylis, our General Counsel.
I’d like to then begin the call today by making a few comments about current market conditions and update you on Northstar’s growth and operating strategy, performance, and strategic initiative given this challenging time. Andy will then review the specifics of our second quarter results.
We’re now two and a half years into our macroeconomic and real estate environment characterized by steadily worsening business, unemployment, and capital market conditions. We all know the major events in the financial markets, which have been equally marked in this recession, starting with the cracking of the single-family housing sector in early 2007, the Bear Stearns’ liquidity crisis and sale, US government bail out of AIG and its counterparties, Lehman Brothers bankruptcy, and the passage of the massive $800 billion economic stimulus package earlier this year.
During this period, most efforts by the government were focused on avoiding further significant damage to our major banking institutions and then mitigating the residential mortgage crisis. Several months ago, the Federal Reserve and the Treasury finally introduced programs such as the PPIP that are intended to begin healing the commercial real estate asset-backed finance market almost two years after they stopped functioning.
Unfortunately, commercial real estate lenders and investors will likely not benefit from these programs for many months. Meanwhile, worsening economic conditions and increasing unemployment are ratcheting up pressure on commercial real estate cash flows and value. The negative impact of economic conditions has been further exacerbated by the extended closure of real estate finance market and virtually no new GAAP capital from balance sheet lenders, revealing with their own capital inadequacy issue.
Furthermore, banks with excess capital have used it to re-pay TARP investments to escape restrictions related to this money, and appear to be hording capital to deal with increasing consumer credit problem.
In the second quarter, trend action activity in the commercial real estate sector remained very low. Rather than aggressively seeking foreclosure, most lenders are working with their borrowers to modify or send maturing loans, if the borrower is able to invest more capital, and or there is sufficient cash flow from the collaterals paid that server. Neither property owners nor their lenders are interested in voluntarily selling assets to the current distressed pricing environment.
With new transactions and ever increasing bank failures, 64 year-to-date and 22 since May, we believe that future supply of commercial real estate assets held by the US government is growing at an accelerating pace. The government is not set up to manage these assets and will eventually seek to generate liquidity, most likely offering attractive terms to induce the private sector to bid for these assets.
We also believe that healthier banks will eventually seek to reduce their commercial real estate exposure and may use excess earnings to further write down assets to values, at which they can be thrown with no further loss.
Recently, we have seen some progress in the implementation of the PPIP and the TALF progress for commercial real estate. This month, the Fed announced the initial collection of managers for the PPIP Legacy Securities program, and the Treasury provided the initial loans for the Legacy CMBS TALF program. Since these programs have moved forward, prices of TALF eligible CMBS securities, which can be leveraged by the government on a non-recourse basis up to 61 times, unless the AAA rate and not be on watch for downgrade, and increase significantly, approaching, and it summons to be succeeding over 90% at par.
Unfortunately, SMT’s recent inclusion of a majority of their rated CMBS universe on watch for negative rating action, including super senior AAA securities, has significantly reduced the amount of securities available for financing under TALF. The remainder of the CMBS market, however, has been a slower and more modest decrease in yield. However, spreads appear to have tipped their lightest levels earlier in 2009 and generally have stabilized since then at slightly to significantly tighter levels depending on vintage grading and credit performance.
We’re also observing banks working on a few new commercial real estate loans and which AAA securities can be financed under TALF. Because the cost-to-capital remains very high and real estate values have declined, the new loans provide significantly less debt proceeds when compared to prior period leverage levels and have a relatively high cost.
We expect that over time, the TALF eligible loans will become cheaper and debt proceeds higher. But we think it could be 12 months or more until we see a cost and leverage level that will be attractive and available to a meaningful portion of the real estate market. Even then, leverage will probably be much less than what’s available during the market peak, and many properties will still need additional equity capital in order to successfully refinance maturity debt.
We also believe there will not be more clarity on the timing of an economic recovery until the end of this year, at the earliest, which makes underwriting future property level cash flow and value today very difficult for buyers and lenders.
