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Executives

Jason L. Tienor – Chief Executive Officer

Gene Mushrush – Chief Financial Officer

Analysts

Bill Holland Davis – Empirical Asset Management LLC

Jim P. McIlree – Chardan Capital Markets LLC

Christopher G. Pearson – Davenport & Co. LLC

Mike D. Breard – Hodges Capital Management, Inc.

Telkonet, Inc. (OTCQB:TKOI) Q3 2013 Earnings Conference Call November 14, 2013 4:30 PM ET

Operator

Good afternoon and welcome to Telkonet’s Third Quarter 2013 Financial Results Conference Call and Webcast. As a reminder, today’s conference is being recorded.

Before I turn the call over to Telkonet management, I would like to read the following statement. Certain statements included in this conference call may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements involve a number of risks and uncertainties such as competitive factors, technological development, market demand and the company’s ability to obtain new contracts and accurately estimate net revenues due to variability in size, scope and duration of projects, and internal issues in the sponsoring client.

Further information on potential factors that could affect the company’s financial results, can be found in the company’s SEC financial filings including today’s 10-Q and on its reports on Form 8-K filed with the Securities and Exchange Commission. Telkonet is under no obligation to update items discussed today to reflect subsequent development.

And now, I would like to turn the conference over to Mr. Jason Tienor, Telkonet’s President and CEO. Mr. Tienor, you may begin.

Jason L. Tienor

Thank you, and welcome to Telkonet’s third quarter earnings call. Telkonet’s Chief Financial Officer, Gene Mushrush, will begin by providing a summary of the third quarter financial results. Gene?

Gene Mushrush

Thank you, Jason. Ladies and gentlemen, good afternoon and thank you for joining us. Today, I’ll be summarizing our third quarter and year-to-date financial performances. For the quarter ended September 30, 2013, revenues increased 7% to $3.5 million, compared to $3.3 million for the same period prior year, marking the sixth consecutive quarter where revenues surpassed the same period prior year. This despite a 20% decline in recurring revenues compared to the same period prior year.

We posted gross margins of $1.8 million for the quarters ended September 30, 2013 and 2012. The gross margin percentage of 51% remained on the low side of our historical range. A byproduct of higher installation cost, product mix and the aforementioned decline in recurring revenues, which captured a greater margin percentage versus non-recurring revenues. Operating expenses for the quarter ended September 30 were $1.9 million, compared to $1.3 million for the quarter ended September 30, 2012. Included in this quarter is the settlement accrual of $115,000 for the patent infringement lawsuit with Linksmart Wireless, which was executed on October 1. The remainder of the increase is attributable to sales and marketing costs associated with our revenue initiatives, incentive compensation and the effect of the sales tax liability reversal in the third quarter 2012.

During the quarter, 428 of the original 538 Series B redeemable preferred shares issued were converted to approximately 16.5 million shares of commons stock. As a result, fewer than 50% of the original shares issued will be outstanding from November 19, 2014, and per the agreement, those outstanding shares cannot be redeemed at the shareholders’ option. We incurred both operating and net losses of $174,000 and $480,000 for the three months ended September 30, 2013. We reported both operating and net incomes of $505,000 and $513,000 during the same period prior year. A non-cash charge of $293,000 was incurred during the current quarter related to the difference between goodwill amortization for tax purposes and the carrying value of goodwill for book.

We had a negative adjusted EBITDA, a non-GAAP measure, of $107,000 for the quarter and a positive adjusted EBITDA of $614,000 for the same period prior year. Current year-to-date revenues were $10.2 million, compared to $8.7 million last year, an 18% increase. Non-recurring revenues for high-speed Internet were up 85%, driven largely by new installations with Marriott International and wireless network upgrades at corporately owned Red Lion Hotels. Year-over-year non-recurring energy management revenues increased 7%. Our operating expenses increased 22% to $5.9 million for the first nine months of 2013, compared to $4.9 million for the same period prior year. The increase is attributable to sales and marketing costs associated with our revenue initiative, incentive compensation, fees related to the revolving line of credit and bad debt expense.

