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Associated Estates Realty Corporation (NYSE:AEC)

Q2 2013 Results - Earnings Call Transcript

July 24, 2013 02:00 PM ET

Executives

Jeremy Goldberg - VP of Corporate Finance and IR

Jeff Friedman - President and CEO

Lou Fatica - Chief Financial Officer

John Shannon - SVP, Operations

John Hinkle - VP, Acquisitions

Jason Friedman - VP, Construction and Development

Patrick Duffy - VP, Strategic Marketing

Analysts

Alexander Goldfarb - Sandler O'Neill

Nick Joseph - Citigroup

David Toti - Cantor Fitzgerald

Jana Galan - Bank of America

Tayo Okusanya - Jefferies

Operator

Good afternoon, and welcome to the Associated Estates' second quarter 2013 earnings conference call. My name is Ginger and I will be the operator for your call today. At this time, all participant are in a listen-only mode. Following prepared remarks by the company we will conduct a question-and-answer session. (Operator Instructions)

Please note this event is being recorded. If you're experiencing call-in difficulties please visit associatedestates.com for additional instructions.

Now I would like to turn the call over to Jeremy Goldberg, Vice President of Corporate Finance and Investor Relations for opening remarks and introductions. Please go ahead.

Jeremy Goldberg

Thank you, Ginger. Good afternoon everyone and thank you for joining the Associated Estates' Second Quarter 2013 Conference Call. I'd like to remind everyone that our call today is being webcast and will be archived on the Associated Estates' website for 90 days. Prepared remarks will be presented by Jeff Friedman, our President and Chief Executive Officer; Lou Fatica, our Chief Financial Officer and John Shannon, our Senior Vice President of Operations. Additionally, other members of our management team are available for the Q&A.

Before we begin our prepared comments, we would like to note that certain statements made during this call including answer we give in response to your questions will be forward-looking statements that are based on the current expectations and beliefs of management. Each forward-looking statements are subject to certain risk and trends that could cause actual results to differ materially from projections. Further information about these risks and trends can be found in our filings with the SEC and we encouraged everyone to review them.

As a reminder, Associated Estates' second quarter earnings release and supplemental financial information are available in the Investor section of our website and they include reconciliations to FFO and other non-GAAP financial measures which will be discussed on this call.

At this time, I will turn the call over to Jeff.

Jeff Friedman

Thank you, Jeremy. Thanks everyone for listening to our call. We're having another strong year. We're on track to deliver 5% same community NOI growth. The GAAP between new leased rents and renewal rents is dissipating. New supply is being absorbed and at almost 97% physical occupancy, we're practically full. We have positive sequential revenue trends in all of our regions and in every submarket. Although we put up very solid portfolio wide numbers, our mid-Atlantic properties are performing below our expectations.

We were too optimistic about new lease rent growth in the mid-Atlantic. Lou and John will get into the details, but as we've outlined in our supplemental, we are lowering our same community NOI guidance for the year.

Our non-same community properties representing approximately 11% of our total NOI, are performing ahead of expectations. Therefore our revised full year FFO per share guidance is the result of the impact of the forward equity offering, we did in May. We remained disciplined and focused in our approach to acquisitions. We have a terrific development pipeline. We'll continue to sell properties and use the proceeds toward funding our growth.

Apartment fundamentals remain strong, household formation and propensity to rent are both increasing steadily. We see these positive trends continuing for quite some time.

I will now turn the call over to Lou.

Lou Fatica

Thank you, Jeff. For the second quarter FFO was $0.31 per share or one penny per share less than internal expectations as result of lower than projected same community revenue in NOI. Offsetting some of this (inaudible) was the outperformance of our non-same community portfolio.

Year-to-date same community revenues up 4.1% expenses are up 2.2% resulting in a 5.4% increase in NOI when comparing the first half of 2013 to the first half of 2012. Our expectations for the second half of the year reflect continuing moderation at our Mid-Atlantic portfolio, which results in second half portfolio wide same community revenue growth of 2.9% and second half NOI growth of 4.4%.

John will provide more details on our year-to-date performance and our expectations for the remainder of the year with his prepared remarks. Based on our forward equity issuance set to close on October 1, we have reduced the mid point of our 2013 FFO as adjusted guidance to $1.28 per share, a $0.03 per share decrease from our previous full year FFO as adjusted mid point.