Northstar’s focus on intensive credit risk management and aggressive liquidity management early on in this recession has continued to serve us well. Our overall liquidity grew by $62 million from the first quarter to $253 million at June 30, despite the slant decline $16 million of equity capital during the second quarter, $9 million was reused to purchase $22 million of our convertible notes through 2012, and $7 million was used to fund prior period long commitment. Loan repayments totaled $40 million for the second quarter.
During the second quarter, we further enhanced our liquidity by significantly reducing future non-discretionary capital made. We’re able to eliminate $116 million of funding commitments relating to loans we originated in prior period, of which is $80 million would have been funded over time with unrestricted cash. We now expect that these commitments would require approximately $27 million of unrestricted cash, which would be funded through the end of 2010, assuming all of these commitments qualify for funding.
We also began to make progress in generating additional liquidity by aggressively pursuing loan monetization opportunities, even if the transaction results in an accounting loss. In the second quarter, we took a $23.7 million payoff of a $27.4 million loan, 32 months in advance of its final maturity. The discount resulted in a $3.7 million accounting loss, with the economic value of the cash is much higher than the 5% yield that it’s been generating.
Furthermore, by acquiring $194 million of our own issue debt for $85 million over the past 18 months, we have created a $109 million capital accretion for book credit losses, such as discounted payoff.
On the credit front, we’re continuing to proactively stay ahead of issues before they become problems. We had no new non-performing loans since our first quarter earnings call and our second quarter credit loss provision was not materially different than last quarter. While we are pleased with these results, credit management will be a continuing challenge as economic conditions worsen.
At last quarter’s conference call, we reviewed our efforts towards accessing new capital and fee revenues for Northstar in the non-listed REIT market. In the first quarter, we filed an F-11 with the SEC for a new REIT that will be externally advised and managed by Northstar called Northstar Real Estate Income Trust. That REIT still is in the registration process.
The new REIT investment objectives will be initially be focused on lower leverage commercial real estate finance assets and equity investments. And we expect that its cost-to-capital will be significantly lower than Northstar’s is today. We are targeting receiving all the necessary federal and state approvals, and commencing capital raising by the end of this year at the earliest.
We think the timing of the private REIT capital raising will be complimentary to the availability of exceptional investment opportunities that we have been expecting since last year. While the volume of transactions to date has been much lower than most would have expected, the pressure is building, especially if capital markets remain close and we get closer to the wave of approximately $800 billion of commercial mortgage loans maturing over the next two and a half years.
Our real estate investment platform, which has principles who invested in and manage commercial real estate assets through the early ‘90s RTC period, is well positioned to capitalize on these opportunities.
Last week, we declared our third quarterly cash dividend in 2009. And I believe we remain the only company in our competitive set that has consistently delivered a regular quarterly cash dividend through this cycle. Our management team collectively owns over 10% of the Northstar’s common equity, and we will continue to work in our shareholders’ interests to maximize the long term value of the company through these difficult times.
We believe we have built a strong franchise, with the balance sheet and liquidity to withstand the continuing challenges posed by this environment. We also think our platform has the intellectual capital and infrastructure to take advantage of the unique opportunities provided by these conditions.
Now I’d like to turn the call over to Andy who will review our results for the second quarter. Andy?
Thanks, David. I’ll briefly review the second quarter financial highlights and then go into more detail in credit, liquidity, and our balance sheet.
The second quarter, our GAAP net loss, inclusive of a FAS 159 adjustment, was $4.3 million, or $0.06 per share. AFFO for the second quarter was $19.5 million, or $0.26 per share. We invested approximately $16 million of equity capital during the second quarter, and received approximately $40 million of gross loan repayments.
Net investment or net interest income, which is interest, rental, and advisory fee revenues less interest expense, lost interest expense, property operating costs, and asset management fees, was $26.3 million, an approximately $3 million decrease from $29.2 million in the first quarter. The decrease was primarily related to a $3 million reclassification between rental income and equity and earnings related to converting some of our leases in our healthcare net lease portfolio into a structure that should enable us to participate in improvements in the underlying operations of the facility.