We incurred both operating and net losses of $1.2 and $1.5 million for the nine months ended September 30, 2013. Operating and net losses of $16,000 and $58,000 were incurred during the same period prior year. We had a year-to-date negative adjusted EBITDA $969,000 and a positive adjusted EBITDA of $401,000 for the nine months ended September 30, 2013 and 2012 respectively. We recorded $799,000 in cash and equivalents as of September 30, compared to $1.1 million at this time last year. In January 2013, $382,000 of operating cash was used as collateral to meet performance bond requirements related to two federally funded contracts. A smaller of the two contracts was completed by quarter end and the collateral recovery process has been initiated.

The larger contract remains outstanding and thus these monies will continue as restricted cash until an estimated early 2014. Cash provided by operations during the first nine months was a $158,000, compared to cash used in operations of $212,000 during the same period prior year. Our current ratio, a liquidity measurement of our ability to pay short-term obligations, slipped a tenth of a percentage point to 0.8 for the quarter. During the last nine months, our working capital decreased by $1.3 million. Our debt to equity ratio, a measurement of our financial leverage remained at 0.7 during the last three months.

During the quarter, we successfully executed and paid in full sales tax agreements in four states bringing the year-to-date total to nine and anticipate four more states will be resolved prior to year-end. The remaining states, including the four I just referenced, have an estimated accrued liability of $690,000, with an estimated settlement payment of $310,000. As always, thank you for your interest, and to our shareholders specifically, thank you for your continued support.

I’ll now turn the call back to Telkonet’s President and Chief Executive Officer, Jason Tienor.

Jason L. Tienor

Thank you, Gene. As you’ve heard, we continue to work diligently towards our goal of increasing shareholder value and believes important measurement in this regard, the year-over-year top line revenue growth. We also recognized that more than just top line sales growth is our path to faster expansion. Specifically, our goal is to generate both larger sales as well as repeatable sales as a result of strategic partnerships. This past quarter, we’ve had some success with respect to larger ESCO sponsored projects, including Kansas State University, the Federal Law Enforcement Training Facilities or FLETC, as Gene described earlier, and our Kentucky State Parks initiative. And in order to ensure repeatable sales, we’ve expanded strategic relationships and initiated several new partnerships with industry and international leaders such as Johnson Controls, Muresco, Trane, Control4 and others. Outside the ESCO space, our designation as an improved or endorsed provider for franchises including Hilton, [indiscernible], Marriott, Motel 6, Red Line and others, has positioned us favorably for expanding repeatable revenue streams within the hospitality states.

In order to avoid internal bottlenecks as we implement our growth strategy, we plan to increase our focus on channel and ESCO sales, which we are learning as a different skill set than one-off sales. While tangible results are taking longer than we’ve expected, even before this year’s end, we have compiled the largest backlog of projects waiting into a new year in Telkonet’s history. This backlog is a result of a number of things including the expansion of Telkonet’s focus from simply commercial retrofit environments to new build opportunities, and having our control specification endorsed and submitted to new projects by architects, developers and builders.

While this strategy will lead to larger project awards, these projects also have a longer deployment horizon due to construction timeframes. Our new product releases have also increased the size and scope of our projects such as the Seaport Hotel, where while the project has begun in Q4, it will not complete until Q1 2014. And one of our best and most active relationships is in the educational market, and unfortunately the majority of these projects are deployed during breaks such as holiday and summer, which is great for backlog and planning, but also limits our ability to pull these jobs forward on our installation timeline.

We are working with the same ESCO partners to increase growth and other markets still account for the seasonality. Because of this, while only three years ago, we carried no backlog into our New Year.

Last year, for the first time, we were able to begin the year with almost $1 million in orders to be filled and our progress this year has allowed us to triple that amount with a month and a half remaining prior to 2014, thinking more broadly about the last nine months.

as Gene mentioned, we’ve negotiated the expansion in orderly pay down of our pending short-term $700,000 Dynamic Ratings note, we’ve closed Telkonet’s first ever traditional revolving line up credit totaling $2 million and supporting our growth initiatives moving forward. We’ve seen over $1.3 million in preferred stock converted to common stock by our loyal Series B investors.

We continued to resolve our sales and use tax liability with all the 13 states filed in current. Relating on the responses from the submissions, the remaining states in order to proceed with the process and remove the remaining liability. We expect to be able to do so over the next year at a fraction of what we’re currently going forward.