The reduction in our same community guidance is primarily offset by a projected non-same community full year performance. Significant assumptions related to our revised full year guidance are as follows. Full year same community revenue up 3.5% at the mid point or 100 basis points lower than our previous guidance. Full year same community expense up 1.25% at the mid point or a 125 basis points lower than our previous guidance. Full year same community NOI up 5% at the midpoint or 75 basis points lower than our previous guidance.

Acquisition guidance of $93.5 million to $150 million with a low end of guidance reflecting our acquisition of Doral West. Property sales of $63.2 million to $150 million with a low end of guidance representing completed year-to-date dispositions. Development spend of $105 million to $115 million with year-to-date spend of $64.5 million. The increase in our development spend reflects the acquisition of the San Francisco land parcel in the second quarter.

Diluted weighted average shares outstanding of $51.1 million for Q3, $57.8 million for Q4 and $52.5 million for the full year. These numbers reflect the impact of our completed ATM activity and our forward equity offering.

As you will know from our increased disposition guidance, we are planning to sell more properties than we originally expected, as we would like to take advantage of the current strong demand for well located and well maintained apartment communities.

We are also seeing more deals in our targeted markets and to the extent we find additional acquisition opportunities, we would expect to match fund them with property sales. The extension of our line of credit through June 2017 and our plans to pay-off five properties specific loans on October 1 provides us with significant additional financial flexibility.

We will operate primarily as an unsecured borrower and maintain secured debt below 20% of un-depreciated book value. We are committed to maintaining a strong balance sheet. At this time, I'll turn the call over to John.

John Shannon

Thank you, Lou. As Lou pointed out, our year-to-date same community NOI was up 5.4% over 2012. For Q2, we finished the quarter at 96.6% physical occupancy with revenue up 3.9% over Q2, 2012 and NOI up 4.9%.

Sequentially, same community revenue was up 1.7% compared to Q1 2013 and physical occupancy was in line with Q1. Occupancy in all of our regions remains strong. For the first half of the year, revenue growth from our Midwest, Southeast and Southwest regions was up 4.6% in line with our internal expectations.

In the Mid-Atlantic, revenue growth for the first half of the year was 3.1% as compared to our internal forecast of 5%. Our same community revenue expectations for the second half of the year reflect revenue growth in our Mid-Atlantic portfolio to be flat to slightly up as compared to 3% growth in the first half of the year.

In the Midwest, we are projecting revenue growth in the second half of the year to be strong in the 4% range but 100 basis points less than we achieved in the first half. We expect continued solid performance from our Southeast portfolio with revenue growth of 3.25% and our Southwest properties with revenue growth of approximately 5%, both in line with the first half of the year. This results in second half portfolio wide same community revenue growth of approximately 2.9% at the midpoint. Portfolio wide for the second quarter same community new lease rents were up 3.7% and renewal rents were solid, up 4%.

July month to-date, same community new leases are up 3.1% and renewals are up 4.2%. Renewal letters for August and September were sent out with increases of 3% to 5% and available units are priced with increases of 2% to 4%. Regarding our 2012 acquisitions that are not part of our Q2 same community results, three properties in Raleigh-Durham and one property in the Medical District of Dallas, all performed well and collectively finished the quarter at 97% physical occupancy with NOI 6.5% higher than our acquisition underwrite.

Turning to development, we are approximately 80% complete with the expansion of our San Raphael property in Dallas and we remain on schedule to deliver the first unit in new amenity areas this quarter. We're under construction in Bethesda and at Turtle Creek in Dallas and site work has begun at the Desmond and Wilshire in LA. As announced in late May, we are expanding our presence in California by developing two land parcels in desirable high growth submarket.

In Southern California, we entered into a 50-50 joint venture agreement with respect to the 5.6 acre site known as 950 Third which is adjacent to the Southern California Institute of Architecture in the Arts District of downtown LA. We plan to build 472 apartments with ground floor retail and underground parking. In San Francisco, we acquired a 3.4 acre site located in the South of Market or SoMa neighborhood. We plan to build a 408 unit apartment community that will include ground floor retail and underground parking.

Our intent is to develop the SoMa project in a joint venture as well. Construction of both apartment communities is expected to begin in the first half of 2014. We just closed on our first acquisition in almost a year by acquiring Doral West in Doral, Florida.