Prepayment penalties and other income totaled about $200,000 from the second quarter, which is flat with the first quarter. General and administrative expenses, excluding non-cash, stock based compensation, totaled approximately $11.7 million for the second quarter. Salaries and other comp was approximately $5.0 million dollars, down $600,000 from the first quarter, and down 17% on an annualized basis compared to 2,000 in the actual cost.
For the second quarter, Northstar’s book value was consistent with the prior quarter, due to relatively minimal net mark-to-market adjustments. Overall, our GAAP book value as of June 30th, was $17.74 per share. The earnings release contains a detailed reconciliation between our first quarter and second quarter 2009 book value. If all mark-to-market adjustments and accumulated depreciation were excluded, book value would be $7.89 per share at June 30th.
This quarter, our best investment opportunity continues to be opportunistic acquisitions of Northstar’s senior recourse debt securities at significant discounts to par. During the second quarter, we purchased $22 million (inaudible) of our convertible notes at an average 56% discount to par, resulting in $12 million of extinguishment gains, net of accelerated, deferred financing expenses.
As we have done in prior quarters, we have acquired our debt as we’ve seen attractive offers in the market. From the beginning of 2008 through June 30th, we have retired an aggregate $194 million of Northstar’s issued debt, at an aggregate $109 million discount to it’s face amount. These repurchase gains have created a large capital cushion for credit losses, while decreasing leverage and reducing maturity risk. This type of activity is a good example of how conservative liquidity management can directly benefit our common share holders.
During the second quarter, we also funded $28 million of commitment for under existing loans, representing approximately $7 million of equity capital. We sold securities for $49 million of cash and reinvested the cash in new securities investments. We made no new net lease or joint venture investments during the second quarter.
At June 30th, we had $2 billion of commercial real estate loans, consisting of 108 separate loans. Many of these loans were structure, with commitments by Northstar to provide additional debt proceeds if certain value enhancement hurdles were achieved by the borrowers. These commitments represent our only significant, non-discretionary funding obligations within Northstar.
If a loan is financed in one of our non-recourse CDO financing, the CDO provides all of the capital needed, with no further obligation for Northstar. For those loans held outside of the CDO, but which are financed with bank debt, Northstar’s generally only obligated to fund its proportional share of the un-leveraged portion of the loan. For example, if the lender provides 70% financing for a loan, then the lender will fund $0.70 of every dollar of future funding dollars, and Northstar must fund the remaining $0.30.
During the second quarter of 2009, Northstar made significant progress in reducing its overall future funding commitments, resulting in greatly reduced potential future cash needs. We eliminated $116 million of future funding obligations, of which approximately $80 million were expected to be funded from Northstar’s unrestricted cash.
As of June 30th, we expect that the $27 million remaining equity portion or unrestricted cash needs of this funding will be $17 million for the remainder of ’09, and the remaining $10 million will be funded in 2010. Given that, we assume that each loan with a remaining funding commitment will qualify for that funding.
As expected, and consistent with overall real estate trends, underlying property level performance continues to weaken, principally due to extremely poor macroeconomic conditions. Because most of our loans are floating rates, (inaudible) LIBOR has partially offset the negative impact, declining cash flows have on debt service coverage.
The loans which do not currently have positive debt service coverage, we have approximately 14 months of debt service remaining, on a weighted average basis, based on current LIBOR rates. Funded reserves underlying our loans totaled approximately $79 million as of June 30th.
Also, approximately 79% of our portfolio loan balance is directly originated. Because we focused on originating loans directly with borrowers rather than participating in many of the Wall Street structured and widely syndicated financing, we typically have more control over our loans, and can negotiate directly with our borrowers when issues arise. Also, approximately 40% of our loans have some sort of recourse obligation to the sponsors, such as debt service reserve replenishment. And our experience continues to be, that the ability to go after recourse guarantee provides significant leverage in negotiations with borrowers.