And finally, we continued to recognize institutional and retail interest Telkonet fact and had worked throughout the year to engage via investor conferences, IR efforts and individual investor presentation. To some extent, our recent awards – the defense energy challenge technology award reflects the traction we’re getting in this regard.

Having said all this, I wanted to know that we are not content where we are – with where we are to-date. We’ve made significant investments in sales and marketing infrastructure and help own communication activities and return on investments has laid our expectations. We’ve recognized the need for more rapid gains and revenue and result in increases in profitability in order to drive shareholder value. Looking forward, this is where our efforts are fully focused and we expect to see increasing results.

We continue to appreciate your support at Telkonet and look forward to answering any questions you might have. Operator?

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, we will now be conducting a question-and-answer session. (Operator Instructions) Our first question is coming from the line of Mr. Bill Davis with Empirical Asset Management. Your line is now open; you may proceed with your question.

Bill Holland Davis – Empirical Asset Management LLC

Thank you. Hi, my name is Bill Davis, I’m actually open investor in Telkonet, I’m also Board Chair of the company and I don’t normally jump in on the Q&A session, but I actually just really wanted to jump in with a comment on and I will preface it by saying that I’ve been involved in the board for – I think about 3 to 3.5 years. I originally joined as a part of an effort to turn around the company from the condition it was in and I subsequently became Chair of the board.

So speaking from my thoughts actually and I would say for my fellow directors. I wanted to weigh in here and say that although, the board is happy on a number of levels with the progress that the company has made in cleaning up the balance sheet and also I think in creating a foundation to support growth. I want an echo what Jason said, which is that we are not particularly content either with their – with where we are with respect to revenue growth and increases in shareholder value and it might be actually more appropriate to say that we are restless.

And I think the reason for that is that the job of this organization and the management team and the board is to create shareholder value. I think we’ve made a lot of important investments in cleaning things up, but I think that this value has, the increase in value has really lagged a lot of the decision of the organization has made and to be clear, I think, the company is doing a very good job from a blocking and tackling standpoint, and Gene and Jason both alluded to a backlog and that’s certainly a leading indicator of future growth, but I think it’s important for shareholders and stakeholders to understand that we will continue to look at everything from our infrastructure to our internal resources to channel strategies in order to try and accelerate the pace of those.

And the last thing I want to say is that as a shareholder, first of all, this company has a lot of shareholders and some have been shareholders for a long time and some less long. And I think depending on how long you’ve been involved in the company at somewhat frames how you look at the progress in the company regardless of your state of intensiveness with where we are, I just wanted to reiterate that we can be better, I think that the organization is poised to do better and it’s something that we’re very, very focused on as we wrap up this year and begin next year.

So that’s it, thanks a lot. I’ll turn it back over to the operator.

Operator

Thank you. Our next question is coming from the line of Jim McIlree with from Chardan Capital. Your line is now open. You may proceed with your question.

Jim P. McIlree – Chardan Capital Markets LLC

Thanks, it’s Jim McIlree with Chardan Capital and good evening everyone. Can you help me understand a couple of things, the recurring revenue down year-over-year, I think in the Q you have said that there were some low margin renewals that you didn’t pursue and advertising impairment as well, can you talk about how much advertising is as a percent of the recurring revenues? And then on the low margin renewals that you decided to not pursue, is that reasonable to think that there are other low margin renewals that you won’t pursue in further quarters or has it kind of flushed out all of those? And then I have some other ones – other questions if you don’t mind?

Jason L. Tienor

Thank you, Jim. Absolutely, let’s [indiscernible] one at a time, Jim is actually looking up the percentage of the overall recurring revenue for U.S. as I respond to the second question, with regards to low margin recurring revenue, what we’ve seen happen throughout the year this year, is a cleaning up of what have been in our customer base thus far, as we’ve talked about previously. Well, we recognized a solid booking for recurring revenue, we also quarterly recognized write-off for bade debt and if you look at that number, that number has continued to decrease over the past couple of years. Largely, through this year through quarter-by-quarter simply because of cleaning up those recurring stats are very non-sensitive to service and to quality more so sensitive to price overall.

So we’ve gone through a comprehensive audit of our accounts and have been able to make significant progress proven by the fact that our DSO has been normalized and say that’s historically low levels for the entire course of this year and it’s at the second lowest that the DSO has ever been in our company’s history. So I can assure you that I believe we are currently at a space where anything from standardized support recurring revenue basis looking forward is on an increasing level. In response to your first question, with regards to where advertising was as a component of revenue last year….

