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Lufkin Industries, Inc. (NASDAQ:LUFK)

Q3 2009 Earnings Call

October 14, 2009 10:00 am ET

Executives

Jack Lascar – Dennard Rupp Gray & Easterly LLC

John Glick – Chief Executive Officer

Christopher Boone – Vice President, Chief Financial Officer

Analysts

[William Eagen – Raymond James]

Jeff Tillery – Tudor Pickering & Co.

[Neil Dingman – Wanderlake Securities]

Terese Fabian – Sidoti & Company

Operator

Welcome to the Lufkin Industries third quarter earnings conference call. (Operator Instructions) I’ll now turn the conference over to Mr. Jack Lascar of DRG&E.

Jack Lascar

Good morning everyone. A quick apology for being a few minutes late. We had some technical problems being re-connected. With me today are Jay Glick, Lufkin’s President and CEO, Chris Boon, Vice President and Chief Financial Officer and Angela McCarty, Corporate Controller.

Before I turn the call over to Jay, I have a couple of housekeeping items. If you would like to be on our email distribution list for future news releases, please call us at 713-529-6600. If you’d like to listen to a replay of today’s call, it will be available via webcast by going to the investor relations section of Lufkin’s website at www.lufkin.com or via recorded replay until October 21.

This information was also provided in this morning’s new release.

Information reported on this call speaks only as of today, October 14, 2009, so please be aware that any time sensitive information may no longer be accurate as of the time of any replay.

Also be aware that today’s conference call may contain certain forward-looking statements. The assumptions that these forward-looking statements are based on, are beyond the company’s ability to control or estimate precisely and in some cases they may be subject to rapid and material changes. Actual results may differ materially. With that, I’ll turn the call over to Jay.

John Glick

Thank you Jack. Good morning everyone and thank you for being with us. We continue to face a challenging market environment. There remains significant uncertainty today about the timing and the pace of improvement in demand for our products and services. This was evident in our third quarter results.

At the same time, we are encouraged by recent increases in demand projections for oil and gas that suggest an improving outlook for industry fundamentals which should support more robust activity in the second half of 2010. All of this assumes that the global economy continues to slowly expand out of the recession in which it’s been mired.

This morning we announced earnings from continuing operations of $5 million or $0.34 a share. That compares with earnings of almost $25 million or $1.65 a share in the third quarter of last year when we enjoyed record levels of business in both divisions, but especially in the Oil Field division.

For the combined company, new order bookings in the third quarter were $89.2 million which was up more than 14% from the second quarter, but down about 70% from a year ago. Keep in mind that the $300 million in new business booked in the third quarter of last year made Q3 2008 a record quarter and reflected an unusual level of demand fueled by a shortage mentality in which customers ordered early to book capacity.

At the same time, our total company backlog as of September 30, 2009 declined to $133.8 million from $413.9 million a year ago and from $162.3 million at the end of the second quarter of this year. I would again note that the $413 million back log of one year ago was unusually large as we pointed out at the time.

While Q3 2009 proved to be a difficult quarter, it was no more difficult than we had anticipated. Looking ahead to the fourth quarter, our opinion is that the market will continue to present challenges as customers evaluate capital projects very cautiously. Buy sensitivity will continue as budgets remain under pressure.

However, there are positive signs of gradual returns to activity. Oil prices appear to have stabilized or recently even increased. The slow but steady increase in land drilling rig count, particularly the increase in the number of rigs drilling for oil may signal a higher level of confidence in demand fundamentals.

If this trend continues, we think that this will spark a gradual recovery on our Oil Field business in 2010. We will address this further as we examine the outlook for the Oil Field division.

We’ve also seen a noticeable increase in both Oil Field and Power Transmission division quotation activities over the last six weeks or so which is a very positive sign. Encouragingly, the pumping unit order cancellations that plagued the Oil Field division during quarters one and two of this year have virtually stopped.

So while we’re not predicting a vigorous rebound in the near term, we are seeing some initial signs that the worst of this market cycle may be behind us.

Looking ahead in more detail at the Oil division, the recent improvement and stabilization in oil prices and the corresponding increase in the number of land drilling rigs at work may be an early indication of a modest ramp up in capital spending in the fourth quarter which will likely gain pace in the first quarter of next year if pre-prices are stable or on the rise.