We discussed our more aggressive approach to generating liquidity from loan sales or payoffs, even if the transaction generates an accounting charge. Debt capital for refinancing properties is extremely scarce. And at the beginning of the second quarter, we had just $55 million of final maturities for the rest of 2009, exclusive of our non-performing loans.
Nevertheless, we received $40 million of repayment proceeds in the second quarter, of which $24 million came from a loan payoff 32 months in advance of its final maturity and at a $4 million discount to our carrying value. Along with the first mortgage planned asset, which potentially could be difficult to re-finance and had a current interest rate of approximately 5%, but we determined that the economic benefit from taking a slightly discounted payoff well in advance of its maturity was attractive.
Going forward, we expect to continue to pursue the strategy where we believe the transaction makes economic sense, event though we will take an accounting charge. Our discounted purchases of Northstar debt have created a book value cushion that allows us to exploit these liquidity opportunities without adversely impacting our original common book value.
During the second quarter, we sold three loans totaling $39 million at par to a buyer with experience in owning and operating the types of multi-family collateral properties underlying the sold loans. As part of this sale, we financed the buyer’s acquisition of these loans and the buyer provided additional credit support by cross-collateralizing the deal with a portion of it’s equity in another property. They liked the strategy of selling weaker loans to experienced owners of like-kind collateral properties in return for additional credit enhancement to our bases. The buyer can aggressively work the properties that foreclose and enhance value, or pursue other strategies to enhance value which may be unavailable to us due to our structure or resource priority.
During the second quarter, we added $17 million of new credit loss reserves relating to eight loans, bringing our total loan credit loss reserves to $50 million as of June 30th. We have four non-performing loans at June 30th, totaling $73 million, all of which have unresolved maturity default. Three of the loans totaling $64 million represent two first-mortgages, and one is a first mortgage participation. And the remaining loan is a $9 million mezzanine loan that was fully reserved for as of the end of the first quarter. All of these loans have partially developed their (inaudible) land for underlying collateral type.
We more fully described each of these loans in our first quarter conference call in 10-Q and did not have additional non-performers since that time. As of June 30th, we have reserves totaling $24.4 million for these four assets and are actively working to maximize recovery of our capital in each of these loans.
As we expected, our $3.2 billion managed securities portfolio continues to suffer ratings downgrade, with downgrade actions impacting approximately $300 million of our securities in the second quarter. They had no upgrades this quarter. Such downgrades may not necessarily be indicative of the current performance of the security.
Weighted average credit rating of our managed securities portfolio remained double-B plus, as of June 30th. Approximately $800 million of our managed securities are consolidated, and $2.4 billion are accounted for in off balance sheet financing. Many are seasoned with 73% of the REIT CMBS portfolio issued in 2005 or prior years.
As the continued negative ratings actions across the CMBS sector, all of our managed CMBS securities are current and paying according to our contractual terms. Virtually all of our securities will finance the maturity and CDO term financings were held un-leveraged. So we only not have the intent, but also the ability to hold these assets to maturity.
During the second quarter, there were no significant changes to our net lease portfolio. We have approximately $1.2 billion of real estate assets based on un-depreciated book values that are subject to long term net leases with the weight average remaining term of 8.3 years as of June 30th. Of the $1.2 billion, $753 million represent healthcare related assets. The remaining $483 million of assets, exclusive of the Chatsworth California properties formerly leased from WaMu, our office, industrial, and retail net lease property. We are working with the first mortgage special servicer to complete the transfer of the WaMu assets during the third quarter.
Our carrying value is approximately equal to the first mortgage debt balance, so expect no material impact on our financial statements from the transfer. For details on these facilities, including related non-recourse debt financing, please see the tables in the back of this quarter’s earnings release.
Turning to the right side of the balance sheet, we intend to fully repay the $12 million outstanding balance on the secure credit facility with J.P. Morgan, when it matures next month. The facility has a one-year extension at lender’s option and J.P. Morgan was not interested in extending the facility at terms attractive to us.