Unidentified Company Representative

Is it Jim, right?

Jim P. McIlree – Chardan Capital Markets LLC

Yes.

Unidentified Company Representative

Jim, last year, advertising revenue year-to-date as of 9/30, accounted for about 6% of the recurring revenue number. This year, that’s down to 1% and a lot of that is driven by seasonal campaigns. I know in the past, there have been a number of campaigns that were initiated by a group called Nine, which had, I think, links to Google, so it is – it does fluctuate. Although, we are exploring ways in order to increase that number, purely not just from a revenue growth standpoint, but because of how profitable it is. There is very little resources that need to be devoted both on the front-end and during the course of the campaign from our standpoint.

Unidentified Company Representative

There is a lot of aggregation that takes place in the advertising field, especially that which used our hospitality channels over the last year, Jim. So we have had a lot of interest in our, what we call, inventory or the number of sessions available. Just recently, in fact, in the past month, we’ve seen a resurgence in interest in our inventory, so we definitely are picking up a little bit here at the end of the year and we hope to maintain those relationships moving forward.

Jim P. McIlree – Chardan Capital Markets LLC

Okay. And then on backlog, you mentioned that backlog has increased from about $1 million to about $3 million. Can you discuss over what time period that $3 million is expected to be delivered and can you segment it into whatever you feel comfortable segmenting it, energy management versus high-speed Internet or geographically or…

Unidentified Company Representative

Absolutely. Absolutely, and I’m going to try not to ramble on this while it’s a bit more of an in-depth explanation; the number that we spoke to and while we didn’t give an exact number, it gives you an idea of the size of the backlog. The backlog that we spoke to is the backlog proceeding into 2014. So that number itself doesn’t apply to what we’re completing here in the fourth quarter. It’s laying out, as we have said earlier this year, the fact, and as I said throughout my conversation, the fact that we are not able to set up engagements that have more of a long-term view.

Historically, we’ve been doing much smaller projects. We’ve been completing those smaller projects in a very near-term timeframe. So we haven’t had a lot of business and weren’t’ able to forecast a lot looking out 12, 18, 24 months. The nice part about the relationships that we have today is that we’re able to line up opportunities, new build engagements, new developments that our business for next year, so that we have a longer-term view on what our sales forecast looks like. So that amount of backlog we’re talking about is 2014 moving forward.

The segmentation that you described the split between HSIA and EcoSmart; that is all EcoSmart business. Our HSIA backlog, we try to maintain within a 30 to 45 day window. We use a lot of outside integration, if necessary, as the window starts to become longer than that. There’s a lot of competition in that market. So if we make our customers wait too long, they will move to other opportunities. So we try it in the near-term window, plus I will be able to give you a really good idea of what you would have for HSIA backlog beginning in 2014 and so right about starting tomorrow, does that make sense?

Jim P. McIlree – Chardan Capital Markets LLC

Yes, that’s very helpful, and that answers my questions purposely. Thank you very much and good luck with everything.

Unidentified Company Representative

You’re welcome. Thank you, Jim.

Operator

Thank you. Our next question is coming from the line of Mr. Bruce Pearson with Davenport & Company. Your line is now open. You may proceed with your question.

Christopher G. Pearson – Davenport & Co. LLC

Hey, guys. It’s actually Chris. Pearson. I didn’t change my name. Just a follow-up on the last question there, maybe asking a little bit differently. That wasn’t good color, maybe, putting us into a bit of a historical context, you said you started this year with about $1 million in backlog, if there’s any way you can give us a sense of how much of that you have taken down to this point?

Jason L. Tienor

All of that $1 million has been taken down, Chris. In fact, I want to say that all of that – if not, all of it, the majority of it was taken down prior to the end of the second quarter. If there was anything remaining, it would have been part of that flossy engagements that build over into third quarter.