Land drilling rigs for oil in North America have increased by almost a third over the past three months, although the number of rigs drilling for gas is up only about 3%. Fortunately, close to 60% of our Oil Field business is leveraged to oil, although depressed natural gas prices have certainly impacted our customers’ cash flow that’s available for oil drilling projects.

New bookings in the Oil Field division continued to improve from the low water mark in the first quarter of this year. New Oil Field bookings were $56.4 million which was an increase of 62% versus the second quarter and it was more than triple the level of the first quarter. This is certainly a very encouraging trend. 73% of third quarter Oil Field bookings were for U.S. projects and 27 % were international.

The quarter on quarter growth in new orders came mainly from Texas, California and the Southern Rockies. Internationally, Latin America and North Africa were up quarter on quarter. Canada was also up from the second quarter but still below historic levels.

This growth was actually slower than we had expected due to delays in finalizing several large international projects. However, we expect to book some of that business in the fourth quarter.

Price competition was more intense during the third quarter than the second quarter in the Oil Field division. We were able to largely offset this through a combination of lower material costs and better manufacturing performance, resulting from lean initiatives we launched last year and that we’ve talked about in previous calls. The division’s gross profit margin still declined 2.2% points.

Oil Field pumping revenue held up pretty well during the third quarter, up 2.4% quarter on quarter, but still down about 28% from the third quarter of last year. Automation was down 10% from the prior quarter mainly due to slow responses from the majors, but we expect the fourth quarter to be stronger for Automation revenue if commodity pricing and industry activity trends hold.

We have redoubled our focus on smaller accounts and we have seen positive results from that. We are continuing to focus on growing our business internationally by expanding the geographic reach of our traditional products as well as by introducing new and newly acquired products through our global network of offices.

In Latin America for example, we are working to develop a service and spare parts market in Columbia and in Brazil and Mexico, and we are working to expand our business levels in a range of products and services.

We believe that significant opportunities exist to expand the products acquired through international list systems in several international markets. Our service model can also be applied more widely in targeted international markets.

Domestically, we continue to upgrade our service center network. The new, more capable Bakersfield, California facility opened during the third quarter. Construction also began on a similar facility in Odessa, Texas which should be operational in the second half of 2010. In addition, we opened two smaller service centers in Utah and North Dakota.

Turning to Power Transmission, the division had a strong quarter for revenue and operating income, but new order intake continued to reflect the softer market conditions typified by 2009’s economic climate. Power Transmission bookings were $32.7 million which is down 24% quarter on quarter and year over year.

The bulk of the weakness was in bookings for international oil and gas projects. However, the majority of those projects are still active and we expect to book several of those in the fourth quarter. Our back log in Power Transmission now stands at $97.9 million versus $109 million at the end of the second quarter and $134 million at the end of the third quarter a year ago.

Viewed from an industry segment standpoint, the third quarter looked a lot like the second quarter with the strongest new order activity in oil and gas, refining and power generation, albeit at reduced levels from those seen in Q2 and with ongoing weakness in the marine, petrochemical, sugar, mining and steel industry segments.

In recent weeks however, we have experienced encouraging developments from selected segments. Several oil and gas projects have been booked and life appears to be returning to long delayed L&G construction projects.

We had a modest pick up in our gear repair business with new orders coming from sectors such as tire and rubber that have been depressed for most of the year. Several refining and petrochemical customers have scheduled maintenance turn arounds at regional plants which will benefit our field service and gear repair business.

It’s unclear when several of our core markets will return to the robust activities we saw in 2007 and 2008, but there are signs that spending on new equipment, repair and services is steadily increasing.

Looking at Q3 operational results, we saw an improvement in gross margin of 2.6% quarter over quarter and 1.2% year on year primarily due to a favorable mix of high margin products such as high speed units and parts. Margins were also favorably affected by 1, material price reductions achieved through our focus sourcing efforts, 2, efficiency gains and productivity improvements realized through the lean efforts in our factories and thirdly, the benefit of more capable machine tools acquired in our capital investment projects.

The declining volumes began to impact absorbed overhead starting in September. This reduction in volume will impact utilization rates and significantly erode margins for the division in the fourth quarter and will likely be an issue in the first quarter of next year. We are confronting this fall in revenue as a result of low booking activity in the first quarter of 2009 coupled with the fact that we were unable to fill available close in capacity in Q4 with new orders with short deliveries.