The property was built in 1998 and contains 388 units in two and three story garden style walk-up buildings with concrete walls and floors and cement décor exterior and barrel tile roofs. The property is adjacent to the Florida Turnpike and is in close proximity to 11 million square feet of office space and 72 million square feet of industrial space.

The property also offers easy access to downtown Miami and the Miami International airport. The former owners of Doral West were in the process of upgrading the interiors. We will complete the renovation of the remaining 252 units, and in addition, we will upgrade the entire property including the community areas, landscaping and building exteriors.

The acquisition price represents a 5.1% nominal cap rate which excludes the benefit of the expected increased rent from the renovations as well as the cost. This is a 4.7% economic cap rate assuming $450 per unit in CapEx and a 3% management fee. With regard to dispositions, we have been marketing two non-core properties in Columbus, Ohio. Response to the offerings has been exceptional and we plan on going to contracts on both assets shortly with closing expected by the end of the third quarter.

I want to thank all of our employees for another good quarter. We are on track to deliver 5% same community NOI. We expect occupancy to remain high and the fundamentals underpinning apartment demand remain very positive.

I will now turn the call back to Jeff.

Jeff Friedman

Thanks John, Lou. Ginger, why don't we open up the call for questions?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from the line of Alexander Goldfarb from Sandler O'Neill.

Alexander Goldfarb - Sandler O'Neill

Just a few quick questions here. First off on the guidance, can you just provide a little more color, I mean the trends first quarter to second quarter looked good, but the drop is just precipitated.

Would you say this is something that you would say is unique to you guys and just thinking how to NAREIT some of your peers in the Washington area, they spoke about may be with product next to Pentagon or may be a submarket which had some recent new supply. But your commentary suggests the bigger slowdown than what some of the other, what some of your peers were suggesting at NAREIT. So can you just provide a little more color as to what you think is going on here?

Jeff Friedman

Hi Alex, this is Jeff, before I get or ask John or Patrick to provide some more details. First, we have our plate full talking about our business. So we are really not going to talk about our or the other companies with exposure in similar markets. At NAREIT, we did speak to the 0% to 2% flat to 2% increases we were seeing from new leases and we talked about the moderation that we saw on the new leases that we're re-entering into particularly in the Mid-Atlantic portfolio.

And so, this is not a surprise to us. We talked about this with just about everybody we sat with at NAREIT and as part of the follow-on in terms of what we saw was a moderation. John, Patrick you want to add anything to that?

John Shannon

Sure. In the DC Metro area, we operate in four submarkets, Eastern Loudoun County; Vienna, Virginia; Woodbridge and Silver Spring. In three of these four markets, we are seeing new supply and it's this new supply that is making difficult for us to increase rents on new leases. In the first half of the year, in Metro DC and Northern Virginia, we generated approximately 4% revenue growth. In the second half, we're not seeing revenue growth because several new properties will open in the second half in our Metro DC and Northern Virginia markets.

Alexander Goldfarb - Sandler O'Neill

Okay. And then can you just comment the reduction in expenses just and presumably people are dialing back real estate taxes or getting cheaper on insurance, so how did that, I understand on the revenue side but how did expenses cut back as well?

John Shannon

Alex, John Shannon. First let me start by saying our properties are very well maintained. The lowering of the guidance range is due to a few factor, one being the reduction of accruals and projections for incentive compensation plans as well already realized savings in repairs and maintenance line items such as snow earlier in the year, savings on our extraordinary projects. We've had a few insurance reimbursements for losses from last year. And on the insurance side, we have been very fortunate, I should not (inaudible). We have not had any new claims this year which we do budget for, so we will see savings in that line as well.

Alexander Goldfarb - Sandler O'Neill

Okay. And just finally just wrapping this up, I mean you guys did an equity raise right before NAREIT, obviously you knew that the revenues were coming in line. Just curious why you didn't update guidance at that point, I mean the number of folks when they issue equity will come out right afterwards and update guidance to reflect an equity offering. It seemed like there were three material events that you would have known the guidance was coming down. Just curious why you didn't update the street then, why wait till now?