We also have an approximately $380 million loan from Wells Fargo, having an initial maturity in November this year, which is extendable for one year at our option. Under the terms of this debt, the lender may require amortization payments based on the trail of declines in the credit quality of the underlying loan collateral pledged to the line. Future declines in credit quality may result in Northstar having to amortize a portion of the line in advance of its maturity though we currently cannot predict the amount, if any, and timing of amortization that may be demanded by the lender.
At June 30th, we were in compliance with the financial covenants in our debt facilities. And our CDO financings were in compliance with the related interest in collateral coverage tests. The table contained in the supplemental information section of the earnings release shows the data to the CDO coverage tests. If we were to fail any of these tests, cash flow from the respective financing will be temporarily diverted from Northstar to repay senior debt until the failed test is back in compliance.
Credit ratings downgrades to the CMBS collateral backing our security CDOs can negatively impact over-collateralization tests, if the downgrades reach certain levels; even if the security is fully performing. Typically, a CDO can have a maximum amount of triple-C rated securities before over-collateralization deteriorates.
This quarter, the CMBS market continue to experience ratings downgrade actions as the ratings agency adjusted their ratings models to incorporate more secure -- more severe economic and underlying asset performance assumptions. Notwithstanding these actions, our security CDOs continue to comply with our coverage test, largely because investment opportunities have allowed us to invest in this kind of security that resulted in increased over-collateralization cushions.
This strategy has proven effective to-date. However, S&P recently put virtually every CMBS issue rated by them on negative ratings watch. Even super senior, triple-A securities, which many industry professionals believe have virtually no risk of principle loss, appeared to be candidate for downgrade. We expect these rating actions to be taken over the next three to six months. At this time, we cannot predict whether these future downgrades will cause us to not comply with our over-collateralization text in our security CDOs.
CDOs I and II currently have no reinvestment remaining, so their coverage tests are more susceptible to ratings downgrade and default because we cannot sell securities with ratings issues and purchase higher quality securities with the proceeds. By the quarter end at June 30, we received just $396,000 of cash distributions from CDOs I and II. In our loan CDOs, actual loan defaults negatively impact those stakes. The agencies may also downgrade our issued CDO notes. But such downgrades would have no liquidity impact on Northstar.
Consolidated assets total $3.8 million at June 30th, the same as March 31st, due to relatively minimal net mark-to-market adjustment during the second quarter. Northstar also had approximately $263 million of total liquidity at June 30th, comprised of $106 million of unrestricted cash and $157 million of un-invested cash in our CDO term financing, an increase of $62 million from March 31st.
This concludes our prepared remarks today. Now let’s open up the call for questions. Operator?
Thank you, sir. We will now begin the question-and-answer session. (Operator instructions) Our first question comes from the line of James Shanahan with Wells Fargo. Please go ahead.
James Shanahan - Wells Fargo
Thank you. Good morning, gentlemen, a question for you please about the net rental income. Obviously, below our estimates, but are you suggesting here, Andy, that the line item equity and earnings loss of unconsolidated ventures that was only -- that was a actually modest positive earnings of 159, but sequentially very significant improvement from the linked quarter. Is that where some of those earnings are now flowing?
Hey, Jim. Yes, there is about $3 million of income from the healthcare portfolio that is now classified in equity and earnings. And if you wanted to look at it on an apples-to-apples basis, you would include that in rental income in the revenue line. And the reason for that is, there is a portfolio that we actually became an affiliate of the venture; became the lessee during the quarter. And we’re permitted to do that under the new REIT legislation that came out last year. And we’re basically -- the lessor of those -- the lessee of those properties, is a non-consolidated affiliate of the venture. So we’re picking up the “net income”, if you will from leasing that to ourselves, and having a third party operate it through equity and earnings.