As we look ahead at the Power Transmission outlook, the timing of new projects booking in the fourth quarter will determine revenue performance in the second and third quarters of next year. If the projected bookings occur early in the fourth quarter, the engineering cycle and material procurement lead times will allow many of those projects to generate revenues in the second quarter of 2010. If the bookings occur later in the quarter, it will more likely generate revenue for the later part of the second or early third quarter.

The long term outlook for the Power Transmission division is bright as we expand our global coverage with sales and service resources that will improve our ability to support customers. In addition, we have a lot more scope to expand on the early benefits and efficiency gains that we’ve seen from lean initiatives in the division along with our intensified efforts to reduce material costs with sharper focus on sourcing. This combination will make the division even more competitive going forward.

We’re pursuing growth in our international business as we expand our sales resources in Europe and the Middle East. Summing up on Power Transmission, we are optimistic that the factors that have weighed on the timing of order placement are abating. Power Transmission will focus on booking core projects in the oil and gas sector along with industrial and infrastructure projects that are on the horizon.

In both Oil Field and Power Transmission, we will continue to look for acquisitions that will position us to be more a more competitive company for the long term and we have the strength on our balance sheet to pursue to upside opportunities presented by those.

We’re pleased with the two acquisitions we made this year, ILS in March and RMT in July. The integration process is going well for both ILS and RMT. We are beginning to see synergies between products and the Lufkin organization. We will continue to use Lufkin’s global organization and sales and service network to gain access to new markets for those products.

In addition to the two acquisitions we made this year, we continue to invest organically in our business. We expect CapEx excluding acquisitions to come in at $40 million to $45 million for the year. As mentioned previously, our capital spending was directed at three strategic goals; expanding our global footprint, reducing product costs and providing a platform for rolling out improved services.

While we recognize that the global markets are not out of the woods, it appears that confidence may be returning among the E&P companies and our industrial customers. In the absence of further economic dislocations, we believe the markets we serve will continue to strengthen at a gradual pace.

The recent IEA forecast for increasing demand for oil together with data from Asia suggesting that the economic recovery is gaining strength there support a more positive outlook for 2010.

Throughout 2009 however, we have positioned the company to remain competitive and profitable through this cycle. We made head count reductions in the first two quarters that we believe sized our capacity to fit the business levels of this reduced market.

While we maintain a strong balance sheet, we continue to invest in greater factory efficiencies and in training for our people. We are continuing to explore and invest in new international opportunities because we think those offer the greatest opportunity for profitable growth over the longer term.

Our objectives continue to be that we ensure our position to maximize the opportunities we are confident the company will have as the economic cycle gathers pace.

Now I will ask Chris to give you a more detailed review of Lufkin’s financial performance during the third quarter.

Christopher Boone

Good morning everyone. Before I get into the detail of the numbers, a quick footnote about the presentation of our financial statement. You’ll remember that we shut down our trailer business in the second quarter of 2008, but since we didn’t sell it, we will continue to refer to results from continuing operations in our discussions of quarterly results going forward. All of the results I’ll discuss this morning refer to results from continuing operations.

To quickly recap our financial results, net earnings were $5 million or $0.34 per diluted share. This represents a decline of 80% from the third quarter a year ago which was our second best quarter on record for earnings.

Total revenues for the third quarter were $117.7 million which is down 40% from a year ago. EBITDA from continuing operations for the third quarter was $12.4 million versus $43.2 million for the third quarter of ’08.

Looking at sales and gross margin by division starting with Oil Field, third quarter Oil Field revenues were $73.7 million which is down 50% from a year ago but down only about 1.5% from the second quarter.

Breaking Oil Field down by product line, $37.3 million came from new pumping units which is a decline of 60% from the third quarter of 2008. Pumping unit services contributed $19.9 million, down almost 28% from a year ago.

Automation contributed $9.9 million which is down 49% year over year. Commercial castings generated $2 million which is off by 73% from a year ago, and ILS which we acquired in early March of this year, contributed $4.7 million.