Lou Fatica

This is Lou. I mean, I think, it's a couple of things here. In terms of guidance, as we look at the FFO impact, you know that's really a function of the equity raise. And so although some of the pieces that compile the FFO, the change will, when we look at, it was looking at total FFO and the impact of the equity offering which was a $0.03 that we did talk about that being the impact.

In terms of the specific revenue guidance, we wanted to get through the peak leasing season in the mid-Atlantic in terms of, although leases and new leases were flat to up 2%. We thought there maybe some opportunity to see some pick up which we haven't seen and as we fast forward an additional two months and see that color and project kind of basically flat to slightly up in the mid-Atlantic, I mean really that's what drove the full year guidance reduction on the revenue front.

Operator

The next question is from Nick Joseph from Citigroup.

Nick Joseph - Citigroup

Thanks. What's the additional capital costs that are remaining renovations and upgrades for Doral West?

John Hinkle

This is John Hinkle. We plan to spend on the interiors alone for the remaining units. We will spend about $10,000 a unit. And then on top of that, we will spend another $2.5 million on exteriors and common areas.

Nick Joseph - Citigroup

And then, so you now have the three California development projects, two in Southern California and one in Northern. Looking out a few years, what percentage of your overall portfolio would you like to see in those two markets?

John Hinkle

Would you repeat that question please?

Nick Joseph - Citigroup

Sure. So you have the two developments in Southern California and one in Northern California. So just looking out a few years, what kind of allocation would you like in those two markets in terms of your overall portfolio?

John Hinkle

As part of our strategic objectives, Nick, our plan is to have to build a portfolio that represents about 20% of our overall exposure. 20% of our total assets we'd like to had in coastal markets and Southern California and in San Francisco.

Michael Bilerman - Citigroup

Jeff, it's Michael Bilerman speaking. Just coming back to the equity raise, I guess in addition to really not updating these reasons in terms of your views, in terms of the fundamental, you are opposite the deal on a forward basis to take our debt later on the year rather than doing it on a current basis. One could argue that knowing the fundamentals of where they were going to go, not really needing approaches at that point, you sort of took advantage of what you perceived to be few valuations at the time. So I guess how do you reconcile that?

Jeff Friedman

I really didn't hear the question, Mike.

Michael Bilerman - Citigroup

You raised equity on a forward basis rather than doing a spot deal for proceeds to be used to pay down debt. That was coming due later in the year, right. It was a little bit odd, I would say to at least to do that. And then taking to the fact that your fundamentals are weaker than expected and you sort of have anything of that in late May clearly the street, and your stock is underperforming and is down a lot. We should have put those together, then once we can be very skeptical of how things have transpired. Is that clear?

Jeff Friedman

Well, I really didn't hear a question, I hear you commenting and making a statement, but I really, I don't mean deceive your argument as if I didn't hear you ask us a question.

Michael Bilerman - Citigroup

Let me try to ask another question. When you raise equity, you raise it at a substantial discount to NAV. Will you perceive NAV to be to say back debt, why do that?

Jeff Friedman

Well, Mike we've had these discussions a number of times. As part of our growth we've indicated, we are going to grow in a way that doesn't stress the balance sheet for us. That means that $0.60 of every dollar depending on when we are in that cycle that we spend, we need to fund with equity and 40% in debt. As a result of the forward equity that we sold to pay off debt with a 6.1 plus coupon that positions us from a balance sheet standpoint to fund our development spend for the balance of 2013, our development spend for 2014 and to do so in a way that keeps the balance sheet strong without the need to issue any additional equity.

We thought that using the proceeds from the sale of equity to pay off that high coupon project specific debt and then take those five properties and add them to our incumbent pool, enhanced our financial flexibility in a very significant way. We recognized that at the price we sold it at that it was a discount to our NAV. When we made the decision to go forward, we were trading at a 15 year half. There was some deterioration in price following our decision to proceed and we continue to believe that that equity offering is in the best interest of the company on a going forward basis.

Michael Bilerman - Citigroup

It doesn't, the implied value from a cap rate perspective of where your portfolio is trading in the public markets and how it's performing give you some pause that perhaps the market is saying we don't want you to be issuing equity to fund high price acquisitions or enter into development into markets that you are not have experience in. So, it isn't that, and don't you set back at some point and say well maybe we're not, maybe our capital deployment is really not what the market wants irrespective of whether your stock is in a 15 year high, do you understand where trades relatives to the peers, maybe the market is telling you something?