James Shanahan - Wells Fargo
Okay. And relating it to credit, the credit performance here, especially given the rapid deterioration among some of your peers, it just continues to surprise and it almost makes -- begs the question, it is not as good as it appears? And I’m just wondering how would you respond to the criticism? Not suggesting this, but how would you respond to the criticism that your reporting of credit metrics isn’t as aggressive as that some of your peers? How would you respond to that?
Yes, Jim. I think there are two points that I would make. I think first, you have to look at the allocation of the portfolio amongst various asset classes.
James Shanahan - Wells Fargo
And I think if you look at where the major non-performers are, it’s in land and condo construction. To put it into the perspective, we didn’t have a lot of that exposure. Our land exposure today is 2.5% of assets under management, and our condo exposure is 2.5% of assets under management. Only 5% of the portfolio is in those asset categories. And if you look at our non-performers, all four non-performing loans are land loans. I think a lot of it had to do with focusing on cash flowing assets, as opposed to non-cash flowing assets.
And then I think the second thing that we continue to talk about is that we spend a lot of time and money building on infrastructures so that we can originate our products as opposed to buying from the street. And the fact that 40% of our loans have guarantees and we have a lot of reserves built up because we structure these loans and knew we were going to holding them toward maturity, basically is one of the primary drivers for why our credit performance is better than the credit performance of people who just (inaudible) product from the street.
James Shanahan - Wells Fargo
Okay. And they realize it’s in registration and it is -- and they guess it’s going to be a private transaction. But what can you tell us about the economics of this private REIT and will -- who will -- for example, the public company be a 100% owner of the external manager and benefit from all of those stakes and incentive management fees, if any?
Yes. The way -- in terms of the fees, there area various asset management acquisition and incentive fees associating with managing that entity. And as currently structured, the -- those deeds will flow into Northstar and the shareholders will benefit from those deeds.
James Shanahan -Wells Fargo
Is management, say, some percentage owner of the external manager, and then are asked a majority owner?
That adviser entity hasn’t been structured at his point. As we said in terms of the timing of this, we’re still in the process of building the distribution team associated with this business. And a big component -- this is a long term proposition for us. It takes a while to get name recognition amongst the broker-dealer network.
So this is not something that’s going to happen overnight. Distribution is a key component of having a franchise here, and we’re at the early stages of the hiring people. Part of attracting the best people is potentially giving them a piece of the adviser. So I would think at some point that some percentage of that may have to be given to employees in order to attract some of the best distribution people. But at this point, we’re still at the early stage of that.
James Shanahan - Wells Fargo
Okay. And then one more question. There are probably others waiting and I don’t mean to be selfish. But I’m just curious what your view is on all of the recent filings, not only agency R&BS, REITs, hybrid REITs, REITs focused more on these credit sensitive assets. What is your view on all of that and do you -- how do you think that impacts your transactions?
Yes. I think our view on it is, the fact that there is all these people lining up to do it, suggests the magnitude of the opportunity and how great the investment opportunities there’s going over the next two or three years, which is -- we concur with. I think that we have looked at some of the teams that had been put in place and think that the infrastructure and intellectual capital and real estate debt investing experience that they have is not any where near the experience and platform that we built up here.
So to the extent that that capital can be raised, it bodes very well for us. I think the PennyMac transaction that just got done in the residential space was a difficult deal to get done, and it traded down. But it did get done. So I think we view it as a positive that at some point, new money is going to start coming into this space in order to take advantage of the opportunities. And as it does, we will be able to benefit and take advantage of those capital flows.
James Shanahan - Wells Fargo
Okay. Thank you very much.
Thank you. (Operator instructions) And at this time, I’d like to turn the call back over to management, please continue.
We have no further comments. Thanks to all the shareholders for continuing to support us, and we’ll talk to you next quarter.
Thank you. Ladies and gentlemen, that does conclude the Northstar Realty Finance second quarter conference call. If you’d like to listen to a replay of today’s conference, please dial 303-590-3030 or 1-800-406-7325 with the access code of 4117554#. We thank you for your participation. And at this time, you may now disconnect.
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