Comparing those same numbers to the second quarter of 2009, revenue from new pumping units declined 3.3%, pumping unit services revenue was up slightly, automation sales declined by 10.2%, foundry revenues increased by6 13.7% and ILS increased 10%.

Gross margin for the Oil Field division was 15% versus 28% a year ago and 17.2% in the second quarter. This decrease reflects lower prices in response to material price decreases and lower customer demand, plus the negative impact of lower plant utilization on fixed cost absorption. We expect gross margin in the fourth quarter to stay relatively flat versus the third quarter levels.

Turning to Power Transmission, revenue in the third quarter was $44 million which is down 8.5% from the third quarter a year ago and down 9.8% from the second quarter of this year. Looking at that total by product line, new units contributed $34 million, down 5.5% from the third quarter of last year and down 9.8% from the second quarter of this year.

Repair contributed $9.1 million which is down 24.5% versus the third quarter a year ago and down 14.6% from the second quarter of 2009. And RMT, which we acquired July 1 of this year, contributed almost $1 million.

Marine sales which you’ll probably recall was extremely strong last year, accounted for the biggest drop in Power Transmission revenues last quarter. Compared to a year ago, they were off by one third and versus the first quarter, they dropped 40% as shipyards slowed orders.

Gross margin in Power Transmission was 31.6% compared to 30.4% for the third quarter of last year and 29% in the second quarter of this year. This gross margin increase was the result of increased sales of high speed units versus lower margin marine units and repair jobs.

On a consolidated company wide basis, overall gross margin for the second quarter was 21.2% versus 28.6% in the third quarter of last year and 21.8% in the second quarter of 2009.

Looking at some of our individual expense items for the quarter, selling, general and administrative expenses were $17.6 million versus $17 million a year ago and $18.6 million in the second quarter. SG&A as a percentage of sales was 15.1% for the third quarter, basically flat versus the second quarter, but up from 8.7% a year ago when we had much higher levels of sales activity.

While we have cut factory labor this year, we’ve made the strategic decision to maintain employment levels in the sales organization and professional ranks to pursue international growth opportunities and product development. We expect SG&A expenses to remain in the $18 million to $19 million range for the fourth quarter.

Depreciation and amortization in the second quarter was $4.7 million, up from $3.9 million a year ago, primarily reflecting depreciation of intangible assets acquired as part of the ILS in the first quarter and RMT in the third quarter along with new machine tools we’ve added to our factories over the last year. We expect D&A in the fourth quarter to be about $5 million.

Turning to the balance sheet, as Jay mentioned a moment ago, we have maintained a very strong capital liquidity position despite the lower business activity levels we’re seeing in 2009. At the end of the third quarter we had $102.2 million of cash and cash equivalents which is up from $86.3 million at the end of the second quarter. This reflects additional draw down of trade receivables and better than expected decreases in inventory levels.

We spent $10.7 million in the third quarter on CapEx and we anticipate fourth quarter spending somewhere between $12 million and $17 million.

At September 30, we had long term debt of $2 million and current debt of $1.3 million on notes we assumed as part of the ILS acquisition. We continue to have access to the $40 million credit facility that extends through the end of next year. Excluding $17 million of outstanding letters of credit, we had $23 million of borrowing capacity available on that credit facility at September 30.

During the third quarter the company paid dividends of $3.7 million or $0.25 per share.

The third quarter net effective tax rate was 33.9% versus 35.8 a year ago. We benefited from adjustments in this quarter to prior period tax filings in the U.S. The tax rate for the fourth quarter is expected to be approximately 36%.

That concludes the financial overview, so I’ll turn it back to Jay.

John Glick

Operator, I think we’re ready for questions now.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from [William Eagen – Raymond James]

[William Eagen – Raymond James]

You talked about September being the strongest month for Oil Field inbound orders. Can you give us a sense of what’s happening during the different months of the quarter and maybe how October is looking so far?

John Glick

Let me start with how October is looking. We’re early days in October but we are seeing stronger U.S. demand. The first couple of weeks it was difficult to determine whether that’s a result of budgets being spent or a fundamental change in activity. But I think what we saw throughout quarter three, month to month, was just a steady increase really that began to gather pace I guess in mid August. And if you track oil prices, and the rig count, you can understand our bookings sort of follow both of those and we’re seeing that same thing continue as we begin quarter four.