Jeff Friedman

Michael you and I have had this discussion since we did our first follow-on offering in many years at $11.10 and if we just roll back the clock to that discussion, your comments were the same as in the $11 stock price. If we look at our performance over a long period of time whether it be in terms of our asset allocation, the properties we've bought and sold, how we've transformed the portfolio terms of age and quality and rents and we believe that the market has as a result of the outperformance of our stock and the total shareholder returns, we generated over both the five and the ten year period, that we have outperformed. And so we look at the decisions we make on a long term basis remaining very sensitive any time we sell stock, issue equity.

Michael Bilerman - Citigroup

Okay.

Jeff Friedman

Thanks for joining -- for being on the call today.

Operator

Your next question is from David Toti from Cantor Fitzgerald.

David Toti - Cantor Fitzgerald

Good afternoon, guys. Quick question relative to your development pipeline and some of the increased investment allocation that you have identified in your updated guidance, how are you thinking about risk mitigation on many of this forward spend as it applies to a higher cost of capital. Obviously, two you mentions but one is a lower stock price and the other is a rising, potentially a rising cost of capital on the debt side. So as you are increasing and spending how are you thinking about mitigating the risk and protecting your margins in that context?

Lou Fatica

David, this is Lou. I mean part of that is the strategy in terms of partnering up with joint venture partners is part of the funding strategy and risk mitigation involved with the two recently announced deals.

David Toti - Cantor Fitzgerald

Well, I mean I understand joint venture partners mitigating risks in terms of spreading the overall risk but when you think about your cost of capital on a forward basis and you essentially locked in stabilized yields on much of the spend to some extent, how are you thinking about that potential spread compression and how do you protect the company against that margin compression?

Lou Fatica

Well, there's a couple of things I mean in terms of our overall weighted average cost of debt we would expect the debt to continue to go down as we repay some of that higher coupon debt and either fund that through additional unsecured bond issuances that are still priced in the kind of 4.5% range or utilizing our line of credit where we've lowered the spread on that to 130 basis points based on our current ratings. And I think from an overall cost of capital standpoint and we don't view our cost of capital increasing in the near term and certainly throughout this development period as you look at whether its forward [LIBOR] curves or other metrics that someone may look at or other points that people may look at in terms of where debt levels are projected to go to.

Jeff Friedman

David this is Jeff, also I want to emphasize that we will increase dispositions, number of our properties will obtain pricing with four for sure maybe, low five, maybe even into the three handles on the cap rates and so our expectation is that we will fund some of that growth, some of that development spend, some of the additional acquisitions with proceeds from dispositions.

David Toti - Cantor Fitzgerald

Okay, that's helpful and I just have one small question and maybe I missed this earlier, when you were talking about Metro DC in Maryland, did you comment on move outs to home purchases is that all, has there been any change in that dynamic as well obviously some of the issues around supply but did you see a change in that as well?

John Shannon

David, John Shannon, now in the mid-Atlantic, this past quarter, 17.8% of our move outs were attributed to buying a home. That compares to 17% last year, Q2 and just over 16% Q1 of this year. So I would say not a material difference in the reason.

David Toti - Cantor Fitzgerald

Okay. Thanks for the details guys.

John Shannon

Thanks.

Operator

Your next question is from Jana Galan from Bank of America.

Jana Galan - Bank of America

Thank you, good afternoon. I'm sorry if I missed this John, but did you provide new leasing renewal rates for June and what you're seeing in July?

John Shannon

For the Q2 are all in, new deals were at 3.7% and our renewals were at 4% and our July month-to-date were at 2.8% portfolio wide on new deals and our renewals are coming in around 4.3%.

Jana Galan - Bank of America

Thank you and just one up on the last question with move outs to home purchase, is there comments on changes in turnover and reasons for move outs?

John Shannon

Reasons for move out it's been pretty consistent over the last several quarters for us buying a home is the number one reason for people moving out, relocating out of the area is in the 13% range, whereas buying home was in the 19% range as a portfolio. And then hovering around 10% is the reason being is rent too high pushing rents out there in the field.

Jana Galan - Bank of America

And looking at our revised guidance is there any change in occupancy expectations?