Christopher G. Pearson – Davenport & Co. LLC

Okay, all right. Great, that’s helpful. And then quickly on the SG&A, you mentioned about $115,000 for any concern and a couple other one-time items in there. I guess that number went out materially, went from 30% of revenues to 44% or something like that. Could you help us understand how much of that is kind of a recurring increase and maybe where to expect SG&A as a percent of revenues going forward or maybe at a $1 level, I know you’re adding sales people and that’s good. We want to generate the revenue, but just wondering how to think about that in terms of a going forward basis?

Jason L. Tienor

Honestly, if I look back at the numbers, our SG&A has actually dropped over the last year at this time by 5%, and that’s something that Gene and I work on extensively, is monitoring where we’re at and where our expenditure is applied to. As you mentioned, one of the large hits to us in the third quarter was a litigation settlement over a wireless patent lawsuit of which, we were one of 13 co-defendants.

In the end, our much larger co-defendants decided that in order to resolve the action, which has been ongoing for roughly six years, it was cheaper to move through the settlement process, and obviously, whilst the majority of the litigation costs were sold by the larger co-defendants in order to move ahead with the process everybody needed to agree.

Thus we did. We’re able to negotiate a fairly agreeable settlement. In that, we have a 12-month payment timeframe to pay it out and it was the smallest settlement amount that any of the co-defendants. So we felt that it was in our best interest. It was far less than what our litigation costs were. We continued to clean up a lot of these things that existed before us, Chris.

One thing that Gene and I are very, very aware of is trying to make our company as mature and stable as possible. but we wanted to do so in light of knocking out each of these issues that have played that in the past and I think we’ve done a fairly good job in that. we continued to negotiate better terms with our vendors. We continued to bring on new customers who when moving through financial discussions, because of the ongoing concern, because of the state of our finances in the past, we still are able to win those engagements, because of that, we still look at the process that we’ve made or we’re making is suitable to achieve our long-term strategy.

Christopher G. Pearson – Davenport & Co. LLC

Okay. Thank you. I guess, just one more thing on that, and sorry to belabor it, I guess, maybe another way if you could – of the $500,000 increase, how much of that would be new sales people, additional costs that are actually kind of core to operations and will be sticking around?

Jason L. Tienor

Chris, the year-to-date delta as it pertains to human capital compared to last year is about $225,000 all-in that I would expect to continue to some degree.

Christopher G. Pearson – Davenport & Co. LLC

Okay.

Jason L. Tienor

That’s where we talked about that initial investment and those sales and marketing in order to drive revenue initiatives. The remainder of the amount that you’re talking about, Chris, it would be a one-time initiative that we’re moving through such as pay downs on DDAs, such as the settlements of the litigation, initiatives like that. So rather than – I can’t explain them specifically, I can definitely dig into each individual option of breaking down the amount and get back to you another few minutes.

Christopher G. Pearson – Davenport & Co. LLC

All right. No, that’s okay.

Jason L. Tienor

I mean, I just said that’s perfect. You don’t need spend any more time on it.

Gene Mushrush

All right.

Christopher G. Pearson – Davenport & Co. LLC

I guess the last thing that I wanted to ask about, I appreciate Bill’s comments at the beginning of the call, he alluded to some of these new channel strategies and how we’re constantly reviewing and thinking about our process and how we go to market. I mean, I guess it would be great to hear what some of the new strategies are what we’re kicking around, what can we do better and why are we confident that we can get a lot better from here?

Jason L. Tienor

Absolutely. I’ll keep it brief, but just as an explanation of the channel strategy, when you have eight internal individual sales people; you are quite limited with the number of conversations and the number of opportunities that you can become engaged and move towards a closer process and initiate the installation et cetera.

When you have the ability to convert those eight people to supporting 10 partners each, and each of those 10 partners has anywhere from five to 200 sales people each, obviously, then you see the size of the sales force that we are working for, that is the result of what we’ve done over the last year and a half.

Unfortunately, prior to that timeframe, it was difficult to engage in partners, because of Telkonet’s relative obscurity in the clean technology segments, in the energy management and energy controls markets. So having to get our products out there through direct sales, achieved success with our savings to be able to approve those through third-party measurements and verification, and then advertise those results to our partners in order to win credibility in this market was crucial.

Once having completed that, we were able to gain trust and credibility, move through the conversations with these partners about why our product is better than most that are on the market and engage with those partners at sales levels. If you take, for instance, one of our key relationships with Johnson Controls in the ESCO space and the educational market, we don’t have the ability to reach into universities that have long-term energy performance contracts in place with an existing ESCO.