[William Eagen – Raymond James]

And the for Power Transmission revenues, you’ve been averaging about $45 million per quarter. What do you think the quarterly run rate is over the next couple of quarters?

John Glick

It’s going to be down. I think we’re around $34 million for next quarter, so we’re going to be down pretty sharply quarter on quarter.

Operator

Your next question comes from Jeff Tillery – Tudor Pickering & Co.

Jeff Tillery – Tudor Pickering & Co.

On Power Transmission margin for the past couple of quarters has been very good. Obviously with volumes coming down, those will decline. Do you think margins on a gross margin basis can sustain the low twenties in the Q4, Q1 time frame or is that too optimistic?

John Glick

While Chris is looking for our estimate, the real issue on Power Transmission is the loss in utilization of shop.

Christopher Boone

Mid twenties should be a reasonable estimate at least for the fourth quarter.

Jeff Tillery – Tudor Pickering & Co.

With the increase of orders that you’ve seen in the U.S. and some of the international bookings that slipped from Q3 to Q4 and beyond, is it reasonable to think about the revenue in Oil Field to be kind of at least flat in Q4, or with the level in Q3, or do we see one last quarter of down take.

John Glick

I think we estimate revenue being up slightly in Q4. And again, we’re looking at kind of a gradual build from a low point in Q3 at this point.

Jeff Tillery – Tudor Pickering & Co.

With the increase in orders in the U.S., I would take it that you are seeing the inventories that the customers have maintained deplete enough to level where you expect that demand to be more representative of the kind of orders you see going forward. Is that fair?

John Glick

I think we’re not totally out of the woods on the overhang of inventory in the field, but I think the burn off rate is accelerating as the rig count goes up so I urge a little bit of caution. I don’t think we’re quite back to the ratio you’d expect between billing activity and our new order placements yet. But I think we’re gaining on that.

Operator

Your next question comes from [Neil Dingman – Wanderlake Securities]

[Neil Dingman – Wanderlake Securities]

On the pricing aspect, would you have to see, I guess two questions around pricing. One, is it sort of depends on what part of the segment we see a rise in the latter part of this year, early part of next year is going to help that, or would you have to see like the prior question, some of this inventory burned off to see pricing rebound much like activity.

John Glick

I think pricing, it really depends. If you’re talking about Oil Field for a second, it’s probably easier to explain this or answer this one in terms of the two divisions. For Oil Field, the pricing issue has a lot to do with the size of the units, the size of the operation in terms of big projects, typically can involve higher levels of discounting. Small units certainly are more competitive than some of the larger units.

To answer the question from their side, I think as we get more international opportunities and as the inventory levels subside in the field on the larger units, I think we’ll see margins maybe firming up a little bit. I think next year is still going to have a lot of competition on price, but I think we may see a little bit of relief there.

The big issue though for Oil Field in terms of margin is getting the activity levels up in the plant so we can get better utilization on the fixed assets in the foundry and in the oil field.

On Power Transmission, I think as we go forward, there will be more competition on price in some of the international markets we’re in, and the trick for us will be to get the volume up so that we get higher levels of utilization to support more competitive pricing in that division, and that’s the strategy we’ll be pursuing going forward.

[Neil Dingman – Wanderlake Securities]

Obviously you have a pretty nice cash position and you’ve obviously completed pretty nice acquisitions in the last year. So I was wondering number one what that acquisition market looks like and if you’re looking at things like [Downhold] Tools or if there’s certain areas that maybe appear more interesting than others.

John Glick

We’re looking at a range of issues when it comes to M&A some of which involve small bolt on, some of which involve technologies that we think have strong growth potential. It probably wouldn’t be appropriate to get into a lot of that now other than to say we continue to explore opportunities that get presented to us and we continue to seek out opportunities on our own in both divisions.

Operator

Your next question comes from Terese Fabian – Sidoti & Company.

Terese Fabian – Sidoti & Company

I have a question on the unit rod pump sales. Can you talk a little bit about what kind of competition you’re seeing? At one time you had said those units are a large factor or maybe units in China. Is this still a factor for you?

John Glick

The Chinese I think are active certainly on some of the smaller units. They’re I think a major player in Canada, less so in other parts of the world, but the Chinese are clearly out there and for projects that are very price sensitive where the purchase decision maybe is not based on long term ownership in the field or other factors, the Chinese maybe have a more positive reception than they do in the traditional areas.