John Shannon

No, I think as Patrick said that the important thing is here is Mid-Atlantic as well as the entire portfolio we have been full and we anticipate again very full out in all of our regions in the 95.5% to 96% range.

Jana Galan - Bank of America

And then just on what you are seeing in the Mid-Atlantic, does that change anyway that you're thinking about yields for your Bethesda development?

John Shannon

I don't think it really changes our yields on the Bethesda deals, it's a smaller property, it's a pretty much insulated from competition being in downtown Bethesda. So we are still comfortable with our original yields and we anticipate that rents in downtown Bethesda will creep up overtime.

Patrick Duffy

And our project in Bethesda is extremely well located; well within walking distance to a metro stop. We're right next to the Greenway. It's one of the best locations in Bethesda. So I am confident that we are going to be able to achieve the revenue growth that we've underwritten.

Jeff Friedman

This is Jeff, Jana, in Bethesda particularly, we're looking at the midpoint about a fixed return on cost and we're talking about $3 a square foot rent. I think the rents today Patrick are significantly higher than the $3 rents. And so, again these are untrended and this investment decision was made at the underwrite and fortunately we have to wind it at our backs that there has been significant growth. Anything you want to add on that?

Patrick Duffy

Jeff, you are right. The average rent in 2013 for our Bethesda project is approximately $2,400 or $3 a square root. And there are a number of nearby properties that are older that are achieving a higher rent than what we have underwritten.

Jana Galan - Bank of America

Thank you.

Operator

(Operator Instructions) Your next question is from Tayo from Jefferies.

Tayo Okusanya - Jefferies

Just a couple of questions on external growth. First of all, the Doral property, how much did you pay for that asset and on what cap rates?

John Hinkle

This is John Hinkle again. Let me first correct the number I gave earlier on the renovation. We plan to spend $10,000 per unit on the interior plus another 1.3 on exterior and common areas for all in of about $3.8 million. To your question the purchase price was $93.5 million which is about 241 a door and the nominal cap rate as John reported earlier was at 5.1, economic 4.7, that is before the renovation that we have planned. Using very conservative underwriting, we projected only 15% rent growth in the market rate over the next five years. And by way of comparison, when we bought the Wellington deal two years ago, we're looking at five year rent growth in the low 20% range. So we've been very conservative both on what we expect from the renovations as well as what we expect in the market.

Tayo Okusanya - Jefferies & Company

Okay, that is helpful. And then just moving over to California a real quick with the 950 Third as well as 8th and Harrison, for each of those individual projects could you also kind of talk about how much you expect to spend developing those assets and what do you think the stabilized yields will be?

Jason Friedman

Tayo, this is Jason. On 950 Third we expect to have our total development cost around $143 million which is on a per unit basis comes out to about 300,000 per unit. Those untrended return on cost are expected to be between 5.5% and 6%. And now San Francisco on our 8th and Harrison deal we will have estimated cost of about $230 million or 550,000 per door and those return on cost untrended are expected to be between 5.5% and 6%.

Tayo Okusanya - Jefferies & Company

Okay, that is helpful. The increasing guidance on dispositions, I know you talked about two properties in Ohio going for sale, I mean just kind of giving where fundamentals are going in the mid-Atlantic region, could we potentially see more asset sales in that market?

Patrick Duffy

Tayo, this is Patrick. We do plan to sell some additional properties and we've identified a couple of properties that are in sub-markets where there's extremely high demand for products and we think we will do well with those sales, but I don't believe any of them are in the mid-Atlantic, that was Tayo's question. We haven't targeted anything in the mid-Atlantic Tayo to sell at this time.

Tayo Okusanya - Jefferies & Company

Okay. And then the potential of higher sales, what kind of cap rates do we see on those?

Jeff Friedman

This is Jeff, Tayo. I don't believe, I think the two properties we are currently marketing that John referred to are the last of the properties that we have any plans to sell. The properties that we would be selling are in the other markets in the hotter faster growing markets, lower cap rate markets where we will take advantage of some of the very attractive pricing right now.

Operator

There are no further questions in queue. Jeff, do you have any closing remarks?

Jeff Friedman

No, thanks very much. I want to thank everyone for joining us today. That will conclude our call.

Operator

Ladies and gentlemen, this does conclude today's conference call. Thank you for participating. At this time you may now disconnect.

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