For us to be able to do business in those markets, we have to do business through the ESCO that owns those ESP teams, because of the relationship that we have with Johnson, because of their inability over there, the lack of performance in the pharma space for performing in the administrative and executive space, it created a market opening for us to help fulfill the energy, the sustainability needs in those existing contracts, which we – they have taken us into and whom they continue to take us into in past, current and new customers moving forward.

The same being in hospitality, we’ve partnered with two very large PTEC manufacturers and HVAC control companies. Our ability to work through their sale force and that’s as domestically as we have in the past. but internationally with the limited internal resources that we have, it’s enormous for our capability to grow at a significant multiple of where we are today.

We’ll never be more than $1 million or $2 million growth company, if we continue to try to do so with only eight sales individuals, but by moving through channel sales strategies like we have, we’ve opened up a far margin potential audience for our products.

Christopher G. Pearson – Davenport & Co. LLC

Sorry, one more, does the $3 million backlog include the Motel 6 contract. Our backlog includes only those deals that we actually have paper on individual performance, so an actual project, an actual cost and actual installation. The Motel 6 engagement is a master contract, if you think of it as a hunting license; it gives us and only us, the ability to work with those properties as each properties move through a sustainability measure. They have not moved extensively through sustainability measures this year due to the acquisition by Blackstone and what Blackstone has done with that brand. We hope to see more progress with that next year, but none of that, is included in our backlog number. Our backlog is truly orders that remains to be fulfilled through 2014.

Christopher G. Pearson – Davenport & Co. LLC

Great. Thanks a lot.

Operator

Thank you. Our next question is coming from the line of Mike Breard with Hodges Capital. Your line is now open. You may proceed with your question.

Mike D. Breard – Hodges Capital Management, Inc.

I was wondering about your competition, are you seeing increased competition from older energy management companies, are you seeing new companies coming in with the significant expenditures?

Jason L. Tienor

That’s actually a very good question, Mike. Our largest competitor was actually acquired by a partner that we’d worked with in the past last year. We haven’t seen a lot of activity in their regard or as much activity as we’d seen in the past and a lot of that stems from the fact that we have the newest products on the market. It’s the most expensive product on the market and we continue to advance our product in the – we just received UL and SEC certification of our new plug loaded light switching devices, of which, they don’t have. This fact will now allows us to control, command and report on all the energy consumption in room in any of these environments that we work within military, education, hospitality commercial, public, housing.

When I answer the question with regards to competitivity in any of these markets, I typically have go into a much longer explanation, because there are different audiences and different products available to each of those markets, but specifically with hospitality, we don’t seen it growing. We see more grouping of opportunities under different companies. We see more M&A activity. We just don’t see a lot of new entrance into this space. On the other side, in some of the larger performance contract related industries, we see a lot of groups that are acquiring companies that fit this [indiscernible], as I mentioned, what we do for Johnson Controls, we fit the small mix of occupancy based spaces, we see a lot of other companies like Schneider Electric picking up a smaller player to fill that space as well.

Mike D. Breard – Hodges Capital Management, Inc.

Okay. Is there any possible opportunities out there for you to either merge with someone or to acquire someone?

Jason L. Tienor

There are always opportunities available from a mergers and acquisitions perspective. One of the things that the Board and management have always talked about is timing of those objectives. What’s going to be key for Telkonet in any of those conversations is recognizing potential both of our product and platform and recognizing the partner whom best benefits from that existing product and platform.

Mike D. Breard – Hodges Capital Management, Inc.

Okay. Thank you.

Jason L. Tienor

Thank you.

Gene Mushrush

Thank you.

Operator

Ladies and gentlemen, there are no further questions at this time. I would like to turn the call back over to management for any closing comments.

Jason L. Tienor

I’d again like to thank everybody for joining us here today for Telkonet’s 2013 third quarter earnings call. I’d especially like to Telkonet’s Chairman, Bill Davis, for joining and for his kind words. We look forward to speaking with you here as we wrap up the year and move into 2014 and the discussions ahead. I hope everybody has a great afternoon.

Operator

Ladies and gentlemen, this does conclude today’s teleconference. You may disconnect your lines at this time. Thank you very much for your participation and have a wonderful day.

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