We don’t see a lot of competition from used units. In fact we’ve talked about used units availability being fairly scarce still, and that’s a little bit of a surprise in this environment. But the Chinese are clearly out there. Price competition in general is pretty fierce in the small units particularly.

Terese Fabian – Sidoti & Company

This concerns the natural gas segment you still have, relatively a percentage of sales coming from there I guess in terms of your overall revenue. Can you talk about that?

John Glick

I’m not exactly sure how to respond to that. We still see activity there. The Barnett’s very quiet. That’s really been kind of a depressing element for ILS. However, we see Haynesville and other areas presenting opportunities on gas and again, ILS are participants in that as well as [inaudible].

But we see the gas market potentially improving as gas prices come back up. For us, one of the big issues is as gas prices improve, it will provide a source of revenue for the majors to fund other oil projects and we see that as a positive.

Terese Fabian – Sidoti & Company

On the international front, you mentioned looking at a number of areas. Can you talk about some specifics that you’re doing and where you’re seeing maybe a fuller range of growth opportunities? We know that a lot of the oil field service providers are looking at international markets. Can you address what you’re doing specifically?

John Glick

Really, every area of the world is under a pretty good study. We see Asia as having opportunities for us in both units and with our ILS product. We see Latin America, Brazil, Argentina, Chile, Columbia all as having growth possibilities for us in the next few years. We’re pursuing a lot of activity in all those countries to qualify products and position ourselves to take advantage of market movements on the upside there.

We think that the U.S. still has several areas that have very strong promise; hence our investments in expanding our service center networks here.

Terese Fabian – Sidoti & Company

Can you talk about how your CapEx spending divides between the Oil Field and the Power Transmission segment?

Christopher Boone

During the quarter it was still weighted more towards the Oil Field group, but during the second quarter it will still be probably weighted that way. But there are quite a few machine tools, again for Power Transmission in the fourth quarter. So there will be some, but we have a lot of facility work we’re doing in the service center and the automation area, will drive a lot of the CapEx both in the third quarter and will drive some of that in the fourth quarter.

So it will still follow generally sort of where you see the revenue. It’s not going to be exact but overall CapEx is generally going to follow general percentage of revenue.

John Glick

Chris is right. One thing that I guess I’d add is a lot of our expansion in facilities is really designed to serve both divisions so it makes the break out very difficult. Bakersfield for example, will support the Power Transmission product from the repair point of view as well as our service for Oil Field products out there. So the facility investments ought to be viewed as being shared between both divisions.

Terese Fabian – Sidoti & Company

You had at one time mentioned wind power turbines as being an area that you were going into or looking at. Are there any new developments on this area?

John Glick

I thought about putting something in the write up on that and I really decided I’d wait till we have a little more to report. But what I can tell you is we’re continuing to build out the organization to support our wind turbine efforts. We’ve completed some CapEx projects that are aimed at that product line, and we continue to work not only with some of the core accounts that we’ve mentioned in the past, but also new utility accounts.

So there are a number of areas underway and that’s a topic that I’d like to return to maybe in more depth in a future call.

Operator

There are no further questions at this time. Please continue with any closing comments you may have.

John Glick

I guess it remains for us to just close the call by saying that recapping the outlook; we are encouraged that things are beginning to turn around. We’re cautiously optimistic that oil prices appear to have stabilized in the $60 to $75 range and that the recent improvements in natural gas prices may signal a continued gradual growth and activity.

We know the next quarter is going to be challenging with sluggish revenues, ongoing pricing pressure and lower utilization rates. These factors will keep margins under pressure into the first half of 2010.

However, if the recovery in drilling activity continues, customer inventories will be drawn down and the pace of new orders will continue to increase. That should result in higher revenues starting in the second quarter of next year. We expect both an improved market environment and higher levels of activity for 2010 although the pace of that improvement is hard to gauge at this early stage of the recovery.

We are doing everything we can to remain competitive, efficient and to position the company for the eventual upswing. Thanks very much. We look forward to next quarter’s call.

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Source: Lufkin Industries Inc. Q3 2009 Earnings Call Transcript
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